Download THE ECONOMY AT FULL EMPLOYMENT: THE CLASSICAL MODEL

THE ECONOMY AT
FULL EMPLOYMENT:
THE CLASSICAL MODEL
CHAPTER
What’s Next?
Our Initial Roadmap:
•
•
•
Review Basic Economic Principles – DONE
Introduce the Key Indicators of
Macroeconomic Performance – DONE
Apply Economic Principles to Model the
Determination of the Key Indicators of
Macroeconomic Performance
Our Economy’s Compass
– Our economy follows a path like that of an
explorer probing new terrain.
– Sometimes the explorer strays of course.
– But the explorer has a compass that helps
keep getting back on the main track.
– Our economy wanders around its main
course—its full employment trend—but like
the explorer, has a compass that keeps
bringing it back.
– The classical model is the compass and you’ll
learn about it in this chapter.
The Classical Model: A Preview
–Economists have made progress in understanding how
the economy works by dividing the variables that describe
macroeconomic performance into two lists:
– Real variables
– Nominal variables
–Real variables like real GDP, employment, and the real
wage rate describe what is happening to living standards
–Nominal variables like the price level and nominal wage
rate tell us how dollar values and the value of money are
changing.
The Classical Model: A Preview
–The two lists of variables form the basis of a
huge discovery called the classical dichotomy,
which states:
–At full employment, the forces that determine
real variables are independent of those that
determine nominal variables.
–For example, we can explain why real GDP in
the United States is 20 times that of Nigeria by
looking only at real variables. We don’t need to
look at the price levels in the two countries.
The Classical Model: A Preview
– The classical model is a model of the
economy that determines the real variables—
real GDP, employment and unemployment,
the real wage rate, consumption, saving,
investment, and the real interest rate—at full
employment.
– Most economists believe that the economy is
rarely at full employment but that the classical
model provides a benchmark against which to
measure the actual state of the economy.
The Essential Stocks and Flows in
the Macroeconomy
Labor (L) and Capital (K) are combined via the
available Technology (A) to produce Output (Y).
Part of that output is Consumed (C). The
remainder is Saved (S) and gets added to the
economy’s capital stock as Investment (I). Thus,
I = S.
The Main Questions
1. What determines L and, therefore, Y?
(Given K and A, L determines Y)
2. What determines S and I and, therefore
K and C?
(Given Y, S determines C; Given K, I
determines the future K).
3. What determines A?