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TheClassicalLong RunModel 1 2 TheClassicalLong RunModel EconomistssometimesdisagreewitheachotherActuallymuchmoreagreementexistsamongeconomiststhanthereappearstobeOncedistinctionbetweenlong runandshort runbecomesclearManyapparentdisagreementsamongmacroeconomistsdissolveIfnotimehorizonisspecified however aneconomistislikelytofocusonhorizonheorshefeelsismostimportantSomethingaboutwhicheconomistssometimesdodisagree 3 TheClassicalLong RunModel Ideally wewouldlikeoureconomytodowellinbothlong runandshort runUnfortunately thereisoftenatrade offbetweenthesetwogoalsDoingbetterinshort runcanrequiresomesacrificeoflong rungoals andviceversaPolicesthatcanhelpussmoothouteconomicfluctuationsmayproveharmfultogrowthinthelong runWhilepoliciesthatpromiseahighrateofgrowthmightrequireustoputupwithmoreseverefluctuationsinshort run 4 MacroeconomicModels ClassicalVersesKeynesian Classicalmodel developedbyeconomistsin19thandearly20thcenturies wasanattempttoexplainakeyobservationabouteconomyOverperiodsofseveralyearsorlonger economyperformsratherwellIfwethinkintermsofdecadesratherthanyearsorquarters businesscyclefadesinsignificanceIntheclassicalview thisbehaviorisnoaccidentPowerfulforcesareatworkthatdriveeconomytowardsfullemploymentAnimportantgroupofmacroeconomistscontinuestobelievethatclassicalmodelisusefuleveninshorterrunIn1936 inmidstofGreatDepression BritisheconomistJohnMaynardKeynesofferedanexplanationforeconomy spoorperformanceArguedthat whileclassicalmodelmightexplaineconomy soperationinlong run long runcouldbeaverylongtimeinarriving 5 MacroeconomicModels ClassicalVersesKeynesian Keynesianideasbecameincreasinglypopularinuniversitiesandgovernmentagenciesduring1940sand1950sBymid 1960s entireprofessionhadbeenwonoverMacroeconomicswasKeynesianeconomicsClassicalmodelwasremovedfromvirtuallyallintroductoryeconomicstextbooksClassicalmodelisstillimportantInrecentdecadestherehasbeenanactivecounterrevolutionagainstKeynes sapproachtounderstandingthemacroeconomyUsefulinunderstandingeconomyoverlong runWhileKeynes sideasandtheirfurtherdevelopmenthelpusunderstandeconomicfluctuations movementsinoutputarounditslong runtrendClassicalmodelhasprovenmoreusefulinexplainingthelong runtrenditself 6 AssumptionsoftheClassicalModel AllmodelsbeginwithassumptionsabouttheworldClassicalmodelisnoexceptionManyofitsassumptionsaresimplifyingMakemodelmoremanageable enablingustoseethebroadoutlinesofeconomicbehaviorwithoutgettinglostindetailsOneassumptioninclassicalviewthatgoesbeyondmeresimplificationMarketsclearPriceineverymarketwilladjustuntilquantitysuppliedandquantitydemandedareequal 7 AssumptionsoftheClassicalModel Market clearingassumptionprovideshintaboutwhyclassicalmodeldoesabetterjoboverlongertimeperiods severalyearsormore thanshorteronesWe lluseclassicalmodeltoansweravarietyofimportantquestionsabouteconomyinlong run suchasHowistotalemploymentdetermined Howmuchoutputwillweproduce Whatroledoestotalspendingplayintheeconomy Whathappenswhenthingschange 8 HowMuchOutputWillWeProduce Howcanwedisentanglewebofeconomicinteractionsweseearoundus Decidewhichmarketormarketsbestsuittheproblembeinganalyzed andIdentifybuyersandsellersIdentifytypeofenvironmentinwhichtheytradeButwhichmarketshouldwestartwith LogicalstartismarketforresourcesLabor landandnaturalresources capitalandentrepreneurshipWe llconcentrateourattentiononlaborOurquestionisHowmanyworkerswillbeemployedintheeconomy 9 Figure1 TheLaborMarket 10 TheLaborMarket LaborsupplycurveslopesupwardBecause aswagerateincreases moreandmoreindividualsarebetteroffworkingthannotworkingThus ariseinwagerateincreasesnumberofpeoplewhowanttowork tosupplytheirlaborAswagerateincreaseseachfirmwillfindthat tomaximizeprofit itshouldemployfewerworkersthanbeforeWhenallfirmsbehavethiswaytogetherariseinwageratewilldecreasequantityoflabordemandedThisiswhyeconomy slabordemandcurveslopesdownwardInclassicalview economyachievesfullemploymentonitsown 11 DeterminingtheEconomy sOutput Mosteffectivewaytomasteramacroeconomicmodelis divideandconquer Startwithpartofmodel understanditwell andthenaddinotherpartsAccordingly ourclassicalanalysisofeconomyisdividedintotwoseparatequestionsWhatwouldbethelong runequilibriumoftheeconomyiftherewereaconstantstateoftechnologyAndifquantitiesofallresourcesbesideslaborwerefixed Whathappenstothislong runequilibriumwhentechnologyandquantitiesofotherresourceschange 12 TheProductionFunction RelationshipbetweentotalemploymentandtotalproductionintheeconomyGivenbyeconomy saggregateproductionfunctionShowstotaloutputeconomycanproducewithdifferentquantitiesoflaborGivenconstantamountsofotherresourcesandcurrentstateoftechnologyInclassical long runvieweconomyreachesitspotentialoutputautomaticallyAnimportantconclusionofclassicalmodelandanimportantcharacteristicoftheeconomyinlong runOutputtendstowarditspotential full employmentlevelonitsown withnoneedforgovernmenttosteertheeconomytowardit 13 Figure2 OutputDeterminationintheClassicalModel 14 TheRoleofSpending Whatifbusinessfirmsareunabletosellalloutputproducedbyafullyemployedlaborforce EconomywouldnotbeabletosustainfullemploymentforverylongIfweareassertingthatpotentialoutputisanequilibriumfortheeconomyHadbetterbesurethattotalspendingonoutputisequaltototalproductionduringtheyearButcanwebesureofthis Inclassicalviewanswerisyes 15 TotalSpendinginaVerySimpleEconomy ImagineaworldwithjusttwotypesofeconomicunitsHouseholdsandbusinessfirmsCircularFlowAdiagramthatshowshowgoods resources anddollarpaymentsflowbetweenhouseholdsandfirmsInasimpleeconomywithjusthouseholdsandfirmsinwhichhouseholdsspendalloftheirincomeTotalspendingmustbeequaltototaloutputKnownasSay sLaw 16 Figure3 TheCircularFlow 17 TotalSpendinginaVerySimpleEconomy Say sLawnamedafterclassicaleconomistJeanBaptisteSay 1767 1832 whopopularizedtheideaInSay sownwords Aproductisnosoonercreatedthanit fromthatinstant affordsamarketforotherproductstothefullextentofitsownvalue Thus themerecircumstanceofthecreationofoneproductimmediatelyopensaventforotherproducts Say slawstatesthatbyproducinggoodsandservicesFirmscreateatotaldemandforgoodsandservicesequaltowhattheyhaveproducedorSupplycreatesitsowndemand 18 TotalSpendinginaMoreRealisticEconomy DoesSay slawalsoapplyinamorerealisticeconomy IntherealworldHouseholdsdon tspendalltheirincomeRather someoftheirincomeissavedorgoestopaytaxesHouseholdsarenottheonlyspendersintheeconomyBusinessesandgovernmentbuysomeofthefinalgoodsandservicesweproduceInadditiontomarketsforgoodsandresources thereisalsoaloanablefundsmarketWherehouseholdsavingismadeavailabletoborrowersinbusinessorgovernmentsectors 19 SomeNewMacroeconomicVariables Plannedinvestmentspending IP overaperiodoftimeistotalinvestmentspending I minuschangeininventoriesovertheperiodIP I inventoriesNettaxes T aretotalgovernmenttaxrevenueminusgovernmenttransferpaymentsT totaltaxrevenue transfersHouseholdsaving S It softenusefultoarriveathouseholdsavingintwostepsDeterminehowmuchincomehouseholdsectorhasleftafterpaymentofnettaxesHouseholdsector sdisposableincomeDisposableIncome TotalIncome NetTaxesPartthatisnotspentisdefinedassaving S S DisposableIncome CTotalSpendinginClassicaInClassica totalspendingissumofpurchasesmadebyhouseholdsector C businesssector IP andgovernmentsector G Totalspending C IP G 2020 1 15 20 21 SomeNewMacroeconomicVariables SavingandnettaxesarecalledleakagesoutofspendingAmountofincomethathouseholdsreceive butdonotspendTherearealsoinjections spendingfromsourcesotherthanhouseholdsAgovernment spurchasesofgoodsandservicesPlannedinvestmentspending IP TotalspendingwillequaltotaloutputifandonlyiftotalleakagesintheeconomyareequaltototalinjectionsOnlyifsumofsavingandnettaxesisequaltosumofplannedinvestmentspendingandgovernmentpurchases 22 Figure4 LeakagesandInjections 23 TheLoanableFundsMarket WherehouseholdsmaketheirsavingavailabletothosewhoneedadditionalfundsTotalsupplyofloanablefundsisequaltohouseholdsavingFundssuppliedareloanedout andhouseholdsreceiveinterestpaymentsonthesefundsBusinesses demandforloanablefundsisequaltotheirplannedinvestmentspendingFundsobtainedareborrowed andfirmspayinterestontheirloansBudgetdeficitExcessofgovernmentpurchasesovernettaxesBudgetofsurplusExcessofnettaxesovergovernmentpurchasesWhengovernmentpurchasesofgoodsandservices G aregreaterthannettaxes T GovernmentrunsabudgetdeficitequaltoG TWhengovernmentpurchasesofgoodsandservices G arelessthannettaxes T GovernmentrunsabudgetsurplusequaltoT G 24 TheSupplyofFundsCurve SinceinterestisrewardforsavingandsupplyingfundstofinancialmarketRiseininterestrateincreasesquantityoffundssupplied householdsaving whileadropininterestratedecreasesitSupplyoffundscurveIndicateslevelofhouseholdsavingatvariousinterestratesQuantityoffundssuppliedtothefinancialmarketdependspositivelyoninterestrateThisiswhythesaving orsupplyoffunds curveslopesupwardOtherthingscanaffectsavingsbesidestheinterestrate includingTaxratesExpectationsaboutthefutureGeneralwillingnessofhouseholdstopostponeconsumption 25 Figure5 SupplyofHouseholdLoanableFunds 26 TheDemandforFundsCurve WheninterestratefallsinvestmentspendingandthebusinessborrowingneededtofinanceitriseBusinessdemandforfundscurveslopesdownwardWhataboutgovernment sdemandforfunds Willit too beinfluencedbytheinterestrate ProbablynotverymuchGovernmentseemstobecushionedfromcost benefitconsiderationsthathauntbusinessdecisionsAnycompanypresidentwhoignoredinterestratesindecidinghowmuchtoborrowwouldbequicklyoutofajobU S presidentsandlegislatorshaveoftendonesowithlittlepoliticalcostGovernmentsector sdeficitanditsdemandforfundsareindependentofinterestrateAsinterestratedecreasesquantityoffundsdemandedbybusinessfirmsincreasesWhilequantitydemandedbygovernmentremainsunchangedTherefore totalquantityoffundsdemandedrises 27 Figure6 BusinessDemandforLoanableFunds 28 Figure7 TheDemandforFunds 29 EquilibriumintheLoanableFundsMarket InclassicalviewloanablefundsmarketisassumedtoclearInterestratewillriseorfalluntilquantitiesoffundssuppliedanddemandedareequalCanwebesurethatalloutputproducedatfullemploymentwillbepurchased 30 Figure8 LoanableFundsMarketEquilibrium 31 TheLoanableFundsMarketandSay sLaw Aslongasloanablefundsmarketclears Say slawholdsTotalspendingequalstotaloutputThisistrueeveninamorerealisticeconomywithsaving taxes investmentandgovernmentdeficitHere sanotherwaytoseethesameresult intermsofasimpleequationLoanablefundsmarketclears S IP G T RearrangingthisequationbymovingTtoleftsideLoanablefundsmarketclears S T IP GSay slawshowsthattotalvalueofspendingineconomywillequaltotalvalueofoutputRulesoutageneraloverproductionorunderproductionofgoodsintheeconomyItdoesnotpromiseusthateachfirmwillbeabletosellalloftheparticulargooditproduces 32 Figure9 AnExpandedCircularFlow 33 TheClassicalModel ASummary BeganwithacriticalassumptionAllmarketsclearInclassicalmodel governmentneedn tworryaboutemploymentEconomywillachievefullemploymentonitsownInclassicalmodel governmentneedn tworryabouttotalspendingEconomywillgeneratejustenoughspendingonitsowntobuyoutputthatafullyemployedlaborforceproduces 34 UsingtheTheory FiscalPolicyintheClassicalModel Couldgovernmentincreaseeconomy stotalemploymentandtotaloutputbyraisingtotalspending TwoideasforincreasingspendingcometomindGovernmentcouldsimplypurchasemoreoutputitselfMoregoods liketanksandpolicecars ormoreservices likethoseprovidedbyhighschoolteachersandjudgesGovernmentcouldcutnettaxes lettinghouseholdskeepmoreoftheirincomeSotheywouldspendmoreonfood clothing furniture newcars andsoonFiscalpolicyisachangei