Chapter 8 The Classical Long Run Model Macroeconomic Models Classical vs Keynesian Classical Model a macroeconomic model that explains the long run behavior of the economy o Economy eventually returns to full employment powerful forces are at work that drive the economy toward full employment o Some economists believe that the classical model is the foundation for explaining the economy s short run behavior During the Great Depression output was stuck far below its potential for many years economy wasn t working the way the classical model said it should o John Keynes offered an explanation Keynesian model Argued that 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 could be stuck below its potential like in the Great Depression Why the Classical Model is Important It is important for 2 reasons Assumptions of the Classical Model o Over the last several decades there has been an active counterrevolution against Keynes s approach to understanding the macro economy many based on classical ideas o It is the best model for understanding 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 Aggregation combine many different interest rates in the economy and refer to a single interest rate combine the many different types of labor in the economy into a single aggregate labor market Markets clear the price in every market will adjust until quantity supplied and quantity demanded are equal o The forces of supply and demand work fairly well throughout the economy and that markets do reach equilibrium o An excess supply of anything traded will lead to a fall in its price o An excess demand will drive the price up How Much Output Will We Produce The Labor Market Real wage tells us the amount of goods that workers can buy with an hour s earnings Households supply labor and firms demand it Labor supply curve tells us how many people will want to work at various real wage Upward slope tells us that the greater the real wage the greater the number of people who Labor Supply rates will want to work o Slopes upward because as the wage rate increase 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 Labor demand curve indicates how many workers firms will want to hire at various real wage rates In deciding how much labor to hire a firm s goal is to earn the greatest possible profit the difference between sales revenue and costs Diminishing returns to labor the rise in output gets smaller and smaller with each o As we keep adding workers further gains from specialization are harder to successive worker achieve o As we continue to add workers each one will have less and less of the other o Each additional worker causes a firm s output and revenue to rise but by less and less for each new worker Also each additional worker adds to the firm s cost 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 The real wage adjusts until the quantities of labor supplied and demanded are equal No cyclical unemployment Cyclical unemployment lasts only as long as the current business cycle itself it is not a In the classical model the economy achieves full employment on its own permanent long run problem From Employment to Output How much output workers will produce depends on 2 things o The amount of other resources available for labor to use o The state of technology which determines how much output we can produce with those resources The Production Function With a constant technology and given quantities of all resources other than labor only one variable can affect total output the quantity of labor The aggregate production function shows the total output the economy can produce with different quantities of labor given constant amounts of other resources and the current state of technology The production function flattens out as we move rightward along it result of the diminishing returns to labor output rises when another worker is added but the rise is smaller with each successive worker Equilibrium Real GDP In the classical long run view the economy reaches its potential output automatically o No need for government to steer the economy toward it The Role of Spending Total Spending in a Very Simple Economy An economy with just two types of economic units domestic households and domestic business firms o Households spend all of their income and are the only spenders in the economy o No govt collecting taxes or purchasing goods o No business investment o No imports from or exports to other countries Total spending is the same as total consumption spending which must be the same as household income the same as total output In a simple economy with just domestic households and firms in which households spend all of their income on domestic output total spending must be equal to total output Say s Law the idea that total spending will be sufficient to purchase the total output Say s Law produced Each time a good or service is produced an equal amount of income is created 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 Supply creates its own demand Because the labor market is assumed to clear firms will hire all the workers who want jobs and produce out potential or full employment output level o Firms will be able to continue producing this level of output only if they can sell it In the simple economy Say s law assures us that in the aggregate spending will be just high enough for firms to sell all the output that a fully employed labor force can produce o As a result full employment can be maintained Total Spending in a More Realistic Economy Now assume a govt collects taxes and purchases goods and services households no longer spend their entire incomes on consumption some is used to pay taxes and some is saved business firms purchase capital
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