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prepared by:
by:
PowerPoint
Andreea CHIRITESCU
CHIRITESCU
Andreea
Eastern Illinois
Illinois University
University
Eastern
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Macroeconomic Models
Classical model
Macroeconomic model that explains the
long-run behavior of the economy
Developed by economists in the 19th and
early 20th centuries
Market forces drive the economy toward
full employment
Great Depression
Output was stuck far below its potential for
many years
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Figure 1
U.S. Real GDP, 18202010 (Logarithmic Scale)
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Macroeconomic Models
1936, John Maynard Keynes
Keynesian model
Classical model might explain the
economys operation in the long run
The long run could be a very long time in
arriving
Production could be stuck below its potential
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Macroeconomic Models
Keyness ideas
And their further development help us
understand economic fluctuations
Movements in output around its long-run trend
Classical model
Has proven more useful in explaining the
long-run trend itself
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Macroeconomic Models
Assumption in classical model
Some simplifying assumptions
Assumption about how the world works:
markets clear
The price in every market will adjust until
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2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
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Real wage
Measured in the dollars of some base year
The amount of goods that workers can
buy with an hours earnings
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Figure 2
The Labor Market
Real
Hourly
Wage
LS
A Excess Supply B
of Labor
$30
25
20
J
Excess Demand
for Labor
150 million =
Full Employment
LD
Number of
Workers
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13
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Figure 3
Output Determination in the Classical Model
Real
Hourly
Wage
LS
In the labor market, the demand
and supply curves intersect to
determine employment of 150
million workers.
$25
LD
Total Output
(Real GDP)
150 million
Number of Workers
$10 Trillion
=Full
Employment
Output
150 million
Number of Workers
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successive worker
16
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Figure 4
Total Spending in a Simple Economy
An economy producing total output of $10 trillion will, by definition, create $10 trillion in factor
payments or total income. If households spend all of this income on consumption goods, then
total spending will equal $10 trillion as well.
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services
Households
Send their income on consumption, taxes,
and savings
Business firms
Purchase capital goods (investment spending)
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Table
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IP=I- inventories
Net taxes (T)
Total government tax revenue minus
government transfer payments
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Total spending = C + IP + G
Leakages = T + S
Income earned by households that they do
not spend on the countrys output during a
given year
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S + T = IP + G
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Figure 5
Leakages and Injections
By definition, total output equals total income. Leakagesnet taxes (T) and saving (S)reduce
consumption spending below total income. Injections government purchases (G) plus planned
investment spending (Ip)contribute to total spending. When leakages equal injections, total
spending equals total output.
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these funds
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Figure 6
Household Supply of Loanable Funds
Interest
Rate
5%
3%
1.5 1.75
Trillions
of Dollars
per Year
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Figure 7
Business Demand for Loanable Funds
Interest
Rate
5%
3%
1.5
Trillions of
Dollars per
Year
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Figure 8
The Demand for Funds
Summing business
demand for loanable funds
at each interest rate
Interest Rate
Interest Rate
(b)
(c)
(a)
5%
3%
Business Demand
for Funds (Ip)
B
1.0
1.5
Trillions of dollars per year
5%
3%
Government
Demand for
Funds (G-T )
B
5%
3%
0.75
Trillions of dollars per year
1.75 2.25
Trillions of dollars per year
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Says law
It holds as long as the loanable funds
market clears
Total spending equals total output
True even in a more realistic economy
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Figure 9
Loanable Funds Market Equilibrium
Interest
Rate
5%
Total Supply
of Funds (Saving)
E
Trillions of
Dollars per Year
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Figure 10
How the Loanable Funds Market Ensures That Total
Spending = Total Output
Because the loanable
funds market clears,
we know that total
leakages will
automatically equal
total injections. The
leakage of net taxes
goes to the
government and is
spent on government
purchases. If the
government is
running a budget
deficit, it will also
borrow part of the
leakage of household
saving and spend
that too.
Any household saving left over will be borrowed by business firms and spent on capital. Thus, every dollar of
leakages turns into spending by either government or private business firms.
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{S
= 1IP4
+(G
- T)
2 43
Quantity of
Quantity of
funds supplied funds demanded
P
Loanable funds markets clear S
+
T
=
I
{
{+G
Leakages
Injections
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Demand-side effects
Macroeconomic policy effects on total
output that work through changes in total
spending
Classical model
Fiscal policy has no demand-side effects
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in savings)
Governments purchases
Have crowded out the spending of
households (C) and businesses (I p)
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Figure 11
Crowding Out from an Increase in Government Purchases
Interest
Rate
Total Supply
of Funds (Saving)
B
7%
F
5%
IP
Ip+G1-T
1.75
AH = G
2.05
Ip+G2-T
Beginning from equilibrium at point A, an increase in the budget deficit caused by additional government
purchases shifts the demand for funds curve from Ip + G1 T to Ip + G2 T. At point H, the quantity of
funds demanded exceeds the quantity supplied, so the interest rate begins to rise. As it rises, households
are led to save more, and business firms invest less. In the new equilibrium at point B, both consumption
and investment spending have been completely crowded out by the increased government spending.
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44
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saving)
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Figure 12
Crowding Out from a Tax Cut
Interest
Rate
B
Total Supply
of Funds (Saving)
AH = T
= Initial C
7%
F
5%
C
I P
Ip+G-T1
1.75
2.05
Ip+G-T2
Beginning from equilibrium at point A, an increase in the budget deficit caused by a tax cut shifts the demand
for funds curve from Ip + G T1 to Ip + G T2. If the tax cut is entirely spent, consumption initially rises by the
distance AH. At the original interest rate of 5 percent, the quantity of funds demanded now exceeds the
quantity supplied. This causes the interest rate to rise. As the interest rate rises, we move from A to B along
the supply of funds curve. Saving rises (and consumption falls) by the distance AF. The final rise in
consumption is FH. We also move along the demand for funds curve from H to B, so investment falls by the
distance FH. In the new equilibrium at point B, consumption (which has risen by FH) has completely crowded
out investment (which has dropped by FH).
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investment
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its own
Fiscal policy
Has no demand-side effects on output or
employment
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Injections = X + IP + G
Exports, planned investment, government
purchases
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Equilibrium: S + (IM X) = IP + (G T)
S + T + IM = IP + G + X
Leakages = Injections
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Figure A.1
The Loanable Funds Market with a Trade Deficit
Interest Rate
Total Supply
of Funds [S +(IM-X)]
5%
Trillions of
Dollars per
Year
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country
Will be matched by an equal drop in global
consumption and investment spending
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