4. The Classical Model
Chapter 20
The Classical Long-Run Model
ECON1006 Principles of Economics II (Macroeconomics)
ECON 1006
Principles of
Economics II
Macroeconomics
1. The Classical Model
 In this and the next topics, we will consider the long-run behavior of the
economy and focus on the determination of potential GDP (i.e. the long-run
trend).
Real output
Peak
Long-run trend:
growth in potential
GDP (Economic
Growth)
Peak
Trough
Trough
Expansion
Recession
Expansion
Time
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1. The Classical Model
 The Classical model
- Assumes wages and prices adjust rapidly enough to maintain equilibrium in all
markets, i.e. market-clearing.
- Argue that government should have, at most, a limited role in the economy.
 In order to fully understand how the macroeconomy works in the long run, we
have to explore the following markets:
- Labor Market – The supply side
- Goods Market
The demand side
- Loanable Funds Market
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1. The Classical Model
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 In this topic, we focus on the supply side first, i.e. the amount of output an
economy produces. It depends on two factors:
- The amounts of inputs (such as labor and capital) utilized in the production.
- The production technology to transform inputs into outputs.
 Note that in the classical model, we focus on the real variables, which are
measured in terms of real purchasing power (or dollars of constant purchasing
power, say in 2014 dollars)
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2. The Production Function
 The production technology is summarized by the production function (or aggregate
production function)
- It shows the relationship between maximum amount of output produced and the amount of inputs (such
as labor and capital) employed, given the current technology.
 The following production function shows the relationship between output and the amount of
labor used, keeping the amount of other inputs constant
Output (Y)
Two important assumptions about a
typical production function:
• The marginal product of labor
(MPL) is positive.
• Diminishing marginal returns:
as more of any variable input is
added, holding other inputs
constant, its marginal product will
eventually decline (why?)
Production Function
Y2
Y1
L1
L2
Labor (L)
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2. The Production Function
 The factors affecting the production function is called a supply shock (or productivity
shock)
- A positive (or beneficial) supply shock raises the amount of output that can be produced for given
quantities of labor.
Output (Y)
It shifts the production function
upward:
• More output can be produced
for a given amount of labor.
New Production Function
Positive supply shock
• It also increases the slope of the
production function, i.e. the MPL
increases.
Old Production Function
How about a negative (or
adverse) supply shock?
L1
L2
Labor (L)
2. The Production Function
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 A negative (or adverse) supply shock lowers the amount of output that can be produced
for given quantities of labor.
 What are the examples of supply shocks?
- Technological improvement
- Increase in employment in other inputs (e.g. capital stock)
• It may due to lower input prices
- Other factors such as weather and natural disasters
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3. The Labor Market: Labor Demand
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 To understand the labor demand, we need to understand individual firms’ employment
decision, which is simply a marginal benefit and marginal cost comparison:
- Marginal Revenue Product of Labor (MRPL)
• Suppose a firm considers employing an additional labor. If this worker can produce an
additional output of 10 units per day and each unit of output can be sold at $10 (suppose other
inputs remain fixed). What is the additional benefit of employing this additional worker?
MRP  $100
L
• The MRPL measures the benefit of employing an additional labor in terms of the extra revenue
produced.
MRP  P  MP
L
L
Should the firm employ this additional labor?
• What is cost of employing this additional labor?
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3. The Labor Market: Labor Demand
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- Nominal wage (W)
• Given the MRPL = $100. Suppose the market wage of each labor is $80 per day, should the firm
employ this additional labor?
o Firms will increase employment as long as MRPL ≥ W.
o Firms will decrease employment as long as MRPL < W.
 In general, firms will demand the amount of labors until
MRP  W
L
- In other words, the maximum amount that firms are willing to pay for an additional worker is
their MRPL.
P  MP  W
L
 In terms of real wage, the maximum amount that firms are willing to pay for an
additional worker is their MPL.:
Marginal benefits
of employing an
additional worker
W
MP 
P
L
Marginal costs of
employing an
additional worker
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3. The Labor Market: Labor Demand
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 Example: Derive the labor demand curve. Consider the following production function of
the economy:
Max willingness to pay
L
1
2
3
4
MPL
10
9
8
7
 Graphically, the MPL curve is exactly the same as the labor demand curve!
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3. The Labor Market: Labor Demand
 Labor demand curve shows the
total amount of labor employed at
each real wage.
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Real wage (W/P)
- It is exactly the same as the marginal
product curve of labor.
- It is downward sloping because of
diminishing marginal returns to
labor.
- Therefore, at a lower real wage,
more labors are profitable to be
employed, other things constant.
 Factors affecting labor demand:
- Any factors affecting the marginal
product of labor (MPL)
• Supply shocks
= MPL
Labor Demand (LD)
Labor (L)
- Taxes (or subsidies) affecting the
marginal benefits of employing
labors
• Corporate tax.
• Payroll tax contributed by firms.
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4. The Labor Market: Labor Supply
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 In deciding how much to work, individuals weigh the benefits against the costs of
working, i.e. the income-leisure tradeoff.
- How would an increase in real wage affect the amount of labor supplied?
• Substitution effect:
o An increase in real wage raises the cost of leisure, inducing workers to supply more
labor units.
• Income (or wealth) effect:
o An increase in real wage makes workers effectively wealthier because for the same
amount of work they now earn a higher real income, inducing households to consume
more leisure (hence supply less labor units).
 It is generally assumed the substitution effect is bigger and the labor supplied would
increase with real wage.
- The labor supply curve, which shows the total amount of labor supplied at each real wage,
is upward sloping.
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4. The Labor Market: Labor Supply
 Factors affecting labor supply:
- Households’ Wealth
- Working-age population
- Labor-force participation rate
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Real wage (W/P)
Labor Supply (LS)
- Taxes (or subsidies) affecting
the returns to labors
• Payroll tax contributed by
labors
• Unemployment benefits
Labor (L)
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5. The Labor Market Equilibrium
 Based on the assumption that the real wage is flexible, the classical economists assumed
the labor market clears, i.e. labor demand equals labor supply.
- It ensures full employment (no cyclical unemployment) in the economy.
- Note that frictional unemployment and structural unemployment still exists.
Real wage (W/P)
Labor Supply (LS)
(W/P)*
Labor Demand (LD)
LF (full employment)
Labor (L)
6. The Labor Market and The Real Output
Real wage (W/P)
 Recall the amount of output an
economy produces depends:
- The amounts of inputs (such as
labor and capital) utilized in the
production.
Labor Supply (LS)
(W/P)
- The production technology to
transform inputs into outputs
o Production function
 The following diagram shows the
relationship between the labors
employed and real output.
- In the classical model, the economy
reaches its potential output or
GDP in the long run.
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Labor Demand (LD)
LF Full employment
Labor (L)
Output
(Y)
Production Function
YF
Potential
GDP
LF Full employment
Labor (L)
7. The Demand Side of the Classical Model
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 In the classical view of output determination, the labor market reaches the full
employment and therefore the economy produces its potential output
automatically in the long run.
 How about the demand side? Is there enough expenditure to buy all the output
produced?
- If firms cannot sell all the output, the full employment and potential output level
cannot sustain.
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The Circular Flow Diagram
- Recall the circular flow diagram that depicts the operation of a very simple economy
consisting of domestic households and domestic firms only.
- Total Production (Output) = Total Income = Total Expenditure
Income
Factor Payments
Resource
(Production Factors)
Markets
Labor, Capital, Land, Entrepreneuership
Given domestic
households spend all of
their income on
domestic output …
Households
(Consumers)
Firms
(Producers)
Goods and Services
Goods Markets
Expenditure
Revenue (Product)
7. The Demand Side of the Classical Model
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 Say’s law: Supply creates its own demand
- By producing goods and services, an equal amount of income is created. In a simple
economy in which domestic households spend all of their income on domestic output,
total expenditure must be equal to total output.
- Note: The Say’s law shows the aggregate spending in economy will equal the
aggregate output. It does NOT apply to individual level.
 The Say’s law ensures the goods market is in equilibrium under the classical
view.
- Does it apply in more general sense (more realistic economy)?
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8. The Goods Market Equilibrium (Closed Economy)
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 To explore the goods market equilibrium in a more general sense (more realistic
economy), we examine the demand for output (the planned expenditure).
 Recall that, when measuring output, the actual expenditure (or GDP) can be defined as:
Spending on capital goods + change in inventories
GDP  C  I  G  NX
 Is it always equal to the planned expenditure, which is the total amount that the
economy (including all households, businesses, government and foreigner) would like to
spend? Why?
- Recall that actual investment expenditure includes both spending on capital goods and change in
inventory.
• Firms may engage in unplanned inventory investment (or unplanned change in inventory)
when their sales do not meet their expectations.
o For simplicity, we assume all inventory investment to be unplanned and the firms’
planned investment expenditure includes only their planned spending on capital goods.
I  I p  inventorie s
- On the other hand, C, G and NX are always intentional.
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8. The Goods Market Equilibrium (Closed Economy)
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 For simplicity, we consider a closed economy, which refers to any economy
that does not deal with the rest of the world, i.e. NX = 0.
 Therefore, a closed economy consists of:
- Households who spend their income on consumption, saving and paying taxes.
- Firms that spend on capital goods (investment expenditure)
- Government that collects taxes and spend the taxes revenues on goods and services
(government expenditure)
 The planned expenditure in the closed economy:
E C  I G
p
p
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8. The Goods Market Equilibrium (Closed Economy)
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 In a closed economy, the goods market is in equilibrium when the supply of output (i.e.
potential GDP) equals the demand for output (planned expenditure):
Y C  I G
p
Potential output:
•
•
Technology
Inputs employed
Planned expenditure
 To explore what ensures that the goods market is in equilibrium, we rearrange the terms
and adding an extra term T (net taxes):
Y C  I G
p
Net taxes: Taxes – Transfer payment
Budget Deficit (if G – T > 0)
(Household) Saving (S)
Y  T  C  I  (G  T )
Budget Surplus (if G – T < 0)
Disposable Income
S  I p  (G  T ) Balanced Budget (if G – T = 0)
p
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8. The Goods Market Equilibrium (Closed Economy)
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 Therefore, the goods market equilibrium condition can be rewritten as:
S T  I G
p
Leakages
Injections
- The left hand side (S + T) is called the leakages out of households spending –
households income received but unspent.
- The right hand side (Ip + G) is called the injections – spending from sources other than
households.
 The goods market will be in equilibrium if and only if total leakages are equal to
total injections.
- This condition ensures that Say’s law holds in the more realistic closed economy.
- But what is the mechanism that ensures leakages = injections?
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9. The Loanable Funds Market
 To understand the equality of leakages and injections, it requires the study of
loanable funds market, i.e. the market in which savers make their funds
available to borrowers.
 Recall that the goods market equilibrium condition can be written as:
S  I  (G  T )
p
Supply of loanable funds
Demand for loanable funds
- The left hand side of the equation is the household saving, which is also the supply of
loanable funds.
- The right hand side of the equation is the firms planned investment expenditure and
government budget deficit, which is also the demand for loanable funds.
• What if the the government runs a budget surplus, i.e. G – T < 0?
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10. The Supply of Loanable Funds (Saving)
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 The households supply funds by putting their savings in banks (which will then
lend the funds), investing in bonds (direct lending to firms or government) or
investing in stocks (buying shares of ownership of firms) in order to earn
interest.
 To understand the determinants of saving/consumption, we must realize
saving/consumption decision involves a tradeoff between current consumption
and future consumption.
- Real interest rate (r): the relative price of current consumption in terms of future
consumption forgone.
• Note: while there are many interest rates in real world, we ignore the fine details in
macroeconomics and regard the interest rate as an average of all the different interest
rate in real world.
• When interest rate increases, consumption spending will decrease and saving will
increase.
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10. The Supply of Loanable Funds (Saving)
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Real interest rate (r)
Supply of loanable
funds, (Saving, S)
Loanable Funds
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10. The Supply of Loanable Funds (Saving)
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 Other factors affecting saving/consumption:
- Current Income (Y) and wealth
• Households desire to have a relatively even pattern of consumption over time
(consumption smoothing), so when current income or wealth (i.e. total value of
households’ assets) increases, households will spend part of the increased income
and save part of it.
• Both the current consumption spending and saving will increase.
- Expected future income
• When expected future income increases, households would increase both the future
consumption and current consumption by reducing saving, given the current income
unchanged.
• Consumption will increase and saving will decrease.
- Taxes (or subsidies) affecting the returns to saving
• Capital gains tax: A tax on profits earned from financial investment (i.e. saving).
• Consumption tax: A tax on the part of income that households spend.
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11. The Demand for Loanable Funds
(Planned investment & Budget Deficit)
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 The firms demand funds to purchase capital goods (i.e. investment) and the government
demands funds to finance their budget deficit by borrowing from the banks, selling bonds or
shares. In return, they have to pay interest.
 To understand the firms’ demand for funds, we have to understand the firms’ investment
decision (demand for capital), which is simply a marginal benefit and marginal cost analysis
(analogous to that of the demand for labor):
- Expected future return
• Suppose a firm considers buying a capital good (machine) that costs $10,000 and has a useful life of
one year (for simplicity). If this machine is expected to produce an additional output of 1000 units per
year and each unit of output can be sold at $12 (suppose other inputs remain fixed).
• What is the expected additional benefit of purchasing this additional capital good?
MRPKe  $12000
• The MRPKe measures the marginal benefit of employing an additional capital in terms of the extra
revenue produced:
MRPKe  P  MPKe
• The MRPK is $12000. Suppose there is no other cost, the expected return on investing the capital is
therefore $2000
e
MRPKe  PK
Should the firm invest in this additional capital?
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11. The Demand for Loanable Funds
(Planned investment & Budget Deficit)
 Real interest rate (r)
- Suppose the firm has to borrow to finance its purchase, the cost of investment is the real interest
rate.
• What if the firm is using its own funds to finance the purchase?
- Given MRPKe = $1,2000. Suppose the market real interest rate is 5%, should the firm invest in the
capital?
PK (1  r )  $10000 (1  5%)  $10500
o Firms will increase its investment in a capital good as long as MRPKe  PK (1  r )
o Firms will decrease its investment in a capital good as long as MRPKe  PK (1  r )
 In general, firms will demand the amount of capital (i.e. invest) until
Marginal benefits of employing an
additional capital
MRPKe  PK (1  r )
Marginal costs of employing an
additional capital
- In other words, the maximum amount that firms are willing to pay for an additional unit of capital
e
is MRPK .
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11. The Demand for Loanable Funds
(Planned investment & Budget Deficit)
 In terms of interest rate, the maximum amount of interest rate that firms are willing to
pay for investing an additional unit of capital is:
MRP  P (1  r )
e
K
K
Expected Return
MRP  P
r
P
e
K
Expected rate of return, E(r)
K
K
 The left-hand side is in fact the expected rate of return, E(r) of an investment.
 Example: Derive the investment demand curve. Consider the following investment
projects:
Max willingness to pay (in terms of interest rate)
Planned Investment Units of capital
$10,000
1
$20,000
2
$30,000
3
$40,000
4
E(r)
10%
9%
8%
7%
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11. The Demand for Loanable Funds
(Planned investment & Budget Deficit)
Real interest rate (r)
Investment demand curve shows the total
amount of investment at each interest rate.
• It is downward sloping because at a lower interest
rate, more investment projects are profitable, other
things constant.
MRPe  P
E (r ) 
K
K
PK
• It is also the demand for loanable funds from the
firms.
Planned Investment (Ip)
Investment (Ip)
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11. The Demand for Loanable Funds
(Planned investment & Budget Deficit)
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 Other factors affecting planned investment:
- Any factors affecting expected rate of return – when expected rate of return increases,
planned investment will increase.
- Expected future marginal productivity of capital
• Technology
• Existing capital stocks
- Expected future business environment and profitability
- Taxes and subsidies affecting the expected rate of return
• Corporate profit tax: A tax on profits earned by firms.
• Investment tax credit (subsidy): A reduction in taxes for firms that invest in new
capital.
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11. The Demand for Loanable Funds
(Planned investment & Budget Deficit)
 On the other hand, the government’ demand for funds simply to finance any budget
deficit
- Unlike firms, government borrowing is independent of the real interest rate.
Real interest rate (r)
Budget Deficit (G – T)
Budget deficit
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11. The Demand for Loanable Funds
(Planned investment & Budget Deficit)
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 The total demand for loanable funds is the horizontal summation of the firms’ demand
for loanable funds (investment demand curve) and the government’s demand for loanable
funds (budget deficit), which is downward sloping.
Real interest rate (r)
What of government runs a budget surplus, i.e. G – T < 0?
•
The government surplus turns into a supply of loanable
funds and is horizontally summed with the household
saving to derive the total supply of loanable funds curve.
Demand for loanable
funds, [Ip + (G – T)]
Loanable Funds
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12. The Loanable Funds Market Equilibrium
 Based on the assumption of the classical economists, the loanable funds market clears i.e.
the equality of demand and supply of loanable funds.
- The real interest rate adjusts until the loanable market is in equilibrium.
- What would happen if interest rate is too low? Too high?
Real interest rate (r)
Supply of loanable
funds, (Saving, S)
r*
Demand for loanable
funds, [Ip + (G – T)]
S = Ip + (G – T)
Loanable Funds
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12. The Loanable Funds Market Equilibrium
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 Notice that when the loanable funds market clears, i.e. S = Ip + (G – T), it implies:
S T  I G
p
Leakages
Injections
 That is, the goods market will also be in equilibrium as the total leakages are equal to
total injections, which ensures Say’s law to hold in the more realistic closed economy.
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13. Fiscal Policy (The classical view)
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 Fiscal policy: a change in government spending or net taxes designed to affect
total output.
 Consider an increase in government spending in an attempt to increase output.
- What is the effect on budget deficit (G – T)?
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13. Fiscal Policy (The classical view)
Real interest rate (r)
S
r2
r1
Increase in S
(Decrease in C)
Decrease in I
(due to increase in r)
(due to increase in r)
D2 (due to
increase in G)
D1
Increase in G
Q1
Q2
Loanable Funds
13. Fiscal Policy (The classical view)
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 Fiscal policy: a change in government spending or net taxes designed to affect total output.
 Consider an increase in government spending in an attempt to increase demand and output.
- What is the effect on budget deficit (G – T)?
- Higher interest rate, which results in:
• An increase in saving (a decrease in consumption)
• An decrease in planned investment
- Crowding Out effect
• A decline in one sector’s spending caused by an increase in some other sector’s spending.
• In the classical model, a rise in government purchases completely crowds out private sector
spending, so total (demand and) spending remains unchanged.
• Therefore, according to the classical economists, the increase in government spending in an
attempt to increase output in the long run is ineffective.
 How about a decrease in net taxes (which might increase consumption)?
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13. Fiscal Policy (The classical view)
Real interest rate (r)
S
r2
r1
Increase in S
(Decrease in C)
Decrease in I
(due to increase in r)
(due to increase in r)
Q1
D2 (due to
decrease in T)
D1
Q2
Decrease in T = Increase in C
Loanable Funds
13. Fiscal Policy (The classical view):
More on impact of a tax reduction
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 Note that in your textbook, it shows that the impact of a decrease in net taxes
(T) is identical to the impact of an increase in government spending (G).
- It is actually based on the assumption that a change in T has NO impact on S.
- Recall that S = Y – T – C. A decrease in T by $1 would not increase S only if the
households increase C by $1 (i.e. assume the households spend all the tax reduction).
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13. Fiscal Policy (The classical view):
More on impact of a tax reduction
•
Real interest rate (r)
In practice, it is reasonable to assume households to
save part of the tax cut and spend the remaining.
S2 (S increases partially
S
due to decrease in T)
r2
r1
Decrease in I
(due to increase in r)
Increase in S
(Decrease in C)
D1
(due to increase in r)
D2 (due to
decrease in T)
Loanable Funds
Increase in S Increase in C (due to decrease in T)
Decrease in T