The Classical Long-Run Model
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Classical Model
• A macroeconomic model that explains the long-run
behavior of the economy.
• Classical model was developed by economists in 19th and
early 20th, to explain a key observation about economy.
– Over periods of several years or longer, economy performs rather
well
• In the classical view, economy operates at full employment
in the long run.
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Assumption of the Classical Model
Markets clear
• Price in every market will adjust until quantity
supplied and quantity demanded are equal
• Markets might not be clear in the short-run, but if we
wait long enough, eventually, the change in price will
equate demand with supply.
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The Classical Model
• We’ll use classical model to answer important questions
about economy in the long-run, such as
– How does economy achieve full employment?
– How much output can we produce?
– How does economy operate on its own?
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The Labor Market
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Output Determination in the Classical
Model
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Full Employment Output
• In the classical or long-run view, economy reaches its
potential output automatically
Output reaches its potential, full-employment level on
its own, with no need for government to maneuver the
economy toward it.
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The Role of Spending
• What if business firms are unable to sell all output
produced by a fully employed labor force?
– Economy would not be able to sustain full employment for very
long
• If we are asserting that potential output is an equilibrium
for the economy
– Total spending on output has to be equal to total production during
the year
– Can we be sure of this?
• In classical view, the answer is YES
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Total Spending in a Very Simple
Economy
• Imagine a world with just two types of economic units
– Households and business firms
• In a simple economy with just households and firms in
which households spend all of their income
– Total spending must be equal to total output
• Known as Say’s Law
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The Circular Flow
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Total Spending in a Very Simple
Economy
• Say’s Law named after classical economist Jean Baptiste
Say (1767-1832), who popularized the idea
• 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 or
• Supply creates its own demand
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Total Spending in a More Realistic
Economy
• In the real world
– Households don’t spend all their income
• Saving & taxes
– Households are not the only spenders in the economy
• Businesses and government buy some of the final goods and
services we produce
– In addition to markets for goods and resources, there is also a
loanable funds market
• Where household’s saving is made available to borrowers in
business or government sectors
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Some New Macroeconomic Variables
• Planned investment spending (IP)
IP = I – Δ inventories
• Net taxes (T)
T = total tax revenue – transfers
• Household saving (S)
Household sector’s disposable income
» Disposable Income = Total Income – Net Taxes
S = Disposable Income – C
• Total Spending
• Total spending = C + IP + G
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Leakages and Injections
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Loanable Funds Market Equilibrium
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An Expanded Circular Flow
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The Classical Model: A Summary
• Began with a critical assumption
– All markets clear
• In classical model, government needn’t worry about
employment.
– Economy will achieve full employment on its own.
• In classical model, government needn’t worry about total
spending.
– Economy will generate just enough spending on its own
to buy output that a fully employed labor force
produces.
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