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Copyright 2005 McGraw-Hill Ryerson Ltd. Slide 0
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C H A P T E R 3
The Economy in the Long Run:The Classical Market Clearing ModelLearning object ives
Understand that the difference between the long run andthe very long run.
Understand that over the long run, all factors ofproduction are fully employed.
Understand that in the Classical model equilibrium outputdepends on equilibrium labour use.
Understand that the demand for goods and services isbased on spending by the various sectors of theeconomy.
Understand that in the long run Classical model, the pricelevel is determined by the level of money supply.
PowerPoint slides prepared by Marc PrudHomme, University of OttawaCopyright 2005 McGraw-Hill Ryerson Ltd.
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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= AKN1 -
o : capitals share of income
o 1 - : labours share of incomeo Canadas production function:
3) Y= AK0.3 N0.7
C
hapter3:TheEc
onomyintheLongRun
General Form of the Production Function
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Copyright 2005 McGraw-Hill Ryerson Ltd. Slide 3
Changes in Factor ProductivityBOX
3-1Percent Change in Total Factor Productivity, 1976-2002
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Copyright 2005 McGraw-Hill Ryerson Ltd. Slide 4
The Supply of Goods and Services
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 theamount of labour input.
o In 2002: Y= 18.7 x (949.90.3) N0.7
C
hapter3:TheEconomyintheLongRun
Production Function in the Long Run
Y = F(K,N) (5)
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Copyright 2005 McGraw-Hill Ryerson Ltd. Slide 5
The Supply of Goods and Services
Outp
ut,Y(billionso
f1997dollars)
Labour, N(millions)0 5.0 10.0
C
hapter3:TheEconomyintheLongRun
Figure 3-1: Production Function with Fixed Capital and Technology
5 more units
of labour
286.1 more units
of output
A458.0
B
744.1
0
300.0
600.0
900.0
1200.0
Theproduct ion
funct ion
relates th e
amount of
outpu t that can
be produced
using v ar ious
amounts of the
labour input ,
hold ing c api tal
an dtechnology
constant .
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Copyright 2005 McGraw-Hill Ryerson Ltd. Slide 6
The Supply of Goods and Services
o Marginal Product of Labour (MPN): Theamount that output increases for eachadditional unit increase in labour input.
o Diminishing Marginal Product of Labour:
As labour use increases, the amount of
extra output that is gained from anincrease in labour input becomes smaller.
Marginal Product of Labour and Labour DemandC
hapter3:TheEconomyintheLongRun
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Copyright 2005 McGraw-Hill Ryerson Ltd. Slide 7
The Supply of Goods and Services
M
arginalProduct
Labour
MPN
N
MPN
C
hapter3:TheEconomyintheLon
gRun
Figure 3-2: Marginal Product of Labour Curve
The MPN curve is
downward
sloping , as each
addi t ional uni t of
labour contr ibutes
less to o utput
than the previousunit did . This is
cal led the
dimin ish ing
marg inal produc t
of labou r.
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Copyright 2005 McGraw-Hill Ryerson Ltd. Slide 8
The Supply of Goods and Services
o Marginal Cost of Labour (W): The amount paid bythe firm for an extra unit of output orThe nominalwage that must be paid to the extra unit of labourthat must be hired.
o Marginal benefit to the firm (or the value of themarginal product): The value of the additional unitof output that is produced by the additional unitof labour.
W = MPNx P (7)w = MPN (8)
C
hapter3:TheEconomyintheLon
gRun
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Copyright 2005 McGraw-Hill Ryerson Ltd. Slide 9
The Supply of Goods and Services
Figure 3-3: Demand for Labour Curve
RE
ALWAGE,M
PN
Labour
W
N
ND
Thedemand for
labour cu rveis
der ived from the
con di t ion that the
marg inal produ ct
of labour equals
the real wage. It is
downward sloping
due to the
dimin ish ing-
returns property
of the product ion
funct ion.
C
hapter3:TheEconomyintheLon
gRun
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Copyright 2005 McGraw-Hill Ryerson Ltd. Slide 10
The Supply of Goods and Services
o Marginal benefit of working: The marginal benefitof working an extra hour is measured by howmuch this extra hour of work will increaseconsumption. The marginal benefit of working anextra hour is measured by the real wage.
o Marginal cost of working: The marginal cost ofworking an extra hour is that the worker mustgive up other activities, which economists call
Leisure.Workers will supply labour up to thepoint where the marginal benefit from an extrahour of work, measured by the real wage, equalsthe marginal cost of giving up an extra hour ofleisure.
The Supply of Labour Chapter3:TheEconomyintheLon
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Copyright 2005 McGraw-Hill Ryerson Ltd. Slide 11
The Supply of Goods and Services
REALWAGE,M
PN
Labour
W
N
NSThelabour
supply curveis
upward s lop ing,
ref lect ing th e
assumpt ion that
the high er realwage wi l l induc e
workers to g ive
up more leisure
and work more
hours .
C
hapter3:TheEconomyintheLon
gRun
Figure 3-4: Labour Supply Curve
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Copyright 2005 McGraw-Hill Ryerson Ltd. Slide 12
The Supply of Goods and Services
o Full employment: Occurs when all members ofthe labour force are employed; individuals notworking are not in the labour force and thereforeare not counted as being unemployed.
Equilibrium in the Labour Market Chapter3:TheEconomyintheLon
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Y* = F(K,N*) (9)
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Copyright 2005 McGraw-Hill Ryerson Ltd. Slide 13
The Supply of Goods and Services
R
EALWAGE,MPN
Labour
W
N
NS
ND
W*
N*
Given that the
real wage m oves
quick ly to
ensure constant
market
equi l ibr ium, the
equi l ibr ium
amount of
emplo yment, N*,
represents ful l
employment in
the labou r
market .
C
hapter3:TheEconomyintheLon
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Figure 3-5: Labour Supply Curve
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Copyright 2005 McGraw-Hill Ryerson Ltd. Slide 14
The Supply of Goods and Services
PRICELEVEL
OUTPUT
P
YY*
In the long run ,
fu l l employment
output d epends
only on the
product ion
funct ion and is
independent ofthe pric e level.
Therefore, the
AS curve is
vert ical at the
level of ful l
employment
output .
C
hapter3:TheEconomyintheLon
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Figure 3-6: Classical Supply Curve
S
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Copyright 2005 McGraw-Hill Ryerson Ltd. Slide 15
The Demand for Goods and Services
o Rate of time preference: The rate at which you arewilling to give up consumption today if you arecompensated by increased consumption in thefuture.
o Rate of interest: Return on an investmentmeasured in dollars of constant value; roughlyequal to the difference between the nominalinterest rate and the rate of inflation.
o Private savings (SP): Saving by individuals, byfamilies, and by firms; saving by everyone otherthan government.
Consumption and Savings Chapter3:TheEconomyintheLon
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Copyright 2005 McGraw-Hill Ryerson Ltd. Slide 16
The Demand for Goods and Services
RealInterestRat
e
Savings
r
S
SP
Thesav ings
curveshows the
amount
consum ers are
wil l ing to save
for each real
interest rate.
Chapter3:TheEconomyintheLon
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Figure 3-7: Savings Curve
The curve
s lopes upward,
as we assume
that an
increased return
on savings (the
real rate of
interest) makes
current
consumpt ion
less attract ive.
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Copyright 2005 McGraw-Hill Ryerson Ltd. Slide 17
The Demand for Goods and Services
RealinterestRate
Investment
r
I
I
The desire of a
f i rm to bui ld
mo re machin ery
and equipm ent,
which is
investmentspending,
depends
negat ively o n
the real rate of
interest.
Chapter3:TheEconomyintheLon
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Figure 3-8: Investment Demand Curve
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Copyright 2005 McGraw-Hill Ryerson Ltd. Slide 18
The Demand for Goods and Services
o Consumers by their savings are suppliers of funds andbusinesses by their borrowing are demanders of funds.
Equilibrium: Saving Equals Investment
o Equilibrium: Savings equals Investment.
o (10)Y = C + I + Gis 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= SP+ SG= I
o TA - TR - Gis government saving
Chapter3:TheEconomyintheLon
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Copyright 2005 McGraw-Hill Ryerson Ltd. Slide 19
ro
Io = So
The Demand for Goods and Services
RealInteres
tRate
Savings, Investment
r
S, I
S
For aggregate
demand
equi l ibr ium, tota l
savings equals
investment.
Total saving s is
compo sed ofpr ivate sector
savings and
government
savings in terms
of the bud getary
surplus or
defici t .I
Chapter3:TheEconomyintheLon
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Figure 3-9: Savings and Investment
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Copyright 2005 McGraw-Hill Ryerson Ltd. Slide 20
ro
Io= So
r1
I1= S1
The Demand for Goods and Services
RealInterest
Rate
Savings
r
S
When the
government
runs a budget
def ic i t ,
government
sav ings is
negative. The S
curve curveshi f ts to the left .
The result is that
the governm ent
bud get defic i t
causes a higher
real interest rate
and lower tota l
savings.I
S
S
Chapter3:TheEconomyintheLon
gRun
Figure 3-10: Effects of a Government Budget Deficit
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Copyright 2005 McGraw-Hill Ryerson Ltd. Slide 21
The Demand for Goods and Services
Chapter3:TheEconomyintheLon
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Figure 3-11: Effects of the Canadian Budget Deficits, 1972-2002
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Copyright 2005 McGraw-Hill Ryerson Ltd. Slide 22
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 circulationo 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/Mo V: measures the speed with which money circulates in the
economy.
Money Chapter3:TheEconomyintheLon
gRun
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Copyright 2005 McGraw-Hill Ryerson Ltd. Slide 23
The Money Stock, the Price Level, and the Inflation Rate
o Using Yas a proxy forT
Money (contd)
o The demand for money is expressed in terms ofreal money
o The supply for money is expressed in terms of
real money and is determined by the centralbank
Chapter3:TheEconomyintheLon
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MV P (15)
DM
P kY (16)
M
P= kY (17)
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Copyright 2005 McGraw-Hill Ryerson Ltd. Slide 24
The Money Stock, the Price Level, and the Inflation Rate
o In equilibrium
o IfV= 1/k and Vis constant
o The Quantity Theory of Moneypredicts
Chapter3:TheEconomyintheLon
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Money (contd)
M1
k
= P (15)
MV = PY (20)
M =P (21)
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Copyright 2005 McGraw-Hill Ryerson Ltd. Slide 25
The Money Stock, the Price Level, and the Inflation Rate
o The Quantity Theory of Moneyin dynamic terms
Money Growth and Inflation
o Because velocity is assumed constant andbecause real income changes only due tochanges in the production process
Chapter3:TheEco
nomyintheLon
gRun%M = %P (23)
%M +%V = %P +%Y (22)
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Copyright 2005 McGraw-Hill Ryerson Ltd. Slide 26
The Money Stock, the Price Level, and the Inflation Rate
Chapter3:TheEco
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Figure 3-12: Rate of Growth of Money and the Inflation Rate, 1880-2000 (Decade
Averages)
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Copyright 2005 McGraw-Hill Ryerson Ltd. Slide 27
The Money Stock, the Price Level, and the Inflation Rate
o The Real Rate of Interesto (24)r = i -o (25)i = r +
o
In the long run, the inflation rate has twocomponents:o Real return (r):your ability to purchase goods and
services
o Inflation rate (): Compensation for the change inpurchasing power.
o The Fisher Effect: A long run increase in theinflation rate will increase the nominal interestrate, so that the real interest rate will not changedue to inflation.
The Real Rate of Interest in the Long Run Chapter3:TheEco
nomyintheLon
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Copyright 2005 McGraw-Hill Ryerson Ltd. Slide 28
Chapter Summary
In the long run, the Classical model states that all factorsof production are fully employed and that prices areflexible.
The Classical model has three ingredients: supply ofgoods and services, demand for goods and services, andthe quantity theory of money.
Aggregate supply is determined by the productionfunction.
Labour demand depends on the marginal product oflabour, the supply depends on workers choosingbetween work and leisure.
Aggregate demand determines the allocation of incomeamong consumption, investment, government spending,and next export spending.
Chapter3:TheEco
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Copyright 2005 McGraw-Hill Ryerson Ltd. Slide 29
Chapter Summary (contd)
Consumers choose between current consumption andsavings.
Government savings is measured by the budgetary deficitor surplus.
In equilibrium, total savings equals investment.
In the long run, the quantity theory of money predicts thatthe price level is determined by the level of the stock ofmoney.
In the long run, changes in the nominal money stock haveno real effect on variables.
The Fisher effect states that a change in the inflation ratewill bring about a change in the nominal interest rate inthe long run.
Chapter3:TheEco
nomyintheLon
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Copyright 2005 McGraw-Hill Ryerson Ltd. Slide 30
The End
Chapter3:TheEco
nomyintheLon
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