Macroeconomics Powerpoint

Copyright 2005 McGraw-Hill Ryerson Ltd.
Slide 0
C H A P T E R
3
The Economy in the Long Run:
The Classical Market Clearing Model
Learning objectives
Understand that the difference between the long run and
the very long run.
Understand that over the long run, all factors of
production are fully employed.
Understand that in the Classical model equilibrium output
depends on equilibrium labour use.
Understand that the demand for goods and services is
based on spending by the various sectors of the
economy.
Understand that in the long run Classical model, the price
level is determined by the level of money supply.
PowerPoint slides prepared by Marc PrudHomme, University of Ottawa
Copyright 2005 McGraw-Hill Ryerson Ltd.
Copyright 2005 McGraw-Hill Ryerson Ltd. Slide 2
The Supply of Goods and Services
o Output is assumed produced through a production
function, which combines factors of production:
o K: capital
o N: labour
1) Y =AF(K, N)
o A: Level of technology (or productivity)
o Cobb-Douglas Production function:
2) Y = AK
u
N
1 - u
o u : capitals share of income
o 1 - u : labours share of income
o Canadas production function:
3) Y = AK
0.3
N
0.7

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General Form of the Production Function
Changes in Factor Productivity
BOX
3-1
Percent Change in Total Factor Productivity, 1976-2002
o Two Assumptions:
o A is ignored
o Ignore effects of capital change on full employment
output
o The amount of output produced depends on the
amount of labour input.
o In 2002: Y = 18.7 x (949.9
0.3
) N
0.7

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Production Function in the Long Run

Y= F(K, N)
(5)
O
u
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p
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,

Y

(
b
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s

o
f

1
9
9
7

d
o
l
l
a
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s
)

Labour, N (millions)
0 5.0 10.0

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Figure 3-1: Production Function with Fixed Capital and Technology
5 more units
of labour
286.1 more units
of output
A
458.0
B
744.1
0
300.0
600.0
900.0
1200.0
The production
function
relates the
amount of
output that can
be produced
using various
amounts of the
labour input,
holding capital
and
technology
constant.
o Marginal Product of Labour (MPN): The
amount that output increases for each
additional unit increase in labour input.

o Diminishing Marginal Product of Labour:
As labour use increases, the amount of
extra output that is gained from an
increase in labour input becomes smaller.

Marginal Product of Labour and Labour Demand

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M
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P
r
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Labour
MPN
N
MPN

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Figure 3-2: Marginal Product of Labour Curve
The MPN curve is
downward
sloping, as each
additional unit of
labour contributes
less to output
than the previous
unit did. This is
called the
diminishing
marginal product
of labour.
o Marginal Cost of Labour (W): The amount paid by
the firm for an extra unit of output or The nominal
wage that must be paid to the extra unit of labour
that must be hired.

o Marginal benefit to the firm (or the value of the
marginal product): The value of the additional unit
of output that is produced by the additional unit
of labour.

W = MPN x P (7)
w = MPN (8)

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Figure 3-3: Demand for Labour Curve
R
E
A
L

W
A
G
E
,

M
P
N

Labour
W
N
N
D

The demand for
labour curve is
derived from the
condition that the
marginal product
of labour equals
the real wage. It is
downward sloping
due to the
diminishing-
returns property
of the production
function.

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o Marginal benefit of working: The marginal benefit
of working an extra hour is measured by how
much this extra hour of work will increase
consumption. The marginal benefit of working an
extra hour is measured by the real wage.
o Marginal cost of working: The marginal cost of
working an extra hour is that the worker must
give up other activities, which economists call
Leisure. Workers will supply labour up to the
point where the marginal benefit from an extra
hour of work, measured by the real wage, equals
the marginal cost of giving up an extra hour of
leisure.
The Supply of Labour

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R
E
A
L

W
A
G
E
,

M
P
N

Labour
W
N
N
S

The labour
supply curve is
upward sloping,
reflecting the
assumption that
the higher real
wage will induce
workers to give
up more leisure
and work more
hours.

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Figure 3-4: Labour Supply Curve
o Full employment: Occurs when all members of
the labour force are employed; individuals not
working are not in the labour force and therefore
are not counted as being unemployed.
Equilibrium in the Labour Market

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Y* = F(K, N*)
(9)
R
E
A
L

W
A
G
E
,

M
P
N

Labour
W
N
N
S

N
D

W*
N*
Given that the
real wage moves
quickly to
ensure constant
market
equilibrium, the
equilibrium
amount of
employment, N*,
represents full
employment in
the labour
market.

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Figure 3-5: Labour Supply Curve
P
R
I
C
E

L
E
V
E
L

OUTPUT
P
Y Y*
In the long run,
full employment
output depends
only on the
production
function and is
independent of
the price level.
Therefore, the
AS curve is
vertical at the
level of full
employment
output.

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Figure 3-6: Classical Supply Curve
S
The Demand for Goods and Services
o Rate of time preference: The rate at which you are
willing to give up consumption today if you are
compensated by increased consumption in the
future.
o Rate of interest: Return on an investment
measured in dollars of constant value; roughly
equal to the difference between the nominal
interest rate and the rate of inflation.
o Private savings (S
P
): Saving by individuals, by
families, and by firms; saving by everyone other
than government.

Consumption and Savings

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Savings
r
S
S
P

The savings
curve shows the
amount
consumers are
willing to save
for each real
interest rate.

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Figure 3-7: Savings Curve
The curve
slopes upward,
as we assume
that an
increased return
on savings (the
real rate of
interest) makes
current
consumption
less attractive.
R
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Investment
r
I
I
The desire of a
firm to build
more machinery
and equipment,
which is
investment
spending,
depends
negatively on
the real rate of
interest.

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Figure 3-8: Investment Demand Curve
o Consumers by their savings are suppliers of funds and
businesses by their borrowing are demanders of funds.
Equilibrium: Saving Equals Investment
o Equilibrium: Savings equals Investment.
o (10) Y = C + I + G is the national income identity
o (11) Y - C - G = I o (12) YD = Y + TR - TA
o (13) (YD - C) + (TA - TR - G) = I
o S = S
P
+ S
G
= I
o TA - TR - G is government saving

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r
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Io = So
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Savings, Investment
r
S, I
S
For aggregate
demand
equilibrium, total
savings equals
investment.
Total savings is
composed of
private sector
savings and
government
savings in terms
of the budgetary
surplus or
deficit.
I

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Figure 3-9: Savings and Investment
r
o

I
o
= S
o

r
1

I
1
= S
1

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Savings
r
S
When the
government
runs a budget
deficit,
government
savings is
negative. The S
curve curve
shifts to the left.
The result is that
the government
budget deficit
causes a higher
real interest rate
and lower total
savings.
I
S
S

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Figure 3-10: Effects of a Government Budget Deficit

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Figure 3-11: Effects of the Canadian Budget Deficits, 1972-2002
The Money Stock, the Price Level, and the Inflation Rate
o Money is a medium of exchange as seen by the quantity equation:
o (14) MV = PT
o M: Money supply (Money stock)
o V: Velocity of circulation
o P: Average price of all transactions
o T: All the real transactions in the economy
o PT: Number of dollars exchanged per period
o (15) V = PT/M
o V: measures the speed with which money circulates in the
economy.
Money

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o Using Y as a proxy for T
Money (contd)
o The demand for money is expressed in terms of
real money
o The supply for money is expressed in terms of
real money and is determined by the central
bank

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MV=PY
(15)

D
M
P
= kY
(16)

M
P
= kY
(17)
o In equilibrium
o If V = 1/k and V is constant
o The Quantity Theory of Money predicts

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Money (contd)

M
1
k

(

(
= PY
(15)

MV= PY
(20)

AM=AP
(21)
o The Quantity Theory of Money in dynamic terms
Money Growth and Inflation
o Because velocity is assumed constant and
because real income changes only due to
changes in the production process

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%AM=%AP
(23)

%AM+%AV =%AP+%AY (22)

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Figure 3-12: Rate of Growth of Money and the Inflation Rate, 1880-2000 (Decade
Averages)
o The Real Rate of Interest
o (24) r = i - t
o (25) i = r + t
o In the long run, the inflation rate has two
components:
o Real return (r): your ability to purchase goods and
services
o Inflation rate (t): Compensation for the change in
purchasing power.
o The Fisher Effect: A long run increase in the
inflation rate will increase the nominal interest
rate, so that the real interest rate will not change
due to inflation.
The Real Rate of Interest in the Long Run

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Chapter Summary
In the long run, the Classical model states that all factors
of production are fully employed and that prices are
flexible.
The Classical model has three ingredients: supply of
goods and services, demand for goods and services, and
the quantity theory of money.
Aggregate supply is determined by the production
function.
Labour demand depends on the marginal product of
labour, the supply depends on workers choosing
between work and leisure.
Aggregate demand determines the allocation of income
among consumption, investment, government spending,
and next export spending.

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Chapter Summary (contd)
Consumers choose between current consumption and
savings.
Government savings is measured by the budgetary deficit
or surplus.
In equilibrium, total savings equals investment.
In the long run, the quantity theory of money predicts that
the price level is determined by the level of the stock of
money.
In the long run, changes in the nominal money stock have
no real effect on variables.
The Fisher effect states that a change in the inflation rate
will bring about a change in the nominal interest rate in
the long run.

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The End

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