The Classical Model
Rational self-interest
-Adam Smith -Decision maker better off -Households maximize "utility" -Firms maximize profit
No Money Illusion
-Agents aware of price changes Economic decisions based on real variables, not nominal variables when there is money illusions
Market Clearing
-Always in equilibrium Wages, prices, and interest rates flexible so that markets (product, labor and capital markets) always clear
Components of Classical Model
-Explains long-run growth -Wages, prices and interest rate are fully flexible, so that markets are always in equilibrium -Relies on microeconomics
Classical Model
A model based on the writings of classical economists from Adam Smith to the Great Depression -Self-adjusting= keep economy at full employment -Little gov't intervention
Crowding out effect
An increase in government spending will lead to an increase in real interest rates, causing investment and consumption spending to decline
Money Neutrality
Change in money supply has no effect on real variables, only nominal variables
Marginal Product
Hiring one more unit of labor/input into the economy
Classical Dichotomy
Idea that real variables can be separated from nominal variables -Real GDP determined without consideration of price level or nominal spending
Product Market
Price level adjusts so that desired spending is equal to the desired output in the economy Aggregate Demand=Aggregate Supply -Law of Diminishing Returns
Diminishing Marginal Returns
Production function for economy will be increasing at a decreasing rate -As quantity of input increasing, marginal product of that input will decline
Production Function
Shows relationship between quantity of labor employed in the economy and the amount of real GDP produced -Real GDP increases at decreasing rate -Technology/ capital held constant
Say's Law
Supply creates its own demand -In production, income is generated to purchase output produced -Spending adjusts to output in economy
Labor Market
The quantity of labor that the economy wants to hire at different wage rates in order to maximize their prices -Real wages make labor supply/ demand decisions
