1. The Classical Long-Run Model © 2003 South-Western/Thomson Learning

2. Macroeconomic Models: Classical Versus Keynesian Classical Model A macroeconomic model that explains the long-run behavior of the economy, assuming that all markets clear

3. Macroeconomic Models: Classical Versus Keynesian Keynesian Model Keynes and his followers argued that, while the classical model might explain the economy’s operation in the long run, the long run could be a very long time in arriving. In the meantime, production could be stuck below its potential.

4. Macroeconomic Models: Classical Versus Keynesian Keynes’s ideas and their further development help us understand economic fluctuations - movements in output around its long-run trend - the classical model has proven more useful in explaining the long-run trend itself.

5. Assumptions of the Classical Model A critical assumption in the classical model is that markets clear: The price in every market will adjust until quantity supplied and quantity demanded are equal.

6. Important Questions About the Economy in the Long Run How is total employment determined?How is total employment determined? How much output will we produce?How much output will we produce? What role does total spending play in the economy?What role does total spending play in the economy? What happens when things change?What happens when things change?

7. Important Questions About the Economy in the Long Run The classical model: focus on real variables - real GDPreal GDP real wagereal wage real saving, and so onreal saving, and so on

8. How Much Output Will We Produce? The Labor MarketThe Labor Market Determining the Economy’s OutputDetermining the Economy’s Output

9. The Labor Market 100 million = Full Employment Number of Workers Real Hourly Wage $20 15 10 H E J B A L D Excess Demand for Labor Excess Supply of Labor L S

10. Determining the Economy’s Output Aggregate Production Function The relationship showing how much total output can be produced with different quantities of labor, with land, capital, and technology held constant

11. Determining the Economy’s Output aa a 100 million Number of Workers Real Hourly Wage $15 L S L D In the labor market, the demand and supply curves intersect to determine employment of 100 million workers. 100 million Number of Workers Output (Dollars) $7 Trillion = Full Employment Output Aggregate Production Function The production function shows that–with given amounts of capital and land and the current state of technology– those 100 million workers can produce $7 trillion of real GDP.

12. Determining the Economy’s Output In the classical long-run view, the economy reaches its potential output automatically.

13. Total Spending in a Very Simple Economy Circular Flow A diagram that shows how goods, resources, and dollar payments flow between households and firms

14. Circular Flow Households Firms Goods Markets Factor Markets Goods and Services Purchased $Consumption Spending $Income Resources Sold $Firm Revenues $Factor Payments Goods and Services Sold Resources Purchased

15. Total Spending in a Very Simple Economy 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.

16. Total Spending in a Very Simple Economy Say’s Law The idea that total spending will be sufficient to purchase the total output produced.

17. Total Spending in a More Realistic Economy In the real world: Households don’t spend all their incomeHouseholds don’t spend all their income Households are not the only spenders in the economyHouseholds are not the only spenders in the economy There is a market for loanable fundsThere is a market for loanable funds

18. Total Spending in a More Realistic Economy Net Taxes Government tax revenues minus transfer payments T = Total taxes – Transfer payments

19. Total Spending in a More Realistic Economy (Household) Saving The portion of after-tax income that households do not spend on consumption goods S = Y – T – C

20. Leakages and Injections Leakages Income earned, but not spent, by households during a given year Injections Spending from sources other than households Planned Investment Spending Business purchases of plant and equipment Business purchases of plant and equipment

21. Leakages and Injections Total spending will equal total output if - and only if - total leakages in the economy are equal to total injections. That is, only if the sum of saving and net taxes is equal to the sum of investment spending and government purchases.

22. Leakages and Injections

23. The Loanable Funds Market Loanable Funds Market Arrangements through which households make their saving available to borrowers

24. Loanable Funds Market When G > T, the government runs a budget deficit equal to G – T When G < T, the government runs a budget surplus equal to T – G

25. The Loanable Funds Market Loanable funds market: The supply of funds is the sum of household saving and the government’s budget surplus, if any.The supply of funds is the sum of household saving and the government’s budget surplus, if any. The demand for funds is the sum of the business sector’s planned investment spending and the government sector’s budget deficit, if any. The demand for funds is the sum of the business sector’s planned investment spending and the government sector’s budget deficit, if any.

26. The Supply of Funds Curve Supply of Funds Curve Indicates the level of household saving at various interest rates. The quantity of funds supplied to the financial market depends positively on the interest rate, so the saving, or supply of funds, curve slopes upward.

27. The Supply of Funds Curve aa a 1.5Trillions of Dollars Interest Rate 5% 3% A Saving = Supply of Funds 1.75 B As the interest rate rises, saving or the quantity of loanable funds supplied increases.

28. The Demand for Funds Curve Investment Demand Curve When the interest rate falls, investment spending and the business borrowing needed to finance it rise, so the investment demand curve slopes downward.

29. The Demand for Funds Curve aa a 1.5Trillions of Dollars Interest Rate 5% 3% A Investment Demand 1.0 B As the interest rate falls, business firms demand more loanable funds for investment projects.

30. The Demand for Funds Curve Government Demand for Funds Curve Indicates the amount of government borrowing at various interest rates Total Demand for Funds Curve Indicates the total amount of borrowing at various interest rates

31. The Demand for Funds Curve aa a Trillions of Dollars Interest Rate 5% 3% A Government Demand for Funds 0.75 B Trillions of Dollars A Business Demand for Funds 1.0 B 1.5 Trillions of Dollars A Total Demand for Funds B 1.752.25 (a)(b)(c) 5% 3% 5% 3% Summing the government’s demand for loanable funds... and business firms’ demand for loanable funds at each interest rate... gives us the economy’s total demand for loanable funds at each interest rate.

32. Equilibrium in the Loanable Funds Market In the classical view, the loanable funds market -like all other markets - is assumed to clear: The interest rate will rise or fall until the quantities of funds supplied and demanded are equal.

33. Equilibrium in the Loanable Funds Market 1.75Trillions of Dollars Interest Rate 5% E Total Supply of Funds (Saving) Total Demand for Funds (Investment + Deficit)

34. The Loanable Funds Market and Say’s Law As long as the loanable funds market clears, Say’s law holds even in a more realistic economy with saving, taxes, investment, and a government deficit.

35. The Loanable Funds Market and Say’s Law The interest rate will adjust until and when the loanable funds market clears

36. The Classical Model: Conclusions The economy will achieve and sustain potential output on its own. We need never worry about there being too little or too much spending; Say’s law assures us that total spending is always just right to purchase the economy’s total output.

37. Fiscal Policy in the Classical Model Fiscal Policy A change in government purchases or net taxes designed to change total spending and total output In the classical view, fiscal policy is ineffective and unnecessary.

38. Fiscal Policy with a Budget Deficit Crowding Out A decline in one sector’s spending caused by an increase in another sector’s spending Complete Crowding Out A dollar-for-dollar decline in one sector’s spending caused by an increase in another sector’s spending

39. Fiscal Policy with a Budget Deficit a aaa 1.75 Funds($Trillions) Interest Rate 7% 5% 2.052.25 Total Supply of Funds (Saving) D 2 = I p + G 2 – T 1 D 1 = I p + G– T B A H C  C  I

40. Fiscal Policy with a Budget Surplus a aa S 2 = Savings + T – G 2 S 1 = Savings + T – G 1 1.75 Funds ($ Trillions) Interest Rate 7% 5% 1.25 1.55 D = Planned Investment B A HC