Macroeconomics 6th Edition Hall

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 CHAPTER 8
THE CLASSICAL LONG-RUN MODEL
MASTERY GOALS

The objectives of this chapter are to:

1. Explain why the classical model seemed to be discredited in the 1930s.
2. List two reasons why the classical model remains useful today.
3. State the classical model’s critical assumption, and use it to explain the classical result
that the economy achieves full employment on its own, without government action.
4. Use the aggregate production function and the labor market to show how the
economy’s potential output is determined.
5. State Say’s law, and explain why it is crucial to the classical view of the economy.
6. Describe the market for loanable funds and explain its role in the macroeconomy.
7. Describe the effects of government budget deficits and surpluses on the loanable funds
market.
8. Demonstrate that Say’s law holds, even in an economy in which households save and
pay taxes.
9. Use the classical model to explain why fiscal policy is both ineffective and
unnecessary.
10. Show how increases in government purchases result in complete crowding out of
private sector spending.
11. (Appendix) Show how the Classical model functions in an open economy.

THE CHAPTER IN A NUTSHELL

Macroeconomists are concerned with the economy’s long-run growth potential, and with
short-run economic fluctuations in growth. Policies that can help us smooth economic
fluctuations may prove harmful to long-run growth, and vice versa.
The classical model says that, although output may fluctuate around its trend for short periods
of time, there are powerful forces at work that drive the economy toward full employment.
During the Great Depression, however, output was stuck far below potential for many years,
and it seemed that the economy wasn’t working the way the classical model said it should.
John Maynard Keynes developed a new model of the economy, arguing that the classical
model may explain the economy’s operation in the long run, but that the long run may be very
long indeed. By the mid-1960s, the entire profession had been won over to Keynesian

215
216 Instructor’s Manual for Economics: Principles and Applications, 6e

economics, and the classical model was removed from virtually all introductory economics
textbooks.
The classical model is still very useful, however, for two reasons. First, it helps us under-stand
the “counter-revolution,” based heavily on classical ideas, against Keynes’s approach.
Second, the classical model is very useful in understanding the economy over the long run.
A critical assumption in the classical model is that markets clear: The price in any market will
adjust until quantity supplied and quantity demanded are equal. This assumption allows us to
answer a variety of important questions about the economy in the long run.
In the classical view, all production arises from one source: our desires for goods and
services. We supply labor and other factors to firms in factor markets in order to earn income
so we can buy goods and services. The labor supply curve tells us how many people will want
to work at each wage. The labor demand curve shows the number of workers firms will want
to hire at any real wage. In the classical view, all markets clear, including the market for
labor. As long as we can count on markets (including the labor market) to clear, the economy
achieves full employment on its own and government action is not needed.
The aggregate production function shows the total output the economy can produce with
different quantities of labor, for given amounts of land and capital and a given state of
technology. The aggregate production function, together with the labor market, determines the
economy’s total output. In the classical, long-run view, the economy reaches its potential
output automatically.
Say’s law says that 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. The circular flow
diagram illustrates this law. In the aggregate, we needn’t worry about there being sufficient
total demand for the total output produced, because supply creates its own demand. Leakages
(savings and net taxes) and injections (government purchases and planned investment
spending) complicate this simple model in the real world, but don’t change its basic
conclusion. As long as the loanable funds market clears (and classical theory says that it will),
Say’s law holds.
Fiscal policy is a change in government purchases or in net taxes designed to change total
spending in the economy and thereby influence output and employment. In the classical view,
fiscal policy is both ineffective and unnecessary. An increase in government purchases, for
example, is ineffective because of the crowding-out effect. An increase in government
purchases completely crowds out private sector spending, so total spending remains
unchanged.
The appendix adds the complication of an open economy to the classical model and discusses
how the model would function under such circumstances.
 Chapter 20 The Classical Long-Run Model 217

DEFINITIONS

In order presented in chapter.

Classical model: A macroeconomic model that explains the long-run behavior of the
economy.

Market clearing: Adjustment or prices until quantities supplied and demanded are equal.

Labor supply curve: Indicates how many people will want to work at various real wage rates.

Labor demand curve: indicates how many workers firms will want to hire at various real
wage rates.

Aggregate production function: The relationship showing how much total output can be
produced with different quantities of labor, quantities of all other resources and technology
held constant.

Say’s Law: The idea that total spending will be sufficient to purchase the total output
produced.

Planned investment spending: Businss purchases of plant and equipment.

Net taxes: Government tax revenues minus transfer payments.

Disposable income: Household income minus net taxes, which is either spent or saved.

Household saving: The portion of after-tax income that households do not spend on
consumption.

Leakages: Income earned by households that they do not spend on the country’s output
during a given year.

Injections: Spending on a country’s output from sources other than its households.

Loanable funds market: The market in which savers make their funds available to borrowers.

Supply of funds curve: Indicates the level of household saving at various interest rates.

Budget deficit: The excess of government purchases over net taxes.

Budget surplus: The excess of net taxes over government purchases.

Business demand for funds curve: indicates the level of investment spending firms plan at
various interest rates.

Government demand for funds curve: Indicates the amount of government borrowing at
various interest rates.
218 Instructor’s Manual for Economics: Principles and Applications, 6e

Total demand for funds curve: Indicates the total amount of borrowing at various interest
rates.

Fiscal policy: A change in government purchases or net taxes designed to change total output.

Demand-side effects: Macroeconomic policy effects on total output that work through
changes in total spending.

Crowding out: A decline in one sector’s spending caused by an increase in some other
sector’s spending.

Complete crowding out: A dollar-for-dollar decline in one sector’s spending caused by an

increase in some other sector’s spending.

TEACHING TIPS

1. This is the first macroeconomic model your students will learn. It’s a good idea to go
slowly here—spend an extra day or so on this material to make sure each part of the
classical model sinks in.
2. To show why it is important that leakages equal injections in the classical model,
illustrate what happens when they are not equal. Reproduce the text’s Figure 5 on the
blackboard, and draw an exaggeratedly large rectangle for saving or taxes; show that
this leads to an exaggeratedly small rectangle for total spending. Then point out that
what applies with exaggerated differences also applies in general: When leakages are
larger than injections, total spending is less than output. (You can do the same in the
other direction: draw an exaggeratedly large rectangle for government spending or
investment, leading to total spending that is much too large.)
3. Make sure that students understand that virtually all variables in the classical model
are real variables, even when not stated explicitly. This includes government
spending, saving, investment, and output = income.
4. If asked whether the interest rate in the classical model is real or nominal, explain that
it makes no difference: The real and nominal interest rates are the same in equilibrium
as long as there is no ongoing inflation. True, the price level can change in the
classical model if the money supply increases. But at this point in the analysis, we
assume that the price level changes from one equilibrium value to another and then
stays put; there is no ongoing inflation in equilibrium.

DISCUSSION STARTERS

1. This chapter focuses on government spending as a tool of fiscal policy designed to

change GDP. Remind students that the government has many reasons for spending,
that GDP management is just one of those reasons, and that sometimes the
government’s goals conflict (such as when it wants to practice contractionary fiscal
policy but gets involved in a war or flood relief efforts). Have students find examples
of conflicting government goals.
 Chapter 20 The Classical Long-Run Model 219

2. Have students look at the relationship between government borrowing and interest
rates over the last 15 years or so. Point out that the positive relationship predicted by
the theory will not necessarily be evident in the raw data. Ask them to explain why
this may be the case. (They should answer that it’s because a lot of other factors are at
work at the same time.)

ANSWERS, SOLUTIONS, AND EXERCISES

PROBLEM SET
1. a. An increase in labor demand will shift the labor demand curve from LD1 to LD2,
raising the real hourly wage from W1 to W2. Given the stock of capital and the
current level of technology, this will move the economy from point A to point B on
the aggregate production function. As a result, potential output increases from Q1
to Q2.

b. An increase in labor supply will shift the labor supply curve from LS1 to LS2,
lowering the real hourly wage from W1 to W2. Other things equal, this will move
220 Instructor’s Manual for Economics: Principles and Applications, 6e

the economy from point A to point B on the aggregate production function.

Potential output increases from Q1 to Q2.
 Chapter 20 The Classical Long-Run Model 221

Total Supply of
Interest Funds
Rate

a
r1

r2

D1 = I + G 1 - T

D 2 = I + G2 - T

Q′ Q2 Q1 Funds
c b

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.
3. a. “Crowding in” is the increase in one sector’s spending caused by a decrease in
some other sector’s spending. If the crowding in is “complete,” then there is a
dollar-for-dollar increase in one sector’s spending caused by a decrease in some
other sector’s spending.
b. This statement is true. To see this, look at the graph shown in the answer to
Problem #2, above. As a result of the decrease in government purchases, both
investment spending and consumption spending increase. The increased spending
by households and businesses exactly offsets the decrease in government
purchases.
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.
222 Instructor’s Manual for Economics: Principles and Applications, 6e

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.

Leakages Injections
T G
$2 trillion $3 trillion
G
S IP
$3 trillion
$2 trillion $1 trillion
IP
$1 trillion

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

Total Total Total

Output Income Spending

5.
 Chapter 20 The Classical Long-Run Model 223

As consumption rises with no change in net taxes, saving will begin to fall. This will
drive up the interest rate in the loanable funds market, until a new equilibrium is
reached where fewer funds are being traded ($X on the accompanying graph). When
the new equilibrium is reached, C will be larger (although not as large as if the interest
rate had not changed), IP will be smaller, and G will be unchanged.
6. a) Government budget deficit would increase.
b) government demand for loanable funds would increase leading to an increase in
the interest rate in the loanable funds market.
c) Increased Social Security payments would increase household disposable income
and increase consumtion. However, the higher interest rate would lead to higher
savings and reduced consumption.
d) Investment spending would decrease due to the higher interest rate.
e) The net effect of the increased Social Security payments would be a crowding out
of Investment by Consumption.
7. a. Government purchases = Government payroll + Government outlays for materials
= $3 + $2 = $5 billion
b. (With a balanced budget) Net Taxes = Government purchases = $5 billion
c. Total Investment = change in the capital stock + depreciation = ($103 – $100) +
(0.07  $100) = $10 billion
d. Real GDP = C + I + G = $50 + $10 + $5 = $65 billion
e. Total saving = Investment + Deficit = $10 + $0 = $10 billion
f. Total leakages = S + T = $10 + $5 = $15 billion
g. Total injections = I + G = $10 + $5 = $15 billion
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.
224 Instructor’s Manual for Economics: Principles and Applications, 6e

b.

9. a. When the government is running a budget surplus, the supply of funds curve is the
horizontal summation of the government supply of funds curve (which equals the
size of the surplus at each interest rate) plus the savings curve.

Total Supply of Funds =

Savings + Government
Budget Surplus

IF = Demand
for Funds
1.5

Note that the numbers on the graph are just for illustrative purposes.
b. Define the surplus as T – G. This surplus will be part of the supply of funds in the
loanable funds market. The interest rate will adjust until the supply of funds equals
the demand for funds, that is, until S + (T – G) = I. Rearrange this expression to
find S + T = I + G.
 Chapter 20 The Classical Long-Run Model 225

c.

Interest SF2
Rate

SF1
∆G
r2

r1

IP (Demand for Funds)

I2 I1 Funds

The total supply of loanable funds (saving plus the budget surplus) will decrease
(shown as the leftward shift from SF1 to SF2), causing the interest rate to rise (from
r1 to r2), which will decrease planned investment from I1 to I2. Saving first falls by
the same amount that G increases, then increases partway back when the interest
rate rises. The net effect is that consumption decreases by the same amount that
planned investment decreases—the distance between I1 and I2.
d. Yes, crowding out is still complete. As a result of the increase in government
spending, both consumption and planned investment fall. As before, each dollar of
additional government purchases causes private sector spending to decline by a
full dollar.

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.
226 Instructor’s Manual for Economics: Principles and Applications, 6e

Interest Rate
S1

S2

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.
11. a. The condition for loanable funds market equilibrium in a closed economy is S = Ip
+ (G – T). With the government’s budget balanced (G = T), this simplifies to S =
Ip. We are told that household saving (S) is $1 trillion. Therefore, in equilibrium,
planned investment must be $1 trillion as well.
b. The equilibrium condition in an open economy is S + (IM – X) = Ip + (G – T). If
trade is balanced and the government’s budget is balanced, this simplifies to S = Ip,
just as in part (a). Therefore, planned investment will be the same as in part (a); Ip
= $1 trillion.
c. With the government’s budget balanced, the equilibrium condition is S + (IM – X)
= Ip. With S = $1 trillion and IM > X, planned investment will exceed $1 trillion
by the amount of the trade deficit.
 Chapter 20 The Classical Long-Run Model 227

12. a.

Interest Rate S

[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

EXPERIENTIAL EXERCISE
Use The Wall Street Journal to find a recent article about fiscal policy that mentions both the
interest rate and the rate of economic growth. Once you have found such an article, try to
translate the argument into graphs similar to those you have encountered in this chapter. Is the
story consistent with what you have learned? If yes, explain how. If not, how might you
account for the discrepancy?