# Classical Macroeconomic Theory - Chapter...

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### Classical Macroeconomic TheoryChapter 3 :

Classical Macroeconomic TheoryChapter 3 Classical model examines: Determination of aggregate supply Factor prices & Income Distribution Demand for goods and services Tendency toward full employment

### Closed-economy, Market-clearing Model :

Closed-economy, Market-clearing Model Supply Factor markets Determination of output/income Demand Determination of demand components Equilibrium Goods markets Loanable funds market

### Supply of national income :

Supply of national income Aggregate Production Function Y = F(K,L)  Relate output to factors of production Technology constant _ K= K _ L = L

### Returns to Scale :

Returns to Scale Production function has constant returns to scale zY = F(zK,zL) If increase in Y equal to z, constant returns to scale If increase in Y > z, increasing returns If increase in Y < z, decreasing returns

### Supply of output :

Supply of output _ _ _ Y = F(K,L) = Y

### Distribution of Output :

Distribution of Output Assume competitive firms in economy Factor prices determine distribution of output Wage, W, is price of labor Rental rate, R, is price of capital P = price level W/P = real wage R/P = real rental rate

### Demand for factors :

Demand for factors Firms maximize profits Profit = PY – WL – RK Profit = PF(K,L) – WL – RK Marginal Product of Labor MP = F(K,L+1) – F(K,L) Diminishing Marginal Product

### The MPL and the production function :

Y output The MPL and the production function L labor MPL

### Demand for Labor :

Demand for Labor ?Profit = ?Revenue - ?Cost = (P x MPL) – W  Hire labor until ?Profit = 0  P x MPL = W  MPL = W/P

### MPL and the demand for labor :

MPL and the demand for labor Each firm hires labor up to the point where MPL = W/P

### Rental Rate :

Rental Rate MPK = R/P = real rental price of capital Economic Profit = income after factor payments Economic Profit = Y–(MPL x L)–(MPK x K) ?Profit = ?Revenue - ?Cost =(P x MPK) – R MPK = R/P

### Euler’s Theorem :

Euler’s Theorem F(K,L) = (MPL x L) + (MPK x K) For constant returns to scale Since firms own capital, accounting profit is Accounting Profit = Economic Profit +(MPK x K) Economic Profit is zero Accounting Profit is the return to capital

### Factor Shares :

Factor Shares Cobb-Douglas Production Function The Cobb-Douglas production function is: where A represents the level of technology. Each factor’s marginal product is proportional to its average product:

### The Cobb-Douglas Production Function :

The Cobb-Douglas Production Function The Cobb-Douglas production function has constant factor shares: ? = capital’s share of total income: capital income = MPK x K = ? Y labor income = MPL x L = (1 – ? )Y Growth in real wages due to productivity

### Slide 15:

Figure 3.5 The Ratio of Labor Income to Total IncomeMankiw: Macroeconomics, Sixth EditionCopyright © 2007 by Worth Publishers

### Demand for Goods and Service :

Demand for Goods and Service Y = C + I + G + NX Assume NX = 0

### Consumption :

Consumption C = C(Y-T) Y-T = Disposable Income MPC = Marginal Propensity to Consume MPC = ?C/?Y

### The consumption function :

The consumption function

### Investment :

Investment I = I(r) Nominal and Real Interest Rates r = real interest rate Cost of borrowing Opportunity cost of own funds

### The investment function :

The investment function

### Government :

Government _ G = G (exogenous) _ T = T (exogenous) Transfers not included in G

### Equilibrium :

Equilibrium _ _ _ _ Y = C(Y – T) + I(r) + G  Only variable is r Real rate adjusts to equilibrate markets Full employment model Factor markets clear

### Supply and Demand for Loanable Funds :

Supply and Demand for Loanable Funds Y – C – G = I Y – C – G = National Saving (Y – C – T) + (T – G) = I (Y – C – T) = Private Saving (T – G) = Public Saving _ _ _ _ Y – C(Y – T) – G = I(r) _ S = I(r) Interest rate adjusts to equate supply and demand for loanable funds

### Loanable funds supply curve :

Loanable funds supply curve National saving does not depend on r, so the supply curve is vertical.

### Loanable funds market equilibrium :

Loanable funds market equilibrium

### Real interest rate :

Real interest rate Equilibrates loanable funds market Equilibrates goods market

### Loanable Funds Market :

Loanable Funds Market Increase in government purchases or tax cut Reduces public saving – r increases Investment crowded out

### CASE STUDY The Reagan Deficits :

CASE STUDY The Reagan Deficits Reagan policies during early 1980s: increases in defense spending: ?G > 0 big tax cuts: ?T < 0 According to our model, both policies reduce national saving:

### 1. The Reagan deficits, cont. :

1. The Reagan deficits, cont. I1 2. …which causes the real interest rate to rise… I2 3. …which reduces the level of investment. 1. The increase in the deficit reduces saving…

### Are the data consistent with these results? :

Are the data consistent with these results? variable 1970s 1980s T – G –2.2 –3.9 S 19.6 17.4 r 1.1 6.3 I 19.9 19.4 T–G, S, and I are expressed as a percent of GDP All figures are averages over the decade shown.

### An increase in investment demand :

An increase in investment demand An increase in desired investment.. r1

### An increase in investment demand when saving depends on the interest rate :

An increase in investment demand when saving depends on the interest rate