Chapter 19
The Classical Long-Run Model
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Classical Model
• A macroeconomic model that explains the longrun 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, powerful forces drive
economy towards full employment
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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
equalize demand and 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 will we produce?
– What role is played by total spending?
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Full Employment
• Our first question is
– How many workers will be employed in the
economy?
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Figure 1: The Labor Market
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The Labor Market
• Labor supply curve slopes upward
As wage rate goes up, the opportunity cost of not working
increases, so people are more willing to provide more
labor
• Labor demand curve slopes downward
As wage rate goes up, the labor cost to firms increases, so
firms tend to employ fewer workers than before
• In classical view, economy achieves full
employment on its own
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Determining the Economy’s Output
• The Production Function
 Relationship between total employment and
total production in the economy
 Given that the amount of other resources and
current state of technology are fixed
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Figure 2: 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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Figure 3: 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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Figure 4: Leakages and Injections
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The Loanable Funds Market
• Where households make their saving available to
those who need additional funds
• Supply of loanable funds – household saving
• Demand of loanable funds – businesses and
government
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The Loanable Funds Market
• Businesses’ demand for loanable funds is equal to
their planned investment spending
– Funds obtained are borrowed, and firms pay interest on
their loans
• Government’s demand for loanable funds
– Budget deficit (G – T)
Excess of government purchases over net taxes
• Government’s supply for loanable funds
– Budget surplus (T – G)
Excess of net taxes over government purchases
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Figure 5: Supply of Household
Loanable Funds
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Figure 6: Business Demand for
Loanable Funds
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Figure 7: The Demand for Funds
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Equilibrium in the Loanable Funds
Market
• In classical view loanable funds market is
assumed to clear
– Interest rate will rise or fall until quantities of
funds supplied and demanded are equal
• Can we be sure that all output produced at
full employment will be purchased?
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Figure 8: Loanable Funds Market
Equilibrium
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Figure 9: 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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