1. The Classical Long-Run Model

2. Classical Model
A macroeconomic model that explains the long-run behavior of the economy.
Classical model was developed by economists in 19th and early 20th, to explain a key observation about economy.
Over periods of several years or longer, economy performs rather well
In the classical view, economy operates at full employment in the long run.

3. Assumption of the Classical Model
Markets clear
Price in every market will adjust until quantity supplied and quantity demanded are equal
Markets might not be clear in the short-run, but if we wait long enough, eventually, the change in price will equate demand with supply.

4. The Classical Model
We’ll use classical model to answer important questions about economy in the long-run, such as
How does economy achieve full employment?
How much output can we produce?
How does economy operate on its own?

5. The Labor Market

6. Output Determination in the Classical Model

7. Full Employment Output
In the classical or long-run view, economy reaches its potential output automatically
Output reaches its potential, full-employment level on its own, with no need for government to maneuver the economy toward it.

8. The Role of Spending
What if business firms are unable to sell all output produced by a fully employed labor force?
Economy would not be able to sustain full employment for very long
If we are asserting that potential output is an equilibrium for the economy
Total spending on output has to be equal to total production during the year
Can we be sure of this?
In classical view, the answer is YES

9. Total Spending in a Very Simple Economy
Imagine a world with just two types of economic units
Households and business firms
In a simple economy with just households and firms in which households spend all of their income
Total spending must be equal to total output
Known as Say’s Law

10. The Circular Flow

11. Total Spending in a Very Simple Economy
Say’s Law named after classical economist Jean Baptiste Say ( ), who popularized the idea
Say’s law states that by producing goods and services
Firms create a total demand for goods and services equal to what they have produced or
Supply creates its own demand

12. Total Spending in a More Realistic Economy
In the real world
Households don’t spend all their income
Saving & taxes
Households are not the only spenders in the economy
Businesses and government buy some of the final goods and services we produce
In addition to markets for goods and resources, there is also a loanable funds market
Where household’s saving is made available to borrowers in business or government sectors

13. Some New Macroeconomic Variables
Planned investment spending (IP)
IP = I – Δ inventories
Net taxes (T)
T = total tax revenue – transfers
Household saving (S)
Household sector’s disposable income
Disposable Income = Total Income – Net Taxes
S = Disposable Income – C
Total Spending
Total spending = C + IP + G

14. Leakages and Injections

15. Loanable Funds Market Equilibrium

16. An Expanded Circular Flow

17. The Classical Model: A Summary
Began with a critical assumption
All markets clear
In classical model, government needn’t worry about employment.
Economy will achieve full employment on its own.
In classical model, government needn’t worry about total spending.
Economy will generate just enough spending on its own to buy output that a fully employed labor force produces.