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

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

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

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