The Classical Long-Run Model
 Economists sometimes disagree with each
other
 Actually much more agreement exists
among economists than there appears to
be
 Once distinction between long-run and
short-run becomes clear
 Many apparent disagreements among
macroeconomists dissolve
 If no time horizon is specified, however, an
economist is likely to focus on horizon he or
she feels is most important
 Something about which economists sometimes
do disagree
The Classical Long-Run Model
 Ideally, we would like our economy to do
well in both long-run and short-run
 Unfortunately, there is often a trade-off between
these two goals
 Doing better in short-run can require some
sacrifice of long-run goals, and vice versa
 Policies that can help us smooth out
economic fluctuations may prove harmful to
growth in the long-run
 While policies that promise a high rate of growth
might require us to put up with more severe
fluctuations in short-run
Macroeconomic Models: Classical
Verses Keynesian
 Classical model, developed by economists in 19th and early
20th centuries, was an attempt to explain a key observation
about economy
 Over periods of several years or longer, economy performs
rather well
 If we think in terms of decades rather than years or
quarters, business cycle fades in significance
 In the classical view, this behavior is no accident
 Powerful forces are at work that drive economy towards full
employment
 An important group of macroeconomists continues to
believe that classical model is useful even in shorter run
 In 1936, in midst of Great Depression, British economist
John Maynard Keynes offered an explanation for economy’s
poor performance
 Argued that, while classical model might explain economy’s
operation in long-run, long-run could be a very long time in
arriving
Macroeconomic Models: Classical
Verses Keynesian
 Keynesian ideas became increasingly popular in
universities and government agencies during 1940s
and 1950s
 By mid-1960s, entire profession had been won over
 Macroeconomics was Keynesian economics

Classical model was removed from virtually all introductory
economics textbooks
 Classical model is still important
 In recent decades there has been an active
counterrevolution against Keynes’s approach to
understanding the macroeconomy
 Useful in understanding economy over long-run
 While Keynes’s ideas and their further development
help us understand economic fluctuations—
movements in output around its long-run trend
 Classical model has proven more useful in explaining
the long-run trend itself
Assumptions of the Classical Model
 All models begin with assumptions about
the world
 Classical model is no exception
 Many of its assumptions are simplifying
 Make model more manageable, enabling us to
see the broad outlines of economic behavior
without getting lost in details
 One assumption in classical view that goes
beyond mere simplification-critical
assumption
 Markets clear
 Price in every market will adjust until quantity
supplied and quantity demanded are equal
Assumptions of the Classical Model
 Market-clearing assumption provides hint
about why classical model does a better job
over longer time periods (several years or
more) than shorter ones
 We’ll use classical model to answer a
variety of important questions about
economy in long-run, such as
 How is total employment determined?
 How much output will we produce?
 What role does total spending play in the
economy?
 What happens when things change?
How Much Output Will We Produce?
 How can we disentangle web of economic
interactions we see around us?
 Decide which market or markets best suit the
problem being analyzed, and
 Identify buyers and sellers
 Identify type of environment in which they trade
 But which market should we start with?
 Logical start is market for resources
 Labor, land and natural resources, capital and
entrepreneurship
 We’ll concentrate our attention on labor
 Our question is
 How many workers will be employed in the
economy?
Figure 1: The Labor Market
Real Hourly
Wage
LS
Excess Supply of Labor
$20
15
10
B
A
E
H
J
Excess Demand for Labor
100 million
= Full Employment
LD
Number of
Workers
The Labor Market
 Labor supply curve slopes upward
 Because—as wage rate increases—more and more
individuals are better off working than not working
 Thus, a rise in wage rate increases number of people
who want to work—to supply their labor
 As wage rate increases each firm will find that—to
maximize profit—it should employ fewer workers than
before
 When all firms behave this way together a rise in
wage rate will decrease quantity of labor demanded
 This is why economy’s labor demand curve slopes
downward
 In classical view, economy achieves full employment
on its own
Determining the Economy’s Output
 Most effective way to master a macroeconomic model is
“divide and conquer”
 Start with part of model, understand it well, and then
add in other parts
 Accordingly, our classical analysis of economy is divided
into two separate questions
 What would be the long-run equilibrium of the
economy if there were a constant state of technology
 And if quantities of all resources besides labor
were fixed?
 What happens to this long-run equilibrium when
technology and quantities of other resources change?
The Production Function
 Relationship between total employment and
total production in the economy
 Given by economy’s aggregate production
function
 Shows total output economy can produce with
different quantities of labor
 Given constant amounts of other resources and
current state of technology
 In classical, long-run view economy
reaches its potential output automatically
 An important conclusion of classical model and
an important characteristic of the economy in
long-run:
 Output tends toward its potential, fullemployment level on its own, with no need for
government to steer the economy toward it
Figure 2: Output Determination in
the Classical Model
Real Hourly Wage
In the labor market, the
demand and supply
curves intersect to
determine employment
of 100 million workers.
LS
$15
LD
100 million
Output
(Dollars)
$7 Trillion
= Full
Employment
Output
100 million
The production function shows that those 100
million workers can produce $7 trillion of real GDP.
Number of
Workers
Aggregate
Production
Function
Number of
Workers
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 since business firms
will not continue to employ workers who
produce output that is not being sold
 If we are asserting that potential output is
an equilibrium for the economy
 Had better be sure that total spending on output
is equal to total production during the year
 But can we be sure of this?
 In classical view answer is yes
Total Spending in a Very Simple
Economy
 Imagine a world with just two types of
economic units
 Households and business firms
 Circular Flow
 A diagram that shows how goods, resources,
and dollar payments flow between households
and firms
 In a simple economy with just households
and firms in which households spend all of
their income without saving it or paying tax
 Total spending must be equal to total output
 Known as Say’s Law
Figure 3: The Circular Flow
Goods and
Services
Demanded
Resources
Supplied
Households
$ Total
Consumption
Spending
$ Total Income
Goods Markets
Factor Markets
$ Total
Revenue of
Firms
Goods and
Services
Supplied
$ Total
Factor
Payments
Firms
Resources
Demanded
Total Spending in a Very Simple
Economy
 Say’s Law named after classical economist Jean Baptiste Say
(1767-1832), who popularized the idea
 Each time a god or service is produced, an equal amount of
income is created, For example,
each time a shirt manufacturer produces a $25 shirt, it
creates $25 in factor payments to households.
 In Say’s own words
 “A product is no sooner created than it, from that instant,
affords a market for other products to the full extent of
its own value…Thus, the mere circumstance of the
creation of one product immediately opens a vent for
other products”
 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 more simply
 ‘Supply creates its own demand’
Total Spending in a More Realistic
Economy
 Does Say’s law also apply in a more
realistic economy?
 In the real world
 Households don’t spend all their income
 Rather, some of their income is saved or goes to
pay 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 saving is made available to
borrowers in business or government sectors
Some New Macroeconomic
Variables
 Planned investment spending (IP) over a period of
time is total investment spending (I) minus change in
inventories over the period
 IP = I – Δ inventories
 Net taxes (T) are total government tax revenue minus
government transfer payments (unemployment
insurance, welfare payments, Social Security benefits)
 T = total tax revenue – transfers
 Household saving (S)
 It’s often useful to arrive at household saving in two
steps
 Determine how much income household sector has left
after payment of net taxes

Household sector’s disposable income

Disposable Income = Total Income – Net Taxes
 Part that is not spent is defined as (household) saving
(S)

S = Disposable Income – C
Some New Macroeconomic
Variables
 Total Spending in Classica
 In Classica, total spending is sum of purchases made by
household sector (C), business sector (IP), and
government sector (G)
 Total spending = C + IP + G
 Saving and net taxes are called leakages out of spending
 Amount of income that households receive, but do not
spend
 There are also injections—spending from sources other
than households
 A government’s purchases of goods and services
 Planned investment spending (IP)
 Total spending will equal total output if and only if total
leakages in the economy are equal to total injections
 Only if sum of saving and net taxes is equal to sum of
planned investment spending and government purchases
Flows in the Economy of
Classica
Total Output (GDP)
7 trillion
Total Income
7 trillion
Consumption Spending (C)
4 trillion
Planned Investment Spending
(Ip)
1 trillion
Government Purchases (G)
2 trillion
Net Taxes (T)
1.25 trillion
Household Saving (S)
1.75 trillion
Figure 4: Leakages and Injections
G
($2 Trillion)
IP
($1 Trillion)
$7 Trillion
Total
Output
=
$7 Trillion
Total
Income
C
C
($4 Trillion)
($4 Trillion)
Total
Spending
The Loanable Funds Market


Where households make their saving available to those who need
additional funds
Total supply of loanable funds is equal to household saving






Funds supplied are loaned out, and households receive interest
payments on these funds (if the funds are provided through stock
market then?)
Businesses’ demand for loanable funds is equal to their planned
investment spending

Funds obtained are borrowed, and firms pay interest on their loans

Excess of government purchases over net taxes

Excess of net taxes over government purchases

Government runs a budget deficit equal to G – T

Government runs a budget surplus equal to T - G
Budget deficit
Budget surplus
When government purchases of goods and services (G) are greater
than net taxes (T)
When government purchases of goods and services (G) are less
than net taxes (T)
The Loanable Funds Market
 When the government runs a budget
deficit, its demand for loanable funds is
equal to its deficit. The funds are
borrowed, and government pays interest
on its loans.
 View of the loanable funds market:
 The supply of funds is household saving
 The demand for funds is the sum of the business
sector’s planned investment spending and the
government sector’s budget deficit, if any.
The Supply of Funds Curve
 Since interest is reward for saving and supplying
funds to financial market
 Rise in interest rate increases quantity of funds
supplied (household saving), while a drop in interest
rate decreases it
 Supply of funds curve
 Indicates level of household saving at various interest
rates
 Quantity of funds supplied to the financial market
depends positively on interest rate
 This is why the saving, or supply of funds, curve
slopes upward
 Other things can affect savings besides the interest
rate, including
 Tax rates
 Expectations about the future
 General willingness of households to postpone
consumption
Figure 5: Supply of Household
Loanable Funds
Interest Rate
As the interest rate rises, saving
or the quantity of loanable funds
supplied increases.
B
5%
3%
Saving (S) or Supply of Funds
A
1.5 1.75
Trillions of Dollars
per Year
The Demand for Funds Curve


When interest rate falls investment spending and the business
borrowing needed to finance it rise

Business demand for funds curve slopes downward

Will it, too, be influenced by the interest rate?
What about government’s demand for funds?





Probably not very much

U.S. presidents and legislators have often done so with little
political cost
Government seems to be cushioned from cost-benefit
considerations that haunt business decisions
Any company president who ignored interest rates in deciding
how much to borrow would be quickly out of a job
Government sector’s deficit and its demand for funds are
independent of interest rate
As interest rate decreases quantity of funds demanded by
business firms increases


While quantity demanded by government remains unchanged
Therefore, total quantity of funds demanded rises
Figure 6: Business Demand for
Loanable Funds
As the interest rate falls, business
firms demand more loanable
funds for investment projects.
Interest
Rate
5%
A
B
3%
Planned Investment
(IP) or Business
Demand for Funds
1.0
1.5
Trillions of Dollars
per Year
Figure 7: The Demand for Funds
Summing business demand
for loanable funds at each
interest rate . . .
Interest
Rate
5%
Business Demand
B
for Funds (IP)
3%
1.0
. . . and the government's demand for
loanable funds . . .
Government Demand
for Funds (G – T)
B
gives us the economy's
total demand for loanable
funds at each interest rate.
Total Demand for Funds
[IP + (G – T)]
B
A
A
A
1.5
0.75
1.75 2.25
Trillions of Dollars per Year
Trillions of Dollars per Year
Trillions of Dollars per Year
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?
Figure 8: Loanable Funds Market
Equilibrium
Total Supply of
Funds (S)
Interest Rate
5%
E
Total Demand
for Funds
P
[I + (G – T)]
1.75
Trillions of Dollars
The Loanable Funds Market and
Say’s Law
 As long as loanable funds market clears, Say’s law
holds
 Total spending equals total output
 This is true even in a more realistic economy with
saving, taxes, investment and government deficit
 Here’s another way to see the same result, in terms of
a simple equation

Loanable funds market clears  S = IP + (G – T)
 Rearranging this equation by moving T to left side

Loanable funds market clears  S + T = IP + G
 Say’s law shows that total value of spending in
economy will equal total value of output
 Rules out a general overproduction or
underproduction of goods in the economy
 It does not promise us that each firm will be able to sell
all of the particular good it produces
Figure 9: An Expanded Circular
Flow
$1.75 Trillion
Loanable
Funds
Market
$1.0 Trillion
$0.75
Trillion
G
($2 Trillion)
IP
($1 Trillion)
$7 Trillion
Total Output
=
$7 Trillion
C
($4 Trillion)
Total Income
C
($4 Trillion)
Total Spending
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
Using the Theory: Fiscal Policy in
the Classical Model
 Could government increase economy’s total employment
and total output by raising total spending? Seems like an
idea that should work? ..business firms might hire more
workers and produce more?
 Two ideas for increasing spending come to mind
 Government could simply purchase more output itself
 More goods, like tanks and police cars, or more services,
like those provided by high school teachers and judges
 Government could cut net taxes, letting households
keep more of their income
 So they would spend more on food, clothing, furniture, new
cars, and so on
Fiscal policy in the CM


Fiscal policy is a change in government purchases or in net
taxes
 Designed to change total spending in the economy and
thereby influence levels of employment and output
Idea behind fiscal policy sounds sensible enough
 But does it work?

Not if economy behaves according to classical model
 Fiscal policy in classical model is completely
ineffective. It can’t change total output or total
employment
 It can’t even change total spending
 Moreover Fiscal policy is unnecessary (?)
since the economy achieves and sustains full
employment on its own
Using the Theory: Fiscal Policy
With A Budget Deficit
 What would happen if the government of Classica—
which is running a deficit—attempted to increase
employment and output by increasing government
purchases
 Crowding out is a decline in one sector’s spending
caused by an increase in some other sector’s
spending
 In classical model a rise in government purchases
completely crowds out private sector spending so total
spending remains unchanged
 In classical model, an increase in government
purchases has no impact on total spending and no
impact on total output or total employment
 Opposite sequence of events would happen if
government purchases decreased
 Total spending and total output would remain
unchanged
Figure 10: Crowding Out With An
Initial Budget Deficit
Total Supply of Funds (S)
Interest
Rate
7%
B
A
C
D IP
H
5%
DC
D2
D1
1.75
2.05
2.25
Funds ($ Trillions)
Fiscal Policy With A Budget Surplus
 Total spending remains unchanged, and
fiscal policy is completely ineffective
 Same conclusion we reached about fiscal
policy with a government budget deficit
 Our exploration of fiscal policy shows us
that, in long-run
 Government efforts to change total output by
changing government spending or taxes are
unnecessary and ineffective
Figure 11: Crowding Out With An
Initial Budget Surplus
S2
S1
B
7%
5%
H
C
DIP
A
DC
Business Demand
for funds (IP)
1.25
1.55
1.75
Funds ($ Trillions)