>	Econ 100b Created 4/30/1996 Go to Brad De Long's Home Page

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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

• 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).