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 cri!cal assump!on, and use it to explain the classical result
that the economy achieves full employment on its own, without government ac!on.
4. Use the aggregate produc!on func!on and the labor market to show how the
economy’s poten!al 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 e,ects of government budget deficit 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 -scal policy is both ine,ec!ve 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 func!ons in an open economy.
THE CHAPTER IN A NUTSHELL
Macroeconomists are concerned with the economy’s long-run growth poten!al, and with
short-run economic 5uctua!ons in growth. Policies that can help us smooth economic
5uctua!ons may prove harmful to long-run growth, and vice versa.
The classical model says that, although output may 5uctuate around its trend for short periods
of !me, there are powerful forces at work that drive the economy toward full employment.
During the Great Depression, however, output was stuck far below poten!al 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 opera!on in the long run, but that the long run may be very long indeed.
By the mid-1960s, the en!re profession had been won over to Keynesian economics, and the
classical model was removed from virtually all introductory economics textbooks.
The classical model is s!ll very useful, however, for two reasons. First, it helps us under-stand
the “counter-revolu!on,” 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 cri!cal assump!on in the classical model is that markets clear: The price in any market will
adjust un!l quan!ty supplied and quan!ty demanded are equal. This assump!on allows us to
answer a variety of important ques!ons about the economy in the long run.
In the classical view, all produc!on arises from one source: our desires for goods and services.
We supply labor and other factors to firm 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 firm 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 ac!on is not needed.
The aggregate produc!on func!on shows the total output the economy can produce with
di,erent quan!!es of labor, for given amounts of land and capital and a given state of
technology. The aggregate produc!on func!on, together with the labor market, determines the
economy’s total output. In the classical, long-run view, the economy reaches its poten!al output
automa!cally.
Say’s law says that in a simple economy with just households and firm in which households
spend all of their income, total spending must be equal to total output. The circular 5ow
diagram illustrates this law. In the aggregate, we needn’t worry about there being suDcient
total demand for the total output produced, because supply creates its own demand. Leakages
(savings and net taxes) and injec!ons (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,
-scal policy is both ine,ec!ve and unnecessary. An increase in government purchases, for
example, is ine,ec!ve because of the crowding-out e,ect. An increase in government
purchases completely crowds out private sector spending, so total spending remains
unchanged.
The appendix adds the complica!on of an open economy to the classical model and discusses
how the model would func!on under such circumstances.
In order presented in chapter.
Classical model: A macroeconomic model that explains the long-run behavior of the
economy.
Market clearing: Adjustment or prices un!l quan!!es 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 firm will want to hire at various real
wage rates.
Aggregate production function: The rela!onship showing how much total output can be
produced with di,erent quan!!es of labor, quan!!es of all other resources and technology
held constant.
Say’s Law: The idea that total spending will be suDcient 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 por!on of aFer-tax income that households do not spend on
consump!on.
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 de’cit: 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 firm plan
at various interest rates.
Government demand for funds curve: Indicates the amount of government borrowing
at various interest rates.
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 e,ects: Macroeconomic policy e,ects 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 injec!ons 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 di,erences also applies in general: When leakages are larger
than injec!ons, total spending is less than output. (You can do the same in the other
direc!on: 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 di,erence: The real and nominal interest rates are the same in equilibrium as
long as there is no ongoing ination. 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 in5a!on in equilibrium.
DISCUSSION STARTERS
1. This chapter focuses on government spending as a tool of -scal 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 some!mes the government’s
goals conflict (such as when it wants to prac!ce contrac!onary -scal policy but gets
involved in a war or 5ood relief e,orts). Have students -nd examples of con5ic!ng
government goals.
2. Have students look at the rela!onship between government borrowing and interest
rates over the last 15 years or so. Point out that the posi!ve rela!onship 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 !me.)