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NOTESonCLASSICALmodelSpring2007

# NOTESonCLASSICALmodelSpring2007 - CLASSICAL MACROECONOMIC...

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CLASSICAL MACROECONOMIC MODEL (THE MARKET-CLEARING MODEL) r Loanable Funds Market Y Production Function S 1 Y=AK α L 1- α Y 1 r 1 I d 1 S 1 =I d 1 S,I d L Money Market (1/P) M 1 (W/P) Labor Market L s 1 (1/P 1 ) w 1 =(W/P) 1 M d L d 1 = MPL 1 M, M d L 1 L

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1.Production Function: Y=AK α L 1- α 2.Labor Market: L s [w 1 = (W/P) 1 ; A 1 , w 2 , WAPOP, LFPR, r] & L d (W/P; A, K) 3.Goods Market (loan funds market): S[r; Y 1 , Y 2 , A 1 | fiscal policy variables] & I d (r; t, permanent change in A) 4.Money Market: M = k (r, π e )PY (lefthand side is money supply and the righthand side is money demand) It is more convenient to write money market equilibrium as M = M d (P; Y, r, π e ). In the classical model, the labor market and the production function determine equilibrium L, W/P and Y. The money market determines the equilibrium P and the loanable funds market determines equilibrium r, S and I d. Symbol Key: w = real wage rate = W/P (with the subscript 1 it represents current-period real wage rate) W = nominal wage rate P = price level L d = labor demand L s = labor supply WAPOP = working-age population LFPR =labor-force participation rate K = capital stock L = labor (employment) MPL = marginal product of labor A = measure of "technology" (total factor productivity) Y = real output = real income S = real national saving I d = desired real investment spending r = expected real rate of interest M = money supply k = the Cambridge k = (desired holdings money expressed as a % on nominal income) k PY = M d = the demand for money ( desired holdings of money) π e = expected inflation rate w 2 = (W/P) 2 = future period real wage rate Y 1 = current period real income (for convenience we will drop the subscript on the graph) MPK f = expected-future marginal product of capital Y 2 = future-period real income T = real (net) tax revenue C = real consumption spending G = real government spending on goods and services A 1 = real wealth (real assets)
I. Temporary Positive Supply Shock (i.e., temporary increase in A) r Loanable Funds Market Y Production Function Y * Y=A 2 K α L 1- α S 1 Y=A 1 K α L 1- α Y 1 S 2 r 1 r 2 I d 1 S 1 =I d 1 S 2 =I d 2 S,I d L Money Market (1/P) M 1 (W/P) Labor Market L s 1 (1/P 2 ) w 1 * = (W/P) 1 * (1/P 1 ) w 1 = (W/P) 1 M 2 d L d 2 =MPL 2 M 1 d L d 1 =MPL 1 M, M d L 1 L 2 L 1. LABOR MAREKT AND PRODUCTION FUNCTION : The increase in A causes the production function to shift up (“labor is more productive”). It also causes labor demand to increase. [Note: Recall that the labor demand is the same

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