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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, powerful forces drive economy towards full employment

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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 equalize demand and supply.

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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 will we produce?– What role is played by total spending?

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Full Employment

• Our first question is– How many workers will be employed in the

economy?

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Figure 1: The Labor Market

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The Labor Market

• Labor supply curve slopes upward As wage rate goes up, the opportunity cost of not working

increases, so people are more willing to provide more labor

• Labor demand curve slopes downward As wage rate goes up, the labor cost to firms increases, so

firms tend to employ fewer workers than before

• In classical view, economy achieves full employment on its own

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Determining the Economy’s Output

• The Production Function

Relationship between total employment and total production in the economy

Given that the amount of other resources and current state of technology are fixed

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Figure 2: 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 Say’s Law

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Figure 3: The Circular Flow

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Total Spending in a Very Simple Economy

• Say’s Law named after classical economist Jean Baptiste Say (1767-1832), 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

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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

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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 TaxesS = Disposable Income – C

• Total Spending • Total spending = C + IP + G

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Figure 4: Leakages and Injections

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The Loanable Funds Market

• Where households make their saving available to those who need additional funds

• Supply of loanable funds – household saving

• Demand of loanable funds – businesses and government

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The Loanable Funds Market

• Businesses’ demand for loanable funds is equal to their planned investment spending– Funds obtained are borrowed, and firms pay interest on

their loans

• Government’s demand for loanable funds– Budget deficit (G – T)

Excess of government purchases over net taxes

• Government’s supply for loanable funds– Budget surplus (T – G)

Excess of net taxes over government purchases

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Figure 5: Supply of Household Loanable Funds

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Figure 6: Business Demand for Loanable Funds

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Figure 7: The Demand for Funds

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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?

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Figure 8: Loanable Funds Market Equilibrium

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Figure 9: 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 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