The Classical Long-Run Model

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• The Classical Long-Run Model

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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.

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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.

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The Classical Model

• Well 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?

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The Labor Market
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Output Determination in the Classical Model
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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.

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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

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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 Says Law

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The Circular Flow
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Total Spending in a Very Simple Economy

• Says Law named after classical economist Jean
  Baptiste Say (1767-1832), who popularized the
  idea
• 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
• Supply creates its own demand

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Total Spending in a More Realistic Economy

• In the real world
• Households dont 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 households saving is made available to
  borrowers in business or government sectors

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Some New Macroeconomic Variables

• Planned investment spending (IP)
• IP I ? inventories
• Net taxes (T)
• T total tax revenue transfers
• Household saving (S)
• Household sectors disposable income
• Disposable Income Total Income Net Taxes
• S Disposable Income C
• Total Spending
• Total spending C IP G

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Leakages and Injections
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Loanable Funds Market Equilibrium
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An Expanded Circular Flow
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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.