Outline

1
The Classical (long run) model

• Outline
• Assumption of the model
• The labor market
• The aggregate production function
• The simple circular flow model
• Says law
• Leakages and injections
• The loanable funds market
• The expanded circular flow
• Fiscal policy in the Classical model

2
The Classical model dominated the economics
profession prior to the publication of the
General Theory of Employment, Interest, and Money
by J.M. Keynes in 1936
3
The Classical view Laissez faire
All would be for the best if we would just leave
well enough alone.
4
Assumption of the Classical Model Markets Clear

• Prices in markets converge quickly to their
  equilibrium value.
• ALL markets clearmarkets for goods, factors of
  production , and loanable funds

S
Price
P
D
0
Q
Quantity
5
The issues

1. How is total employment determined?
2. How is total Output determined?
3. What role does spending play in the determination
   of employment and output?
4. What happens when things change?

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Think of the Classical model as an application of
the principles of supply and demand to the
problem of total employment and total output.We
see this coming next with the labor market
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The Classical Labor Market

• Let
• LS denote the supply of labor, which is presumed
  to be a positive function of the real wage.
• LD denote the demand for labor, which is presumed
  to be a negative (or inverse) function of the
  real wage.

As the real wage increases, the opportunity cost
of leisure rises as well. Hence, people
substitute work for leisure.
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Platos Vineyard
(1) (2) (3) (4) (5) (3) (4)
Number of Workers Output (Units) Marginal Output (Units) Price per Unit () Value of Marginal Output ()
0 --- 0 0.25 0.00
1 70 70 0.25 17.50
2 135 65 0.25 15.25
3 187 52 0.25 13.00
4 222 36 0.25 9.00
5 238 16 0.25 4.00
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Diminishing Returns
Real wage
I couldnt afford to pay more than 15.25 for the
second worker
Platos LD
17.50
15.25
0
1
2
Number of workers
10
The Classical Labor Market
Excess Supplyfor Labor
LS
20
B
A
15
E
Real Hourly Wage
H
10
J
Excess Demandfor Labor
LD
0
100 million Full Employment
Number of Workers
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According to the Classical view, the economy will
achieve full employment naturallythat is, on its
own.
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The Aggregate Production Function

• This function shows the relationship between
  total output (or real GDP) and employment,
  holding all other factors constant
• Factors held constant include Land, capital, and
  technology.

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The Aggregate production function
Aggregate ProductionFunction
7 Trillion FullEmploymentOutput
Output (dollars)
Recall this was determined in the labor market
0
100 million
Number of Workers
14
Goods andServicesPurchased
Households
Resources Sold
ConsumptionSpending
Income
FactorMarkets
GoodsMarkets
The Circular Flow
Firm Revenues
FactorPayments
Firms
Goods andServicesSold
Resources Purchased
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Says Law

• Supply creates its own demand.
• By producing goods and services, firms create a
  total demand for goods and services equal to what
  they have produced.

Says law apparently rules out the possibility of
a widespread glut of goods.
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Spending in a more realistic economy

1. Household dont spend all their income. Rather,
   some is saved and some goes to pay taxes.
2. Households are not the only spending units. Firms
   and government units buy new goods and services
   too.
3. In addition to goods and factor markets, there is
   a loanable funds market where saving is made
   available to borrowers.

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Leakages

• Income received by households but not spent for
  new domestically produced goods and services in a
  year.
• Leakages include saving (S) and Net Taxes (T)
• Net Taxes (T) are equal to total taxes minus
  transfer payments

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Injections

• Spending in the domestic goods market by agents
  other than domestic households.
• Injections include planned investment and
  government expenditure.
• Total investment spending has a planned (Ip) and
  an unplanned component.

19
Aesops Bottles B.C. 400 Investment Plans
Planned spending on buildings, equipment, and tools 20,000 drachmas
Planned inventory investment 0 drachmas
Value of inventories on Dec. 31, 401 B. C. 11,000 drachmas
Value of inventories on Dec. 31, 400 B.C. 13,500 drachmas
Unplanned inventory investment in 400 B.C. 2,500 drachmas
Actual investment in 400 B.C. 22,500 drachmas
20
Leakages and injections in classica
G (2Trillion)
T (1.25Trillion)
7Trillion
7Trillion
IP (1Trillion)
S (1.75Trillion)
G (2Trillion)
IP (1Trillion)
C(4 Trillion)
C(4 Trillion)
TotalOutput
TotalIncome
TotalSpending