Summary of the Classical Model
(or the Full-Employment Model; or the Long-Run
Model; in short, the Model Developed in Chapter 3 of Mankiw's
Textbook)
(Econ 100b; Spring 1996)
Brad De
Long
To find out what are the magnitudes of macroeconomic quantities in
this model, start with:
The economy's resources of labor and capital, L and K
(or, perhaps, the capital stock and labor supply as a function of the
real wage).
- Use the production function F(K, L) to calculate the
total amount of GDP, Y.
- Use the production function to calculate the economy-wide
marginal product of labor (MPL), and so determine the real
wage W/P.
- Use the production function to calculate the economy-wide
marginal product of capital (MPK), and so determine the
real rate of return on physical investment R*.
Then examine the government's accounts--its purchases of goods and
services G and its net taxes (taxes less transfer payments)
T.
- Calculate the government deficit DEF = G - T.
- Calculate households' disposable income = Y - T is GDP
minus net taxes collected.
Then calculate the magnitudes of the private-sector expenditure and
production flows.
- Use the consumption function C(Y-T) to calculate
consumption C.
- Use the identity that all household income must go
somewhere--that Y = C + S_{p} + T--that household
income is equal to consumption, plus net taxes, plus private
savings--to calculate private savings S_{p} =
Y-C-T.
- Use the equilibrium condition in the loanable funds
market--that net new money flowing into the financial
markets must match net uses of finance by the government
and by private investors--that S_{p} - DEF = I--to
calculate domestic investment I.
- Use knowledge of the investment function
I(r)--investment as a function of the real interest
rate--to calculate the equilibrium real interest rate r.
Thus you calculate all macroeconomic variables of interest from 7
pieces of information
- The economy's stocks of capital and labor, and its
technologically-determined production function.
- Government purchases of goods and services, and net taxes.
- Households' collective consumption-savings behavior, as
summarized by the consumption function.
- Businesses' investment behavior, as summarized by the
investment function I(r).
Change any one of these seven pieces of information, and
the values of macroeconomic quantities and prices--the economy's
equilibrium--will change.
Note: is the equilibrium real interest rate r
in the long-run (or "classical", or "full employment", or "chapter
3") model the same as the MPK determined from the production
function? Not necessarily. If the equilibrium real interest rate
r is less than the MPK (or R*), then
investment is probably very high, the economy's capital stock is
probably increasing at a rapid rate--more rapidly than output is
increasing in terms of percentage growth--and the MPK is
probably falling as a result of this "deepening" of the economy's
capital stock. If the equilibrium real interest rate r is
greater than the MPK, then investment is probably low, the
capital/output ratio is probably falling--and the MPK is
probably rising over time as a result of this capital "shallowing"
(if there is such a word).
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