Chapter 7-8 notes

# Chapter 7-8 notes - Chapter 7 The Classical Long Run Model...

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Chapter 7: The Classical Long Run Model The Classical Long Run Model: Prices and wages are flexible, and all markets clear. Equilibrium employment and output will be at their full employment levels. The Keynesian Short Run Model: Prices and wages are fixed in the short run. Equilibrium employment and output may be at levels below full employment. The Classical Long Run Model Some simplifying assumptions: (1)The economy produces one good, call it a widget. (Real world analogue: One widget is a basket of goods.) (2)Total output is denoted by letter Y , the total number of widgets produced in the economy. (Real world analogue: Real GDP , 1 widget = \$1 of output in base year.) (3)The dollar price of a widget is denoted by the letter P≡\$/widget . (Real world: The GDP price index/100 .) (4)Total employment is denoted by the letter L . Output in the Classical Model In general output is produced using land, raw material, labor, and capital. (These inputs are called “factor” inputs, or “factors of production.”) We will simplify things a bit by ignoring some of these factors. For now, total output is a function of capital, K , and labor, L (total hours worked). Postponing changes in capital until the next chapter, we can simplify even further by writing Y=F(L, other inputs)≡F(L) . The function F is called the production function and is determined by the current state of technology. Total output Note: The production function is concave down. This is so because as L increases, Y increases, but the increases in Y become smaller. (This represents the decreasing marginal product of labor.) The Classical Labor Market Total output is determined by total employment. What determines employment in the classical market? Answer : A clearing labor market in which the quantity supplied of labor equals the quantity demanded. Let W be the nominal wage, that is, W =\$/labor. Then the real wage is w≡ W/P= widgets/labor . Some reasonable assumptions: (1)Labor supply, sL , is an increasing function of the real wage. (2)Labor demand, dL , is a decreasing function of the real wage. The real wage will adjust to clear the labor market at full employment, f L . Output is thereby determined by Y=fY =F( f L ), full employment output. Two questions arise: (1)What assures that all of full employment output is purchased by agents in the economy?

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(2)How is output distributed across C, I, and G? Output Demand and the Loanable Funds Market For now we ignore the foreign sector and treat the economy as a “closed” economy, NX=0. Definition: T ≡ Net taxes ≡ Total taxes – transfer payments Consumption (i)Consumption depends upon (a)Disposable income = Y-T , with )(/ TYC >0. (b)The rate of interest, R , with RC /<0. Household saving Y-T-C. Investment
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Chapter 7-8 notes - Chapter 7 The Classical Long Run Model...

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