Lecture Notes for February 21 through February 26, 2001

Chapters 7 and 8

Classical Long Run Model

Economists think of two basic time frames:

Short Run:

Long run:

Issue: What “time frame” is the best one?

The choice of short run or long run depends on the question you seek to answer

Disagreements among economists

Example: the captain sailing the North Atlantic

Classical Model versus the Keynesian Model

Classical Model:

· Developed in 19^th and early 20^th centuries

· Long run perspective

· Tendency to full employment

Keynesian Model

· Great Depression occurs: Classical Model questioned

· 1936 Keynes’ General Theory of Employment, Interest, and Money published:

“In the long run we are all dead.”

· Supplants classical model in the 1960s

Classical Model Today

· Counter revolution to Keynes’ approach illuminated by studying the Classical Model

· Model is useful for its long run insights

Classical Model: a LONG RUN view

Assumptions

· Markets clear: prices in every market adjust until quantity demanded equals quantity supplied

o LR perspective: in many markets prices are not free to fluctuate in the SR

o Classical Model focuses on real variables

· In Classical Model there is a market for every good and for every resource

· No wasted resources

· In studying the model the focus will be on the aggregate labor market

Aggregate Labor Market

• Labor Demand Curve: indicates how many workers firms will want to hire at various wage rates: downward sloping
• Labor Supply Curve: indicates how many people will want to work at various wage rates: upward sloping

• Labor Market clears at the equilibrium wage
• *****In the Classical Model since all markets clear we know that at the equilibrium wage the quantity supplied of labor equals the quantity demanded of labor
• IN THE CLASSICAL MODEL, THE ECONOMY ACHIEVES FULL EMPLOYMENT ON ITS OWN
• What does this imply about cyclical unemployment?

• What does this imply about frictional unemployment?

• What does this imply about structural unemployment?

If we are at F.E. in the labor market, what will be total output in the economy? Total output for the economy will depend on how much labor can produce: labor productivity is a function of

1. Amount of other resources (land and capital)

2. State of technology

In the Classical Model we treat (1) and (2) as fixed.

Consider the following:

What is the total level of output for the economy if resources and technology are fixed?

· Given a fixed amount of land, capital and technology

· Given that the labor market clears

· Total production will depend on the aggregate production function: the aggregate production function shows the relationship between the total level of output an economy can produce with different quantities of labor, holding constant the amount of land, capital and the state of technology

· Ouput initially increases at an increasing rate, but eventually output increases at a decreasing rate: Why?

Put labor market and aggregate production function together:

IN CLASSICAL MODEL (LONG RUN VIEW): THE ECONOMY REACHES FULL EMPLOYMENT AUTOMATICALLY

The Classical Model requires that total spending on output equal the total dollar value of output for a given time period. Let’s consider this statement from a simple situation and then from a more complicated situation.

Simple Situation:

The Circular Flow Model of the Economy suggests that total spending will equal total production.

· Say’s Law (1767-1832): Supply creates its own demand

· Say’s Law is critical to the Classical Model: in Classical Model all markets clear including resource markets: this implies that the economy will be at F.E.

· Say’s Law says firms in the aggregate can sell their output and that F.E. will be maintained

Complicated Model:

• HH spend, pay taxes and save
• HH, businesses, and government buy goods and services
• HH saving is made available to business and government borrowers through loanable funds market

In the complicated model, does Say’s Law still hold true? Yes.

Let’s represent the above differently:

Taxes = net taxes = total taxes – transfer payments

Treatment of transfer payments

Y = C + S + T

Where Y = total income

C = consumption spending

S = Saving

T = net taxes

Can rewrite this as

S = Y – T – C

Leakages:

· Definition:

· Examples:

Injections:

· Definition

· Examples:

Pictorial Representation of these concepts:

• Total spending will equal total output if and only if
• LEAKAGES = INJECTIONS
• Or,

S + T + M = G + I + X

********THIS WILL BE AUTOMATICALLY ASSURED IN THE CLASSICAL LR VIEW****

To see this, let’s look at the Loanable Funds Market:

Loanable Funds Market: the market whereby households make their saving available to borrowers.

Once households pay their taxes and do their consumption, then leftover funds can

1. Go into bank

2. Buy bonds or shares of stock

3. Buy variety of other assets

All of these options lead to funds entering the Loanable Funds Market

Demanders of funds: businesses and government

• Government demands funds when G>T or when spending>revenue
• Deficit = G – T
• Interest rate decreases result in investment increases
• Government borrowing to finance the deficit appears independent of the interest rate

• Total demand for funds is the horizontal summation of business demand for funds and government demand for funds

Suppliers of funds:

• Supply of funds curve is upward sloping: if interest rates increase, the quantity of funds supplied increases
• Determinants of the supply of funds
• Interest rate
• Tax rates
• Expectations about the future
• General willingness of households to postpone consumption

Equilibrium in the loanable funds market:

S = I + G – T

Supply of funds = Demand for funds

Or,

S + T = I + G

Leakages = Injections

With market clearing in the loanable funds market we get Leakages = Injections, that is to say Say’s Law holds even in the more complicated model.

Say’s Law: it is possible to have excess supplies in some markets as long as they are balanced by excess demands in other markets…but, in the LR markets do clear in the Classical Model.

Money and Prices in the Classical Model:

Thus far the focus has been on

· Employment F.E. output

· Loanable funds: equilibrium interest rate

· Leakages = injections in equilibrium

What about prices?

Classical Theory about price level is called the Quantity Theory of Money

Quantity Theory of Money: LR price level depends on the supply of money

· Need to know the demand and supply of money

· Price level will adjust until

o Supply of money = demand for money

o Supply of money approximately = to total value of coins and bills in circulation

o Supply of money controlled by the government

o Demand for money: demand money in order to make transactions easier

o Demand for money = kPY

o PY = nominal output = nominal income

o K = ratio of money to income that people desires

Example:

Summarize Classical Model:

1. Assume all markets clear

2. In labor market: result in full employment output

3. In loanable funds market: leakages = injections so total spending = total output

4. Price level determined by condition for monetary equilibrium

Can government do anything to stimulate the economy in the long run Classical Model

• Demand Management Policy: government policies designed to change the level of spending in the economy
• Demand Management Policies in Classical View are ineffective and unnecessary

Demand Management Policies:

1. Fiscal Policy: change in government purchases or net taxes designed to change total spending and total output

Example:

Example: Crowding Out occurs when an increase in government spending leads to a reduction in investment spending (hence, investment spending is crowded out)

***In Classical Model, an increase in G completely crowds out private sector spending

so total spending remains unchanged.

2. Monetary Policy: manipulation of the money supply to achieve some macroeconomic goal

Example:

An increase in the money supply will not affect real output and real wages

Classical Dichotomy: Classical view that real variables and nominal variables are determined independently: that is, monetary policy can affect price level and nominal variables like nominal wages and nominal output, but it cannot affect real variables like real wages and real output.

BOTH MONETARY AND FISCAL POLICY ARE INEFFECTIVE POLICY TOOLS IN THE CLASSICAL MODEL

So, what SHOULD the government do to help manage the macroeconomy in the long run?