The Classical LongRun Model

1

• Chapter 7
• The Classical Long-Run Model

2
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

3
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
• Polices 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

4
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
• 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
• 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 economys poor performance

5
Macroeconomic Models Classical Verses Keynesian

• Keynesian ideas became increasingly popular in
  universities and government agencies during 1940s
  and 1950s
• In recent decades there has been an active
  counterrevolution against Keyness approach to
  understanding the macroeconomy
• While Keyness ideas and their further
  development help us understand economic
  fluctuationsmovements in output around its
  long-run trend
• Classical model has proven more useful in
  explaining the long-run trend itself

6
Assumptions of the Classical Model

• All models begin with assumptions about the world
• One assumption in classical view that goes beyond
  mere simplification
• Markets clear
• Price in every market will adjust until quantity
  supplied and quantity demanded are equal

7
Assumptions of the Classical Model

• Well 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?

8
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
• Well concentrate our attention on labor
• Our question is
• How many workers will be employed in the economy?

9
Figure 1 The Labor Market
LS
B
A
E
H
J
10
Excess Demand for Labor
LD
100 million Full Employment
10
The Labor Market

• Labor supply curve slopes upward
• Becauseas wage rate increasesmore and more
  individuals are better off working than not
  working
• Thus, a rise in wage rate increases number of
  people who want to workto supply their labor
• As wage rate increases each firm will find
  thatto maximize profitit 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 economys labor demand curve slopes
  downward
• In classical view, economy achieves full
  employment on its own

11
Determining the Economys Output

• 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?

12
The Production Function

• Relationship between total employment and total
  production in the economy
• Given by economys 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,
  full-employment level on its own, with no need
  for government to steer the economy toward it

13
Figure 2 Output Determination in the Classical
Model
LS
15
LD
100 million
Aggregate Production Function
7 Trillion Full Employment Output
100 million
14
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
• Total spending must be equal to total output
• Known as Says Law

15
Figure 3 The Circular Flow
Goods and Services Demanded
Resources Supplied
Total Consumption Spending
Total Income
Total Revenue of Firms
Total Factor Payments
Goods and Services Supplied
Resources Demanded
16
Total Spending in a Very Simple Economy

• Says Law named after classical economist Jean
  Baptiste Say (1767-1832), who popularized the
  idea
• In Says 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 valueThus, the
  mere circumstance of the creation of one product
  immediately opens a vent for other products
• Says 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

17
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 ? inventories
• Net taxes (T) are total government tax revenue
  minus government transfer payments
• T total tax revenue transfers
• Household saving (S)
• Its often useful to arrive at household saving
  in two steps
• Determine how much income household sector has
  left after payment of net taxes
• Household sectors disposable income
• Disposable Income Total Income Net Taxes
• Part that is not spent is defined as saving (S)
• S Disposable Income C
• Total Spending
• Total spending is sum of purchases made by
  household sector (C), business sector (IP), and
  government sector (G)
• Total spending C IP G

18
Some New Macroeconomic Variables

• Saving and net taxes are called leakages out of
  spending
• Amount of income that households receive, but do
  not spend
• There are also injectionsspending from sources
  other than households
• A governments 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

19
The Classical Model A Summary

• Began with a critical assumption
• All markets clear
• In classical model, government neednt worry
  about employment
• Economy will achieve full employment on its own
• In classical model, government neednt worry
  about total spending
• Economy will generate just enough spending on its
  own to buy output that a fully employed labor
  force produces

20
Using the Theory Fiscal Policy in the Classical
Model

• Could government increase economys total
  employment and total output by raising total
  spending?
• 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 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

21
Using the Theory Fiscal Policy With A Budget
Deficit

• What would happen if the government which is
  running a deficitattempted to increase
  employment and output by increasing government
  purchases
• Crowding out is a decline in one sectors
  spending caused by an increase in some other
  sectors 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

22

• Chapter 8
• Economic Growth and Rising Living Standards

23
The Importance of Growth

• Why should we be concerned about economic growth?
• When output grows faster than population, GDP per
  capita will rise
• When output grows more slowly than population,
  average standard of living will fall
• Measuring standard of living by GDP per capita
  may seem limiting
• Still, many aspects of our quality of life are
  counted in GDP such as
• Food, housing, medical care, education,
  transportation services, and movies and video
  games
• Economic growth is especially important in
  countries with income levels far below those of
  Europe, Japan, and United States
• Other than emigration, economic growth is their
  only hope
• Growth is a high priority in prosperous nations,
  too
• When output per capita is growing, its at least
  possible for everyone to enjoy an increase in
  material well-being without having to cut back

24
The Importance of Growth

• When output per capita stagnates, material gains
  become a fight over a fixed pie
• The more purchasing power my neighbor has, the
  less is left for me
• In 1950s and 1960s, economic growth in wealthier
  nations seemed to be taking care of itself
• All of that changed starting in 1970s
• Economic growth became a national and
  international preoccupation
• Over most of postwar period, output in more
  prosperous industrialized countries grew by 2 or
  3 per year
• Beginning in mid-1970s, all of these nations saw
  their growth rates slip
• In late 1990s and early 2000s, only United States
  and United Kingdom returned to their previous
  high rates of growth
• Other industrialized countries continued to grow
  more slowly than their historical averages
• Seemingly small differences in growth rates
  matter a great deal

25
What Makes Economies Grow?

• Useful way to start thinking about long-run
  growth
• Look at what determines our potential GDP in any
  given period
• Real GDP depends on
• Amount of output average worker can produce in an
  hour
• Number of hours average worker spends at the job
• Fraction of population that wants to work
• Size of population
• Amount of output the average worker produces in
  an hour is called labor productivity, or
  productivity
• Measured by taking total output (real GDP) of
  economy over a period of time and dividing by
  total number of hours that everyone worked during
  the period to produce that output
• Productivity Output per hour Total output
  Total hours worked

26
What Makes Economies Grow?

• Hours of the average worker can be found by
  dividing total hours worked over a period by
  total employment, number of people who worked
  during the period
• Average Hours Total hours worked Labor Force
• Fraction of population working is labor force
  participation rate (LFPR)
• Found by dividing labor force (all those who want
  to work) by population
• LFPR Labor Force Population

27
Economic Growth and Living Standards

• Ultimately, growth in potential output does not
  by itself account for a rise in living standards
• What matters for a rising standard of living is
  real GDP per capita
• Whichover long-runwill equal our potential
  output divided by population
• Total output Productivity x Average Hours x
  LFPR x Population
• If we divide both sides by the population, we get
• Total output Population Productivity x
  Average Hours x LFPR
• In terms of percentage growth rates
• ? Output per person ? Productivity ?
  Average hours ? LFPR
• Notice that population drops out of the equation
• Only way to raise living standards is to increase
  productivity, average hours, or labor force
  participation rate

28
Economic Growth and Living Standards

• In most developed countries, average hours are
  slowly decreasing, not increasing
• ? Output per person ? productivity ?
  LFPR
• To explain why U.S.or any developed countryhas
  enjoyed continual rises in living standards over
  long periods of time
• Must look to growth in productivity and growth in
  labor force participation rate

29
Figure 1 An Increase in Labor Supply
A
15
B
12
LD
100
120
B
8 trillion
7 trillion
A
100
120
30
Figure 2 An Increase in Labor Demand
LS
B
17
15
A
100
120
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Figure 3 The U.S. Labor Market Over A Century
W2
B
W1
A
L1
L2
32
How To Increase Employment and the LFPR

• One set of policies to increase employment
  focuses on changing labor supply
• An often-proposed example of this type of policy
  is a decrease in income tax rates
• Tax cut would be just what was needed to get you
  to seek work
• When we extend your reaction to population as a
  whole
• Can see that a cut in income tax rate can
  convince more people to seek jobs at any given
  wage
• Shifting labor supply curve rightward
• Many American workers must pay combined federal,
  state, and local taxes of more than 40 out of
  each additional dollar they earn
• This may be discouraging work effort in United
  States
• In addition to tax rate changes, some economists
  have advocated changes in government transfer
  programs to speed growth in employment
• Redesigning these programs might stimulate growth
  in labor supply
• This reasoning was an important motive behind the
  sweeping reforms in U.S. welfare system in August
  1996

33
How To Increase Employment and the LFPR

• A cut in tax rates increases reward for working
• While a cut in benefits to the needy increases
  hardship of not working
• Either policy can cause a greater rightward shift
  in the economys labor supply curve than would
  otherwise occur and create growth in labor force
  participation and output
• Government policies can also affect labor demand
  curve
• Government policies that help increase skills of
  the workforce or that subsidize employment more
  directly shift the economys labor demand curve
  to the right
• Increasing employment and output

34
Employment Growth LFPR vs. Population

• Increases in employment have been an important
  source of economic growth in United States and
  many other countries
• Has been almost entirely due to increases in
  population, rather than increases in labor force
  participation
• Labor force participation rate did account for
  growth in living standards during 1970s and 1980s
  as womenespecially married womenentered labor
  force at much higher rates than previously
• But by 1990, this source of growth in living
  standards was exhausted
• LFPR did not rise during 1990s and is not
  projected to rise in near future
• Efforts to increase living standards by raising
  LFPR have two serious drawbacks
• LFPR cannot create rapid growth in living
  standards indefinitely, because there is a
  logical upper limit of 100
• In developed economies, raising LFPR means that
  people who currently do not want jobs must change
  their minds and want to work

35
Growth in Productivity

• We eliminated variables that could not explain
  rising living standards over long-run
• Ruled out population growth
• Based on logic of equation for total output per
  person
• Ruled out growth in average hours
• Because of upper limit on this variables growth
  and high opportunity cost paid to raise hours per
  worker when most of labor force is already
  working full-time
• Ruled out increases in labor force participation
• At least as a source of continual, rapid economic
  growth
• Only one variable remains
• Productivity
• Can we do anything to make productivity grow even
  faster?

36
Figure 4 Capital Accumulation and Labor
Productivity
D
8 trillion
7 trillion
A
100
37
Growth in the Capital Stock

• One key to productivity growth is growth in
  nations capital stock
• Amount of capital available for average worker
• With more capital a given number of workers can
  produce more output than before
• Since same number of workers are working same
  number of hours, but producing more output than
  before, productivity rises
• Growth in capital stock will increase
  productivity as long as it increases amount of
  capital per worker
• If capital stock grows faster than labor force
  then capital per worker will rise
• Labor productivity will increase along with it
• But if capital stock grows more slowly than labor
  force, then capital per worker will fall
• Labor productivity will fall as well

38
Investment and the Capital Stock

• An increase in capital stock plays a central role
  in economists thinking about growth
• Contributes to a rise in labor productivity and
  helps to raise living standards
• A stock variable measures a quantity at a moment
  in time
• Capital stock is a measure of total plant and
  equipment in economy at any moment
• Planned investment is a flow variable
• Measures a process that takes place over a period
  of time
• As long as investment is greater than
  depreciation, total stock of capital will rise
• The greater the flow of investment, the faster
  will be the rise in capital stock

39
Targeting Businesses Increasing the Incentive
to Invest

• One kind of policy to increase investment targets
  the business sector itself
• With goal of increasing planned investment
  spending
• Corporate profits tax
• Tax on profits earned by corporations
• Investment tax credit
• A reduction in taxes for firms that invest in
  certain favored types of capital
• Reducing business taxes or providing specific
  investment incentives can shift the investment
  curve rightward
• Speeding growth in physical capital
• Increasing growth rate of living standards

40
Targeting Households Increasing the Incentive
to Save

• While firms make decisions to purchase new
  capital, it is largely households that supply
  firms with funds, via personal saving
• An increase in investment spending can originate
  in household sector, through an increase in
  desire to save
• If households decide to save more of their
  incomes at any given interest rate
• Supply of funds curve will shift rightward
• What might cause households to increase their
  saving?
• Greater uncertainty about economic future
• Increase in life expectancy
• Anticipation of an earlier retirement
• Change in tastes toward big-ticket items
• Change in attitude about saving
• Any of these changesif they occurred in many
  households simultaneouslywould shift saving
  curve to the right
• But government policy can increase household
  saving as well
• One often-proposed idea is to decrease capital
  gains tax

41
Targeting Households Increasing the Incentive
to Save

• Another frequently proposed measure is to switch
  from current U.S. income tax
• Taxes all income whether it is spent or saved
• To a consumption tax
• Would tax only the income that households spend
• Another proposal to increase household saving is
  to restructure U.S. Social Security system
• Provides support for retired workers who have
  contributed funds to system during their working
  years
• Government can alter tax and transfer system to
  increase incentives for saving
• If successful, these policies would
• Make more funds available for investment
• Speed growth in capital stock
• Speed rise in living standards

42
Shrinking the Governments Budget

• A final pro-investment measure is directed at
  government sector itself
• A decrease in government purchases results in
• Raising consumption and investment
• Link between government budget, interest rate,
  and investment spending is major reason why U.S.
  government, and governments around the world, try
  to reduce and, if possible, eliminate budget
  deficits
• Shrinking deficit or rising surplus tends to
  reduce interest rates and increase investment
• Speeding growth in capital stock
• In 1990s, Congress set strict limits on growth of
  government spending
• Budget deficit began shrinking

43
Technological Change

• Another source of growth is technological change
• Invention or discovery of new inputs, new
  outputs, or new methods of production
• New technology affects economy in much the same
  way as do increases in capital stock
• Shifts production function upward
• Since it enables any given number of workers to
  produce more output
• In many cases, new technology requires
  acquisition of physical and human capital before
  it can be used
• In some instances, however, a new technology can
  be used without any additional equipment or
  training
• As when a factory manager discovers a more
  efficient way to organize workers on the factory
  floor
• The faster the rate of technological change
• The greater the growth rate of productivity, and
• The faster the rise in living standards

44
The Cost of Economic Growth

• Why dont all nations pursue these policies and
  push their rates of economic growth to the
  maximum?
• Promoting economic growth involves unavoidable
  trade offs
• Requires some groups, or nation as a whole, to
  give up something else that is valued
• In order to decide how fast we want our economy
  to grow we must consider growths costs as well
  as benefits
• One of the most important things you will learn
  in your introductory economics course is that
  there are no costless solutions to societys
  problems
• What are the costs of growth?

45
Consumption Costs

• Any pro-growth policy that works by increasing
  investmentprivate or government, in physical
  capital, human capital, or RDrequires a
  sacrifice of current consumption spending
• Role of this trade-off in economic growth can be
  clearly seen with production possibilities
  frontier (PPF)
• Greater investment in physical capital, human
  capital, or RD will lead to faster economic
  growth and higher living standards in the future
• But we will have fewer consumer goods to enjoy in
  the present

46
Figure 8 Consumption, Investment, and Economic
Growth
K
A
C
47
Opportunity Costs of Workers Time

• Living standards will also rise if a greater
  fraction of population works or if those who
  already have jobs begin working longer hours
• But this increase in living standards comes at a
  cost
• Decrease in time spent in nonmarket activities
• Thus, when economic growth comes about from
  increases in the labor force participation rate
  (or in average hours), we face a trade-off
• Can enjoy higher incomes and more goods and
  services
• Will have less time to do things other than work
  in the market

48
Figure 9 LDC Growth and Living Standards
49
Figure 10 Growth Options for LDCs