Principles of Macroeconomics Chapter 8 The Classical Long Run Model Vocabulary rates 1 Budget Surplus the excess of net taxes over government purchases 2 Supply of Funds Curve indicates the level of household saving at various interest 3 Total Demand for Funds Curve indicates the total amount of borrowing at various interest rates 4 Aggregate Production Function the relationship showing how much total output can be produced with different quantities of labor when quantities of all other resources and technology are held constant 5 Say s Law the idea that total pending will be sufficient to purchase the total 6 Planned Investment Spending business purchases of plant and equipment 7 Household Saving the portion of after tax income that households do not spend 8 Loanable Funds Market the market in which savers make their funds available to 9 Complete Crowding Out a dollar for dollar decline in one sector s spending caused by an increase in some other sector s spending 10 Budget Deficit the excess of government purchases over net taxes 11 Fiscal Policy a change in government purchases or net taxes designed to change 12 Labor Supply Curve indicates how many people will want to work at various real output produced on consumption borrowers total output wage rates 13 Crowding out a decline in one sector s spending caused by an increase in some 14 Government s Demand for Funds Curve indicates the amount of government 15 Labor Demand Curve indicates how many workers firms will want to hire at other sector s spending borrowing at various interest rates various real wage rates 16 Injections spending on a country s output from sources other than its households 17 Demand Side Effects macroeconomic policy effects on total output that work 18 Business Demand for Funds Curve indicates the level of investment spending through changes in total spending firms plan on various interest rates 19 Markets Clear adjustment of prices until quantities supplied and demanded are 20 Net Taxes government tax revenues minus transfer payments 21 Classical Model a macroeconomic model that explains the long run behavior of 22 Disposable Income household income minus net taxes which is either spent or 23 Leakages income earned by households that they do not spend on the country s output during a given year equal the economy saved Notes Introduction Long run growth of potential output Short run economic fluctuations business cycles Macroeconomic Models Classical Vs Keynesian Introduction The classical model developed by economists in the 19th and early 20th centuries was an attempt to explain a key observation about the economy Over periods of several years the economy operates close to its potential output o Questioned during the Great Depression U S Real GDP 1820 2010 o Plotted with a logarithmic scale equal vertical distances represent equal percentage changes rather than equal absolute changes Keynesian view While the classical model might explain the economy s operation in the long run the long run could be a very long time in arriving In the meantime production is stuck below its potential Why the Classical Model Is Important Reason 1 Over the last several decades there has been an active counterrevolution against Keynes s approach to understanding the macroeconomy Many of the counterrevolutionary new theories are based on classic ideas Reason 2 It remains the best model for understand the economy over the long run Keynes s ideas and their further development help us understand economic fluctuations movements in output around its long run trend But the classical model has proven more useful in explaining the long run trend itself Assumptions of the Classical Model A critical assumption in the classical model is that markets clear The price in every market will adjust until quantity supplied and quantity demanded are equal Keep in mind Variables used in the classical model are expressed in dollars such as the wage rate or total output Variables are real rather than nominal they are measured in dollars of constant purchasing power How Much Output Will We Produce The Labor Market For labor households supply labor and firms demand it Labor Supply o Aggregate Labor Supply curve LS tells us how many people in the country will want to work at each wage rate o The labor supply curve slopes upward because as the wage rate increases more and more individuals decide they are better off working than not working Thus a rise in the wage rate increases the number of people in the economy who want to work to supply their labor Labor Demand o Aggregate Labor Demand curve D shows the number of workers a firm will want to hire at any real wage o Diminishing returns to Labor the rise in output and the revenue the firm gets from selling it gets smaller and smaller with each successive worker Why does this happen As we keep adding workers further gains from specialization are harder to achieve o A firm will want to keep hiring additional workers as long as they add to the firm s profit that is as long as they add more to revenue than they add to cost o As the wage rate increases each firm in the economy will find that to maximize profit it should employ fewer workers than before When all firms behave this way together a rise in the wage rate will decrease the quantity of labor demanded in the economy Equilibrium Total Employment o The real wage adjusts until the quantities of labor supplied and demanded are equal o In the classical model the economy achieves full employment on its own Full employment the number of workers that firms want to hire number of people who want jobs No cyclical unemployment From Employment to Output two things How much output real GDP will workers produce The answer depends on o 1 The amount of other resources available for labor to use o 2 The state of technology Focus 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 The Production Function o The aggregate production function or just production function shows the total amount the economy can produce with different quantities of labor given constant amounts of other resources and the current state of technology The declining slope of the aggregate production function is the result of diminishing returns to labor o In the classical long run view the economy reaches its potential output Equilibrium Real GDP automatically The Role of Spending Total
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