The Classical Long-Run Model

1
The Classical Long-Run Model

• Economists sometimes disagree with each other
• Actually much more agreement exists among
  economists than there appears to be
• Once distinction between long-run and short-run
  becomes clear
• Many apparent disagreements among macroeconomists
  dissolve
• If no time horizon is specified, however, an
  economist is likely to focus on horizon he or she
  feels is most important
• Something about which economists sometimes do
  disagree

2
The Classical Long-Run Model

• Ideally, we would like our economy to do well in
  both long-run and short-run
• Unfortunately, there is often a trade-off between
  these two goals
• Doing better in short-run can require some
  sacrifice of long-run goals, and vice versa
• Policies that can help us smooth out economic
  fluctuations may prove harmful to growth in the
  long-run
• While policies that promise a high rate of growth
  might require us to put up with more severe
  fluctuations in short-run

3
Macroeconomic Models Classical Verses Keynesian

• Classical model, developed by economists in 19th
  and early 20th centuries, was an attempt to
  explain a key observation about economy
• Over periods of several years or longer, economy
  performs rather well
• If we think in terms of decades rather than years
  or quarters, business cycle fades in significance
  
• In the classical view, this behavior is no
  accident
• Powerful forces are at work that drive economy
  towards full employment
• An important group of macroeconomists continues
  to believe that classical model is useful even in
  shorter run
• In 1936, in midst of Great Depression, British
  economist John Maynard Keynes offered an
  explanation for economys poor performance
• Argued that, while classical model might explain
  economys operation in long-run, long-run could
  be a very long time in arriving

4
Macroeconomic Models Classical Verses Keynesian

• Keynesian ideas became increasingly popular in
  universities and government agencies during 1940s
  and 1950s
• By mid-1960s, entire profession had been won over
• Macroeconomics was Keynesian economics
• Classical model was removed from virtually all
  introductory economics textbooks
• Classical model is still important
• In recent decades there has been an active
  counterrevolution against Keyness approach to
  understanding the macroeconomy
• Useful in understanding economy over long-run
• While Keyness ideas and their further
  development help us understand economic
  fluctuationsmovements in output around its
  long-run trend
• Classical model has proven more useful in
  explaining the long-run trend itself

5
Assumptions of the Classical Model

• All models begin with assumptions about the world
• Classical model is no exception
• Many of its assumptions are simplifying
• Make model more manageable, enabling us to see
  the broad outlines of economic behavior without
  getting lost in details
• One assumption in classical view that goes beyond
  mere simplification-critical assumption
• Markets clear
• Price in every market will adjust until quantity
  supplied and quantity demanded are equal

6
Assumptions of the Classical Model

• Market-clearing assumption provides hint about
  why classical model does a better job over longer
  time periods (several years or more) than shorter
  ones
• Well use classical model to answer a variety of
  important questions about economy in long-run,
  such as
• 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?

7
How Much Output Will We Produce?

• How can we disentangle web of economic
  interactions we see around us?
• Decide which market or markets best suit the
  problem being analyzed, and
• Identify buyers and sellers
• Identify type of environment in which they trade
• But which market should we start with?
• Logical start is market for resources
• Labor, land and natural resources, capital and
  entrepreneurship
• Well concentrate our attention on labor
• Our question is
• How many workers will be employed in the economy?

8
Figure 1 The Labor Market
LS
B
A
E
H
J
10
Excess Demand for Labor
LD
100 million Full Employment
9
The Labor Market

• Labor supply curve slopes upward
• Becauseas wage rate increasesmore and more
  individuals are better off working than not
  working
• Thus, a rise in wage rate increases number of
  people who want to workto supply their labor
• As wage rate increases each firm will find
  thatto maximize profitit should employ fewer
  workers than before
• When all firms behave this way together a rise in
  wage rate will decrease quantity of labor
  demanded
• This is why economys labor demand curve slopes
  downward
• In classical view, economy achieves full
  employment on its own

10
Determining the Economys Output

• Most effective way to master a macroeconomic
  model is divide and conquer
• Start with part of model, understand it well, and
  then add in other parts
• Accordingly, our classical analysis of economy is
  divided into two separate questions
• What would be the long-run equilibrium of the
  economy if there were a constant state of
  technology
• And if quantities of all resources besides labor
  were fixed?
• What happens to this long-run equilibrium when
  technology and quantities of other resources
  change?

11
The Production Function

• Relationship between total employment and total
  production in the economy
• Given by economys aggregate production function
• Shows total output economy can produce with
  different quantities of labor
• Given constant amounts of other resources and
  current state of technology
• In classical, long-run view economy reaches its
  potential output automatically
• An important conclusion of classical model and an
  important characteristic of the economy in
  long-run
• Output tends toward its potential,
  full-employment level on its own, with no need
  for government to steer the economy toward it

12
Figure 2 Output Determination in the Classical
Model
LS
15
LD
100 million
Aggregate Production Function
7 Trillion Full Employment Output
100 million
13
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 since business firms
  will not continue to employ workers who produce
  output that is not being sold
• If we are asserting that potential output is an
  equilibrium for the economy
• Had better be sure that total spending on output
  is equal to total production during the year
• But can we be sure of this?
• In classical view answer is yes

14
Total Spending in a Very Simple Economy

• Imagine a world with just two types of economic
  units
• Households and business firms
• Circular Flow
• A diagram that shows how goods, resources, and
  dollar payments flow between households and firms
• In a simple economy with just households and
  firms in which households spend all of their
  income without saving it or paying tax
• Total spending must be equal to total output
• Known as Says Law

15
Figure 3 The Circular Flow
Goods and Services Demanded
Resources Supplied
Total Consumption Spending
Total Income
Total Revenue of Firms
Total Factor Payments
Goods and Services Supplied
Resources Demanded
16
Total Spending in a Very Simple Economy

• Says Law named after classical economist Jean
  Baptiste Say (1767-1832), who popularized the
  idea
• Each time a god or service is produced, an equal
  amount of income is created, For example,
• each time a shirt manufacturer produces a
  25 shirt, it creates 25 in factor payments to
  households.
• In Says own words
• A product is no sooner created than it, from
  that instant, affords a market for other products
  to the full extent of its own valueThus, the
  mere circumstance of the creation of one product
  immediately opens a vent for other products
• Says law states that by producing goods and
  services
• Firms create a total demand for goods and
  services equal to what they have produced or more
  simply
• Supply creates its own demand

17
Total Spending in a More Realistic Economy

• Does Says law also apply in a more realistic
  economy?
• In the real world
• Households dont spend all their income
• Rather, some of their income is saved or goes to
  pay 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 saving is made available to
  borrowers in business or government sectors

18
Some New Macroeconomic Variables

• Planned investment spending (IP) over a period of
  time is total investment spending (I) minus
  change in inventories over the period
• IP I ? inventories
• Net taxes (T) are total government tax revenue
  minus government transfer payments (unemployment
  insurance, welfare payments, Social Security
  benefits)
• T total tax revenue transfers
• Household saving (S)
• Its often useful to arrive at household saving
  in two steps
• Determine how much income household sector has
  left after payment of net taxes
• Household sectors disposable income
• Disposable Income Total Income Net Taxes
• Part that is not spent is defined as (household)
  saving (S)
• S Disposable Income C

19
Some New Macroeconomic Variables

• Total Spending in Classica
• In Classica, total spending is sum of purchases
  made by household sector (C), business sector
  (IP), and government sector (G)
• Total spending C IP G
• Saving and net taxes are called leakages out of
  spending
• Amount of income that households receive, but do
  not spend
• There are also injectionsspending from sources
  other than households
• A governments purchases of goods and services
• Planned investment spending (IP)
• Total spending will equal total output if and
  only if total leakages in the economy are equal
  to total injections
• Only if sum of saving and net taxes is equal to
  sum of planned investment spending and government
  purchases

20
Flows in the Economy of Classica
Total Output (GDP) 7 trillion
Total Income 7 trillion
Consumption Spending (C) 4 trillion
Planned Investment Spending (Ip) 1 trillion
Government Purchases (G) 2 trillion
Net Taxes (T) 1.25 trillion
Household Saving (S) 1.75 trillion
21
Figure 4 Leakages and Injections
Leakages
Injections

22
The Loanable Funds Market

• Where households make their saving available to
  those who need additional funds
• Total supply of loanable funds is equal to
  household saving
• Funds supplied are loaned out, and households
  receive interest payments on these funds (if the
  funds are provided through stock market then?)
• Businesses demand for loanable funds is equal to
  their planned investment spending
• Funds obtained are borrowed, and firms pay
  interest on their loans
• Budget deficit
• Excess of government purchases over net taxes
• Budget surplus
• Excess of net taxes over government purchases
• When government purchases of goods and services
  (G) are greater than net taxes (T)
• Government runs a budget deficit equal to G T
• When government purchases of goods and services
  (G) are less than net taxes (T)
• Government runs a budget surplus equal to T - G

23
The Loanable Funds Market

• When the government runs a budget deficit, its
  demand for loanable funds is equal to its
  deficit. The funds are borrowed, and government
  pays interest on its loans.
• View of the loanable funds market
• The supply of funds is household saving
• The demand for funds is the sum of the business
  sectors planned investment spending and the
  government sectors budget deficit, if any.

24
The Supply of Funds Curve

• Since interest is reward for saving and supplying
  funds to financial market
• Rise in interest rate increases quantity of funds
  supplied (household saving), while a drop in
  interest rate decreases it
• Supply of funds curve
• Indicates level of household saving at various
  interest rates
• Quantity of funds supplied to the financial
  market depends positively on interest rate
• This is why the saving, or supply of funds, curve
  slopes upward
• Other things can affect savings besides the
  interest rate, including
• Tax rates
• Expectations about the future
• General willingness of households to postpone
  consumption

25
Figure 5 Supply of Household Loanable Funds
Saving (S) or Supply of Funds
B
5
A
3
1.5
1.75
26
The Demand for Funds Curve

• When interest rate falls investment spending and
  the business borrowing needed to finance it rise
• Business demand for funds curve slopes downward
• What about governments demand for funds?
• Will it, too, be influenced by the interest rate?
• Probably not very much
• Government seems to be cushioned from
  cost-benefit considerations that haunt business
  decisions
• Any company president who ignored interest rates
  in deciding how much to borrow would be quickly
  out of a job
• U.S. presidents and legislators have often done
  so with little political cost
• Government sectors deficit and its demand for
  funds are independent of interest rate
• As interest rate decreases quantity of funds
  demanded by business firms increases
• While quantity demanded by government remains
  unchanged
• Therefore, total quantity of funds demanded rises

27
Figure 6 Business Demand for Loanable Funds
A
5
B
3
Planned Investment (IP) or Business Demand for
Funds
1.5
1.0
28
Figure 7 The Demand for Funds
29
Equilibrium in the Loanable Funds Market

• In classical view loanable funds market is
  assumed to clear
• Interest rate will rise or fall until quantities
  of funds supplied and demanded are equal
• Can we be sure that all output produced at full
  employment will be purchased?

30
Figure 8 Loanable Funds Market Equilibrium
Total Supply of Funds (S)
5
E
Total Demand for Funds IP (G T)
1.75
31
The Loanable Funds Market and Says Law

• As long as loanable funds market clears, Says
  law holds
• Total spending equals total output
• This is true even in a more realistic economy
  with saving, taxes, investment and government
  deficit
• Heres another way to see the same result, in
  terms of a simple equation
• Loanable funds market clears ? S IP (G T)
• Rearranging this equation by moving T to left
  side
• Loanable funds market clears ? S T IP G
• Says law shows that total value of spending in
  economy will equal total value of output
• Rules out a general overproduction or
  underproduction of goods in the economy
• It does not promise us that each firm will be
  able to sell all of the particular good it
  produces

32
Figure 9 An Expanded Circular Flow
1.75 Trillion
1.0 Trillion
0.75 Trillion
1.25 Trillion
33
The Classical Model A Summary

• Began with a critical assumption
• All markets clear
• In classical model, government neednt worry
  about employment
• Economy will achieve full employment on its own
• In classical model, government neednt worry
  about total spending
• Economy will generate just enough spending on its
  own to buy output that a fully employed labor
  force produces

34
Using the Theory Fiscal Policy in the Classical
Model

• Could government increase economys total
  employment and total output by raising total
  spending? Seems like an idea that should work?
  ..business firms might hire more workers and
  produce more?
• Two ideas for increasing spending come to mind
• Government could simply purchase more output
  itself
• More goods, like tanks and police cars, or more
  services, like those provided by high school
  teachers and judges
• Government could cut net taxes, letting
  households keep more of their income
• So they would spend more on food, clothing,
  furniture, new cars, and so on

35
Fiscal policy in the CM

• Fiscal policy is a change in government purchases
  or in net taxes
• Designed to change total spending in the economy
  and thereby influence levels of employment and
  output
• Idea behind fiscal policy sounds sensible enough
• But does it work?
• Not if economy behaves according to classical
  model
• Fiscal policy in classical model is completely
  ineffective. It cant change total output or
  total employment
• It cant even change total spending
• Moreover Fiscal policy is unnecessary (?)
• since the economy achieves and sustains full
  employment on its own

36
Using the Theory Fiscal Policy With A Budget
Deficit

• What would happen if the government of
  Classicawhich is running a deficitattempted to
  increase employment and output by increasing
  government purchases
• Crowding out is a decline in one sectors
  spending caused by an increase in some other
  sectors spending
• In classical model a rise in government purchases
  completely crowds out private sector spending so
  total spending remains unchanged
• In classical model, an increase in government
  purchases has no impact on total spending and no
  impact on total output or total employment
• Opposite sequence of events would happen if
  government purchases decreased
• Total spending and total output would remain
  unchanged

37
Figure 10 Crowding Out With An Initial Budget
Deficit
Total Supply of Funds (S)
7
B
D IP
A
C
H
5
DC
D2
D1
1.75
2.05
2.25
38
Fiscal Policy With A Budget Surplus

• Total spending remains unchanged, and fiscal
  policy is completely ineffective
• Same conclusion we reached about fiscal policy
  with a government budget deficit
• Our exploration of fiscal policy shows us that,
  in long-run
• Government efforts to change total output by
  changing government spending or taxes are
  unnecessary and ineffective

39
Figure 11 Crowding Out With An Initial Budget
Surplus
S2
S1
B
7
DIP
H
C
5
A
DC
Business Demand for funds (IP)
1.25
1.55
1.75