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
, the total number of widgets produced in the economy.
(Real world analogue:
, 1 widget = $1 of output in base year.)
(3)The dollar price of a widget is denoted by the letter
. (Real world:
The GDP price
.) (4)Total employment is denoted by the letter
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
, and labor,
(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)
is called the production function and is determined by the current state of
Note: The production function is concave down. This is so because as
but the increases in
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?
: A clearing labor market in which the quantity supplied of labor equals the quantity
be the nominal wage, that is,
w≡ W/P= widgets/labor
Some reasonable assumptions:
, is an increasing function of the real wage.
, is a decreasing function of the real wage.
The real wage will adjust to clear the labor market at full employment,
. Output is thereby
), full employment output.
Two questions arise:
(1)What assures that all of full employment output is purchased by agents in the economy?