Econ. 102. Chapter 3: Classical Theory: The Economy
in the Long-run
1. To understand macroeconomic performance of the
economy, economists divide all the
variables that describe macroeconomic performance into real variables and nominal
Real variables: RGDP, the real wage rate, the real interest rate, the level
and unemployment, etc.
Nominal variables: GDP, CPI, the money wage rate, the nominal interest rate, inflation
rate, supply of money, etc.
2.The real variables describe the real economy and tell us what
is really happening to
production, consumption (C
saving (S), investment (I), work and leisure, all
which contribute to the standard of living.
3. The nominal variables describe the nominal economy and
tell us how dollar values
the cost of living are changing.
4. The separation of macroeconomic performance into
a nominal part is
the basis of huge discovery called the classical dichotomy,
When the economy is operating at
full employment, the forces that
real variables are independent of those that determine the nominal variables.
Before Kelmes's general theory (1936), this is the basic classical macroeconomic theory
that is now called the long-run macroeconomic
theory. For example,
pointed out thht "money is a
Modern economists call that money is neutral
the classical economy.
5. It should be noted that the classical dichotomy describes the economy
employmenf. But it does not hold over the business cycle
as the economy fluctuates
full employment. The
forces that shape the real economy and those that
shape the nominal economy interact to create the business
Classical Theory: The Economy in the Long Run
Long-run: A period of time in all endogenous variables are
able to settle at their
equilibrium and all economic processes have time to work in full.
A1. A given time
A2. Two inputs: K (Capital), L (labor)
A3. The amount of inputs (resources) and technology is given.
exhibits constant returns to scale.
K and L are used fully and efficiently.
46. Perfect competition prevails. (Producers
are price takers in the output and
A7. Consumers and producers make rational choice.
A8. A closed economy.