CHAPTER 20

THE CLASSICAL LONG-RUN MODEL

EVEN NUMBERS ANSWERS, SOLUTIONS, AND EXERCISES

ANSWERS TO ONLINE REVIEW QUESTIONS

 2. In the classical model, market clearing in the labor market assures that the economy will
achieve full employment automatically. An excess supply of labor will cause the real
wage to drop; an excess demand for labor will cause the real wage to rise. While this may
not be realistic over shorter periods of time, it does make sense over longer periods. For
example, an excess supply of labor (very high unemployment) will not lead immediately
to falling real wages; but if the excess supply persisted, we would expect the real wage to
drop eventually.

 4. The slope of the production function becomes flatter as employment increases because of
diminishing returns to labor. That is, as we continue to add equal numbers of workers,
output increases, but by less and less each time. Diminishing returns to labor arise
because as we continue to add workers, potential gains from specialization become
exhausted, and because of decreases in the amounts of capital and land available for each
worker.
 6. Net tax revenue is equal to total tax revenue minus transfer payments. The distinction is
important because the part of total tax revenue that goes to transfer payments represents
funds that are moved from one part of the household sector to another; it is only what is
left over—net tax revenue—that is available to the government for spending on goods
and services.
 8. The supply of funds is the sum of household saving and the government’s budget surplus,
if any.
10. The budget deficit does not affect the slope of the demand for funds curve because the
government is assumed to borrow the same total amount at any interest rate. It is only the
business demand for loanable funds that is affected by changes in the interest rate. Thus,
any given rise in the interest rate will cause the same decline in the demand for loanable
funds whether the government runs a deficit or not. While a larger deficit will shift the
demand for funds curve rightward, it will not change the curve’s slope.

12. According to the classical model, demand-management policy (fiscal and monetary
policy) is unnecessary and ineffective. Higher government spending, for example, will
cause decreases in both investment and consumption spending which, in total, are equal
to the increase in government spending. Thus, total spending will remain unchanged,
even though government spending is greater.
14. Changes in investment is the only type of spending in GDP that is not planned. It occurs
when buyers buy more or less than firms thought they would.
 Total Supply of Funds
Interest Rate

a
r1

r2

D1 = I + G1 - T

D2 = I + G2 - T

Q′ Q2 Q1 Funds
c b
PROBLEM SET
 2.

a. The distance marked “a” represents the decrease in government purchases.

b. The distance marked “b” represents the increase in consumption spending.
c. The distance marked “c” represents the increase in planned investment spending.

4. a. Net taxes = total tax revenue – transfer payments = $2.5 million - $0.5 million = $2
million.

Disposable income = Total Income – Net taxes = $10 million - $2 million = $8 million.

Saving = Disposable income – Consumption spending = $8 million - $6 million = $2

million.
b. There is a budget deficit of $1 million (assuming that government spending refers to
government purchases only). Net taxes – Government spending = $2 million - $3
million = -$1 million.
 c. Planned investment = Saving – Government borrowing in the loanable funds market
= $2 million - $1 million = $1 million.
d. Total spending = C + IP + G = $6 million + $1 million + $3 million = $10 million =
Total output.

e. ages Injec
Leak tions
n) G ($
2 trillio 3 tri
llion
T ($ )

n) IP($1 G $3 trillion
2t rillio trillio
n)
S ($

IP($1 trillion)

C $6 trillion
C $6 trillion
$10 trillion $10 trillion
=

Total Output Total Income Total Spending

6.

Total Supply of Funds (Savings)

Interest
Rate

7% B
I AH=Transfers ↑
A F P
5% H

C
IP+G –T1 IP+G –T2

1.75 2.05 2.25 Trillions of Dollars

per Year
 Recall that net taxes (T) is defined as taxes minus transfers. The problem does not mention
any increase in taxes. But because social security benefits are a transfer, increasing them is
equivalent to a reduction in T. As a result, the government’s budget deficit (G – T) will
increase, thereby shifting the demand for loanable funds rightward from Ip + G – T1 to Ip + G –
T2. At the original interest rate (here, for example, 5%), the quantity of funds demanded will
exceed the quantity supplied. This will drive the interest rate upward until equilibrium is re-
established at point B with an interest rate of 7%.
The increase in social security transfers is shown by the distance AH. The increase in the
interest rate causes consumption spending to decrease (as saving increases by amount AF).
Planned investment spending decreases as well (by amount FH).
Note that the numbers here are used just for illustrative purposes.
8. a. If the government ran a deficit, the interest rate would rise. This would cause total
investment spending to decrease, and saving to rise. All of the other variables in
Problem 7 — net taxes, real GDP, total leakages and injections — would be
unaffected.
b.

MORE CHALLENGING

10. a. Initially, the loanable funds market is in equilibrium at point A with an (arbitrarily
chosen) interest rate of 5%. As a result of the tax cut, the government’s budget deficit
increases (by the amount of the tax cut), shifting the demand for funds curve rightward
from D1 to D2. But by the assumption that the entire tax cut is saved, the supply of funds
curve will also shift rightward by an equal amount, from S1 to S2.
 Interest
Rate S1

S
2

A
5% B

D2
D1

Trillions of
Dollars per Year

b. As is evident from the diagram, the result is an increase in the volume of loanable funds
exchanged, but no change in the interest rate.
c. When the tax cut is entirely saved, both the supply of funds curve and the demand for funds
curve shift to the right (as seen on graph) and the interest rate does not change. No change in
the interest rate further implies that C and Ip, components of total spending, do not change.
Government purchases (another component of total spending) are assumed to be fixed
throughout.
12. a.

S
Interest
Rate

[IP + (G – T) + (X – IM)]

Trillions of
 Dollars

b. See the diagram in part (a) above.

c. S = Ip + (G – T) + (X – IM). In words, saving = planned investment + budget deficit + trade
surplus.
d. S + T + IM = Ip + G + X