10 2 12 ch 8 The Classical Model Tuesday October 02 2012 11 10 AM Classical model A The Classical model Long run Optimistic model Critical assumption Markets clear a b c i B Classical equilibrium 1 2 Starts in labor market Labor supply 1 2 The price in any market adjusts until quantity supplied and quantity demands is equal Law of supply and demand a Workers care about their real wage purchasing power of their wage i ii W P Wage over price level b Labor supply curve i Upward curving 3 Labor Demand a b By firms who care about real wage Labor demand curve i Downward sloping 4 Equilibrium a b c Intersection of demand and supply curve Unemployment happens if real wage is too high Equilibrium is also Lfe full employment of people who should be working i Explanation for Unemployment C 1 2 3 Unemployment caused by real wage too high In free market the wage would come down Therefore government fault D 1 a b Min wage Labor Union Classical view of output Variables a b c d e L of workers K capital stock R land and natural resources E entrepreneurialship Y output Real GDP 2 3 4 5 Variables can be combined for output E R K Fixed for the year L determines economy for the year Model a Upward curve i Upward but lower slope each time 1 Diminishing return to labor b c L and Y Aggregate Production function 6 To explain a Two graphs i W P and L 1 Gives the full level of employment Lfe Drag down to lower graph a Lecture Notes Page 1 a Drag down to lower graph ii Y and L 1 Y will then be Yfe a b Full output that the economy should be producing Potential output iii 2 b But just because output should be that much what if no one wants to buy i In Classical Model everyone always will E Spending in a very simple Economy 1 Total Output will by factor payments create equal amount of total income then everyone spends income so spending Is equal amount 3 4 Businesses by producing output also create a demand for goods and services Say s Law a b Total spending will equal total output Supply creates its own demand F Spending in more realistic Economy Assume closed economy 1 Lecture Notes Page 2 1 2 3 Assume closed economy Government collects taxes and purchases goods and services New Variables a Planned Investment Spending I p Spending decision makers only want to do Exclude unintended inventory changes in our model exclude all b Net Tax Revenue T T tax revenue transfer payments c Disposable Income Total income net taxes T d Household Saving S Disposable income C consumption spending e Total Spending in more realistic i Total Spending C I p G Again say s law holds Total Spending total output Leakages and Injections 4 5 a Households don t spend all income i Savings and Net Taxes T are leakages b Government and businesses spend back Government spending G Planned Investment Spending I p i ii c Total Spending equals total output if leakages injections i ii iii i i i d G The Loanable Funds Market 1 2 3 Household sectors can supply funds Business firms and Gov Demand funds The Supply of Loanable Funds a b Equal to household saving Supply of Funds Curve i ii As Interest rate rises more people want to save to lend Curves upward 4 The Demand for Loanable Funds Business demand I p a Demand curve slopes down Borrow more when low b Governments run a budget deficit equal to G T Government always demands this amount Vertical Demand Curve c Total Demand for Funds Curve i ii i ii Lecture Notes Page 3 c Total Demand for Funds Curve i Equilibrium I p G T a Market clears Loanable Funds Market and Say s Law H Now we know that Leakages always equals Injections Savings all go towards Government Spending or planned investment spending As long as loanable funds market clears say s law holds Total value of spending will equal total value of output I Fiscal Policy in the Classical Model When government changes either net taxes or its own purchases in order to influence total output Demand Side Effects Arise from fiscal policy s impact on total spending Shift the demand curve through government purchases transfers net taxes In Classical Model fiscal policy has no demand side effects 3 Increase in Government Purchases To spend more government needs more money without raising taxes Borrows from loanable funds market drives up interest rate business spend less and more people want to save more i If saving is more consumption spending is less c d Increase in government purchases crowded out the spending of households and businesses In classical model a rise in government purchases causes complete crowding out 5 1 2 3 4 1 2 a b c a b e a 4 Decrease in Net taxes b Raises consumption by amount of taxes cut at first since people have more disposable income initially i Later since demand exceeds supply interest rate rises and more people want to save 1 Consumption falls by the amount more savings goes up Lecture Notes Page 4 1 Consumption falls by the amount more savings goes up a Find net change in C by AH AF Investments falls since higher interest rate 2 c d Decrease in net taxes raises C which completely crowds out I p Total spending remains unchanged so tax cut has no demand side effects J Keynesian model a b Short run Explains how economy runs on short run Lecture Notes Page 5 Ch 9 Wednesday December 19 2012 12 07 PM A Measuring standard of living a b Real gross domestic product per capita Real GDP Population B Rule of 70 C Determinants of Real GDP Productivity a i ii Output per hour Total output total hours worked b Average hours c i Total hours total employment Employment population Ratio EPR Total employment population i d Combined i a If variable growing by x each year it will double in 70 x years Lecture Notes Page 6 Changes in GDP Living standards Total Output Total Output Total output Total output total hour total hours total employment total employment Population population A B 10 23 12 Tuesday October 23 2012 11 13 AM a Total output total hour Productivity output per hour b Total hours total employment Average hours worked c Total employment population i i i EPR Population C d Rule 4 a b delta A B delta A delta B Applied i D Total Output per Capita Delta Total output delta productivity Average hours EPR Population a b Total output productivity x average hours x EPR x population Total output population total output per capita i Total output per capita productivity x average hours x EPR 1 Apply rule 4 to this ii Usually only EPR and productivity determine GDP E Growth in Employment Population Ratio a b Greater total employment