Chapter 7 The Classical Long-Run Model
Review Questions
2.In the classical model, market clearing in the labor market assures that the economy will achieve full employment automatically. An excess supply of labor will cause the real wage to drop; an excess demand for labor will cause the real wage to rise. While this may not be realistic over shorter periods of time, it does make sense over longer periods. For example, an excess supply of labor (very high unemployment) will not lead immediately to falling real wages; but if the excess supply persisted, we would expect the real wage to drop eventually.
4.The slope of the production function becomes flatter as employment increases because of diminishing returns to labor. That is, as we continue to add equal numbers of workers, output increases, but by less and less each time. Diminishing returns to labor arise because as we continue to add workers, potential gains from specialization become exhausted, and because of decreases in the amounts of capital and land available for each worker.
6.Net tax revenue is equal to total tax revenue minus transfer payments. The distinction is important because the part of total tax revenue that goes to transfer payments represents funds that are moved from one part of the household sector to another; it is only what is left over—net tax revenue—that is available to the government for spending on goods and services.
8.The supply of funds is the sum of household saving and the government’s budget surplus, if any.
10.The budget deficit does not affect the slope of the demand for funds curve because the government is assumed to borrow the same total amount at any interest rate. It is only the business demand for loanable funds that is affected by changes in the interest rate. Thus, any given rise in the interest rate will cause the same decline in the demand for loanable funds whether the government runs a deficit or not. While a larger deficit will shift the demand for funds curve rightward, it will not change the curve’s slope.
12.According to the classical model, demand-management policy (fiscal and monetary policy) is unnecessary and ineffective. Higher government spending, for example, will cause decreases in both investment and consumption spending which, in total, are equal to the increase in government spending. Thus, total spending will remain unchanged, even though government spending is greater.
14.Changes in investment is the only type of spending in GDP that is not planned. It occurs when buyers buy more or less than firms thought they would.
Problems and Exercises
2.a.Government purchases = government payroll + government outlays for materials = $3 + $2 = $5 billion
b.(With a balanced budget) Net Taxes = Government purchases = $5 billion
c.Total Investment = change in the capital stock + depreciation = ($103 – $100) + (0.07 $100) = $10 billion
d.Real GDP = C + I + G = $50 + $10 + $5 = $65 billion
e.Total saving = Investment + Deficit = $10 + $0 = $10 billion
f.Total leakages = S + T = $10 + $5 = $15 billion
g.Total injections = I + G = $10 + $5 = $15 billion
4.The interest rate would ordinarily rise when the government begins running a budget deficit and the demand for loanable funds curve would shift rightward. But with the usury ceiling, it cannot rise. The result would be an excess demand for loanable funds. The supply of loanable funds (saving) would remain unchanged at $10 billion, while the demand for loanable funds would increase by $2 billion to $12 billion, creating an excess demand for loanable funds of $2 billion. Thus, in this scenario, the leakages (savings plus taxes) do not equal the injections (government spending plus planned investment). Moreover, the short side of the market would determine the quantity of loanable funds traded, which would be $2 billion. So businesses would be unable to borrow all of the funds they wanted to borrow for investment purposes.
6.a.“Crowding in” is the increase in one sector’s spending caused by a decrease in some other sector’s spending. If the crowding in is “complete,” then there is a dollar-for-dollar increase in one sector’s spending caused by a decrease in some other sector’s spending.
b.This statement is true. To see this, look at the graph shown in the answer to Problem and Exercise #5, above. As a result of the decrease in government purchases, both investment spending and consumption spending increase. The increased spending by households and businesses exactly offsets the decrease in government purchases.
8.
Define the surplus as T – G. This surplus will be part of the supply of funds in the loanable funds market. The interest rate will adjust until the supply of funds equals the demand for funds, that is, until S + (T – G) = I. Rearrange this expression to find S + T = I + G. Say’s Law still holds.
10.a and b.
From the text accompanying Figure 10, we know that at point (a) government borrowing was equal to $0.75 trillion and borrowing by business firms was equal to $1 trillion, so that total demand for funds was equal to $1.75 trillion at the 5% interest rate. At point (b), government borrowing has increased by $0.5 trillion to $1.25 trillion, but planned investment has fallen by $0.2 trillion to $0.8 trillion.
12.
As consumption rises with no change in net taxes, savings will begin to fall. This will drive up the interest rate in the loanable funds market, until a new equilibrium is reached where fewer funds are being traded ($X) on the accompanying graph. When the new equilibrium is reached, C will be larger (although not as large as if the interest rate had not changed), IP will be smaller, and G will not change.
Challenge Questions
2.The predictions of doom would cause consumers to cut back on their spending and increase their saving at any given interest rate, for fear that they might lose their jobs or suffer income loss in the future. This would shift the supply of funds curve rightward. At the same time, business firms would pursue fewer investment projects at any given interest rate—the demand for funds curve would shift leftward. Together, these shifts would lead to a lower interest rate. The equilibrium quantity of funds could rise or fall, depending on which shift (supply or demand) is greater.
Economic Applications Exercises
2.a.Empirical data indicates that there is an inverse relationship between economic growth rate and unemployment rate. As the economy goes into a recession (these periods are pointed out in the first diagram), unemployment rises as the wages don’t adjust to clear the labor markets. Thus, in the short-run sticky wages don’t support the classical assumption that labor markets clear.