The Classical

Long-Run Model

2003 South-Western/Thomson Learning

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

Macroeconomic Models:
Classical Versus Keynesian
Keynesian Model
Keynes and his followers argued that, while
the classical model might explain the
economys 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.

Macroeconomic Models:
Classical Versus Keynesian
Keyness 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.

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.

Important Questions About the

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

Important Questions About the

Economy in the Long Run
The classical model: focus on real
variables real GDP
real wage
real saving, and so on

How Much Output

Will We Produce?
The Labor Market
Determining the Economys Output

The Labor Market

Real
Hourly
Wage

LS

$20

15

10

Excess Supply
of Labor
B

J
Excess Demand
for Labor
100 million =
Full Employment

LD
Number
of Workers

Determining the Economys

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

Determining the Economys

Output
The production function shows
thatwith given amounts of capital and
land and the current state of technology
those 100 million workers can produce
$7 trillion of real GDP.

Real
Hourly
Wage

LS

Output
(Dollars)

Aggregate
Production
Function

$7 Trillion
= Full
Employment
Output

$15

LD

In the labor market, the

demand and supply curves intersect
to determine employment of
100 million workers.

100
million

Number
of Workers

100
million

Number
of Workers

Determining the Economys

Output
In the classical long-run view, the
economy reaches its potential
output automatically.

Total Spending in a Very

Simple Economy
Circular Flow
A diagram that shows how goods,
resources, and dollar payments flow
between households and firms

Circular Flow
Goods
and
Services
Purchased

Households
Resources
Sold
$Consumption
Spending

$Income

Goods
Markets

Goods
and
Services
Sold

Factor
Markets

$Firm
Revenues

$Factor
Payments

Firms

Resources
Purchased

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.

Total Spending in a Very

Simple Economy
Says Law
The idea that total spending will be
sufficient to purchase the total output
produced.

Total Spending in a More

Realistic Economy
In the real world:
Households dont spend all their
income
Households are not the only spenders
in the economy
There is a market for loanable funds

Total Spending in a More

Realistic Economy
Net Taxes
Government tax revenues minus transfer
payments
T = Total taxes Transfer payments

Total Spending in a More

Realistic Economy
(Household) Saving
The portion of after-tax income that
households do not spend on
consumption goods

S=YTC

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

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.

Leakages and Injections

es
Leakag
25
T ($1.
)
Trillion
75
S ($1.
)
Trillion

Injectio
ns
G ($2
Trillion)
I ($1
Trillion
)
P

G
($2 Trillion)
IP
($1 Trillion)

$7
Trillion

$7
Trillion
C
($4 Trillion)

Total
Output

Total
Income

C
($4 Trillion)

Total
Spending

The Loanable Funds Market

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

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

The Loanable Funds Market

Loanable funds market:
The supply of funds is the sum of
household saving and the governments
budget surplus, if any.
The demand for funds is the sum of the
business sectors planned investment
spending and the government sectors
budget deficit, if any.

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.

The Supply of Funds Curve

Interest
Rate

As the interest
rate rises, saving or the
quantity of loanable
funds supplied increases.

5%

3%

Saving = Supply
of Funds

1.5 1.75

Trillions
of Dollars

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.

The Demand for Funds Curve

As the interest rate falls,
business firms demand more
loanable funds for investment
projects.

Interest
Rate
5%

3%

Investment Demand

1.0

1.5

Trillions
of Dollars

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

The Demand for Funds Curve

Interest
Rate

5%

3%

Summing the governments

demand for loanable funds
...

and business firms demand

for loanable funds at each
interest rate...

(a)

(b)

5%

1.0
Trillions
of Dollars

Total Demand
for Funds
5%

3%

0.75

(c)

Business Demand
for Funds

Government Demand
for Funds
B

gives us the economys

total demand for loanable
funds at each interest rate.

1.5
Trillions
of Dollars

3%

1.75

2.25
Trillions
of Dollars

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.

Equilibrium in the Loanable

Funds Market
Interest
Rate

5%

Total Supply of
Funds (Saving)
E

Total Demand
for Funds
(Investment + Deficit)
1.75

Trillions
of Dollars

The Loanable Funds Market

and Says Law
As long as the loanable funds market
clears, Says law holds even in a more
realistic economy with saving, taxes,
investment, and a government deficit.

The Loanable Funds Market

and Says Law
The interest rate will adjust until

Quantity of
funds supplied

= 1P + G T
Quantity of funds
demanded

and when the loanable funds market

clears
P
=
S+ T 1 + G
Leakages

Injections

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;
Says law assures us that total spending is
always just right to purchase the economys
total output.

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.

Fiscal Policy with a Budget

Deficit
Crowding Out
A decline in one sectors spending caused by
an increase in another sectors spending
Complete Crowding Out
A dollar-for-dollar decline in one sectors
spending caused by an increase in another
sectors spending

Fiscal Policy with a Budget

Deficit
Interest
R a te

Total Supply
of Funds
(Saving)

7%

B
A

5%

I
H

C
D2 =
Ip + G2 T
D1 =
Ip + G1 T
1.75 2.05 2.25

Funds ($Trillions)

Fiscal Policy with a Budget

Surplus
Interest
Rate

S2 = Savings + T G 2
S1 = Savings + T G1
B

7%

5%

D = Planned Investment
Funds ($ Trillions)
1.25

1.75
1.55