The Classical (long run) model
Outline
•Assumption of the model
•The labor market
•The aggregate production function
•The simple circular flow model
•Say’s law
•Leakages and injections
•The loanable funds market
•The expanded circular flow
•Fiscal policy in the Classical model
The Classical model dominated
the economics profession prior to
the publication of the General
Theory of Employment, Interest,
and Money by J.M. Keynes in
1936
The Classical view: Laissez faire
All would be for the best if we would
just leave well enough alone.
Assumption of the Classical
Model: Markets Clear
•Prices in markets
converge quickly to their
equilibrium value.
•ALL markets clear—
markets for goods, factors
of production , and
loanable funds
S
P*
D
0
Q*
Quantity
The issues
1. How is total employment
determined?
2. How is total Output determined?
3. What role does spending play in
the determination of employment
and output?
4. What happens when things
change?
Think of the Classical model as an
application of the principles of supply
and demand to the problem of total
employment and total output.We see
this coming next with the labor market
The Classical Labor Market
Let
•LS denote the supply of labor, which is presumed to be a
positive function of the real wage.
•LD denote the demand for labor, which is presumed to be
a negative (or inverse) function of the real wage.
As the real wage increases, the
opportunity cost of leisure rises as well.
Hence, people substitute work for leisure.
Plato’s Vineyard
(1)
(2)
(3)
(4)
(5) = (3) • (4)
Output
(Units)
Marginal
Output
(Units)
Price per
Unit ($)
Value of
Marginal
Output ($)
Number of
Workers
0
---
0
$0.25
$0.00
1
70
70
$0.25
17.50
2
135
65
$0.25
15.25
3
187
52
$0.25
13.00
4
222
36
$0.25
9.00
5
238
16
$0.25
4.00
Diminishing Returns
Plato’s
I couldn’t afford to
pay more than
$15.25 for the
second worker
LD
$17.50
$15.25
0
1
2
Number of
workers
Real Hourly Wage
The Classical Labor Market
Excess Supply
for Labor
$20
LS
B
A
15
E
H
10
Excess Demand
for Labor
0
J
100 million =
Full Employment
LD
Number of
Workers
According to the Classical
view, the economy will
achieve full employment
naturally—that is, on its
own.
The Aggregate Production Function
•This function shows the
relationship between total output
(or real GDP) and employment,
holding all other factors
constant
•Factors held constant include:
Land, capital, and technology.
Output (dollars)
The Aggregate production function
Aggregate
Production
Function
$7 Trillion
= Full
Employment
Output
0
Recall this was
determined in the
labor market
100 million
Number of
Workers
Goods and
Services
Purchased
Households
$Consumption
Spending
Goods
Markets
$Income
Factor
Markets
The Circular
Flow
$Firm
Revenues
Goods and
Services
Sold
Resources
Sold
$Factor
Payments
Firms
Resources
Purchased
Say’s Law
•“Supply creates its own demand.”
•By producing goods and services,
firms create a total demand for goods
and services equal to what they have
produced.
Say’s law apparently
rules out the possibility
of a widespread glut of
goods.
Spending in a more realistic economy
1. Household don’t spend all their
income. Rather, some is saved and some
goes to pay taxes.
2. Households are not the only spending
units. Firms and government units buy
new goods and services too.
3. In addition to goods and factor
markets, there is a loanable funds
market where saving is made available
to borrowers.
Leakages
•Income received by
households but not spent for
new domestically produced
goods and services in a year.
•Leakages include saving (S)
and Net Taxes (T)
•Net Taxes (T) are equal to
total taxes minus transfer
payments
Injections
•Spending in the domestic goods
market by agents other than
domestic households.
•Injections include planned
investment and government
expenditure.
•Total investment spending has a
planned (Ip) and an unplanned
component.
Aesop’s Bottles B.C. 400
Investment Plans
Planned spending on buildings, equipment,
and tools
20,000 drachmas
Planned inventory investment
0 drachmas
Value of inventories on Dec. 31, 401 B. C.
11,000 drachmas
Value of inventories on Dec. 31, 400 B.C.
13,500 drachmas
Unplanned inventory investment in 400 B.C. 2,500 drachmas
Actual investment in 400 B.C.
22,500 drachmas
Leakages and injections in classica
T ($1.25
Trillion)
G ($2
Trillion)
IP ($1
Trillion)
$7
Trillion
$7
Trillion
C
($4 Trillion)
Total
Output
Total
Income
G ($2
Trillion)
IP ($1
Trillion)
C
($4 Trillion)
Total
Spending