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Economics: Principles and
Applications, 2e
by Robert E. Hall &
Marc Lieberman
© 2001 South-Western, a division of Thomson Learning
The Classical
Long-Run Model
© 2001 South-Western, a division of Thomson Learning
Macroeconomic Models:
Classical Versus Keynesian
Classical Model
A macroeconomic model that explains the
long-run behavior of the economy, assuming
that all markets clear.
© 2001 South-Western, a division of Thomson Learning
Macroeconomic Models:
Classical Versus Keynesian
Keynes and his followers argued that, while the
classical model might explain the economy’s
operation in the long run, the long run could be a
very long time in arriving. In the meantime,
production could be stuck below its potential.
© 2001 South-Western, a division of Thomson Learning
Macroeconomic Models:
Classical Versus Keynesian
While Keynes’s ideas and their further development
help us understand economic fluctuations-movements in output around its long-run trend--the
classical model has proven more useful in
explaining the long-run trend itself.
© 2001 South-Western, a division of Thomson Learning
Macroeconomic Models:
Classical Versus Keynesian
A critical assumption in the classical model is
that markets clear: The price in every market
will adjust until quantity supplied and
quantity demanded are equal.
© 2001 South-Western, a division of Thomson Learning
Macroeconomic Models:
Classical Versus Keynesian
In our discussion of the classical model, we
will focus on real variables: real GDP, the real
wage, real saving, and so on.
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How Much Output
Will We Produce?
•The Labor Market
•Determining the Economy’s Output
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How Much Output
Will We Produce?
In order to earn income so we can buy goods
and services, we must supply labor and other
resources to firms.
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How Much Output
Will We Produce?
Labor Supply Curve
Indicates how many people will want to work
at various wage rates.
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How Much Output
Will We Produce?
The labor supply curve slopes upward because--as the
wage rate increases--more and more individuals are better
off working than not working. Thus, a rise in the wage rate
increases the number of people in the economy who want
to work--to supply their labor.
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How Much Output
Will We Produce?
Labor Demand Curve
Indicates how many workers firms will want
to hire at various wage rates.
© 2001 South-Western, a division of Thomson Learning
How Much Output
Will We Produce?
As the wage rate increases, each firm in the economy will
find that--to maximize profit--it should employ fewer
workers than before. When all firms behave this way
together, a rise in the wage rate will decrease the quantity
of labor demanded in the economy. This is why the
economy’s labor demand curve slopes downward.
© 2001 South-Western, a division of Thomson Learning
How Much Output
Will We Produce?
In the classical view, the economy achieves
full employment on its own.
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How Much Output
Will We Produce?
Aggregate Production Function
The relationship showing how much total output
can be produced with different quantities of labor,
with land, capital, and technology held constant.
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How Much Output
Will We Produce?
In the classical, long-run view, the economy
reaches its potential output automatically.
© 2001 South-Western, a division of Thomson Learning
The Role of Spending
•Total Spending in a Very Simple Economy
•Total Spending in a More Realistic Economy
•Leakages and Injections
•The Loanable Funds Market
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The Role of Spending
•The Supply of Funds Curve
•The Demand for Funds Curve
•Equilibrium in the Loanable Funds Market
•The Loanable Funds Market and Say’s Law
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The Role of Spending
Circular Flow
A diagram that shows how goods, resources,
and dollar payments flow between households
and firms.
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The Role of Spending
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.
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The Role of Spending
Say’s Law
The idea that total spending will be sufficient
to purchase the total output produced.
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The Role of Spending
Net Taxes
Government tax revenues minus transfer payments.
(Household) Saving
The portion of after-tax income that households do
not spend on consumption goods.
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The Role of Spending
Leakages
Income earned, but not spent, by households during a given year.
Injections
Spending from sources other than households.
Planned Investment Spending
Business purchases of plant and equipment.
© 2001 South-Western, a division of Thomson Learning
The Role of Spending
Total spending will equal total output if and only if
total leakages in the economy are equal to total
injections--that is, only if the sum of saving and net
taxes is equal to the sum of investment spending
and government purchases.
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The Role of Spending
Loanable Funds Market
Arrangements through which households
make their saving available to borrowers.
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The Role of Spending
Budget Deficit
The excess of government purchases over net taxes.
Budget Surplus
The excess of net taxes over government purchases.
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The Role of Spending
National Debt
The total amount of government debt
outstanding.
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The Role of Spending
Supply of Funds Curve
Indicates the level of household saving at various interest
rates. The quantity of funds supplied to the financial
market depends positively on the interest rate. This is why
the saving, or supply of funds, curve slopes upward.
© 2001 South-Western, a division of Thomson Learning
The Role of Spending
Investment Demand Curve
Indicates the level of investment spending firms plan at
various interest rates. When the interest rate falls,
investment spending and the business borrowing needed to
finance it rise. The investment demand curve slopes
downward.
© 2001 South-Western, a division of Thomson Learning
The Role of Spending
Government Demand for Funds Curve
Indicates the amount of government borrowing at various
interest rates. The government sector’s deficit and,
therefore, its demand for funds are independent of the
interest rate.
© 2001 South-Western, a division of Thomson Learning
The Role of Spending
Total Demand for Funds Curve
Indicates the total amount of borrowing at various interest
rates. As the interest rate decreases, the quantity of funds
demanded by business firms increases, while the quantity
demanded by the government remains unchanged.
Therefore, the total quantity of funds demanded rises.
© 2001 South-Western, a division of Thomson Learning
The Role of Spending
In the classical view, the loanable funds market-like all other markets--is assumed to clear: The
interest rate will rise or fall until the quantities of
funds supplied and demanded are equal.
© 2001 South-Western, a division of Thomson Learning
The Role of Spending
As long as the loanable funds market clears,
Say’s law holds even in a more realistic
economy with saving, taxes, investment, and a
government deficit.
© 2001 South-Western, a division of Thomson Learning
The Classical Model: A
Summary
The economy will achieve and sustain potential
output on its own. We need never worry about there
being too little or too much spending; Say’s law
assures us that total spending is always just right to
purchase the economy’s total output.
© 2001 South-Western, a division of Thomson Learning