Classical Model

Production Function variables

L = quantity of labor; measured as # of workers or quantity of labor hours per year K = quantity of capital measured in base years, or factories per year Y = real GDP, annual output measured in units of tools, machines, or factories per year; Y = F (K, L)...assuming K is fixed P = price level, measured as the CPI or GDP price deflator Wage = nominal wage rate, earnings per hour measured in current dollars W = real wage rate, or the purchasing power of the nominal wage rate

M x V = P x Y; money supply increases, aggregate demand increases

M = money supply, quantity of money in circulation V = velocity, the turnover rate of money P = the price level Y = real GDP P x Y = nominal GDP

Pieces of Classical Model

Production Function (Y, L; (Y=F (K,L))) Labor Market (W, L; SL, DL) Product Market (P, Y; AS, AD)

Assumptions of Classical Model

Rational Self-Interest Market Clearing No Money Illusion Diminishing Marginal Returns

Marginal Product

additional output provided by one more unit of input MPl = change of Y / change of L

Diminishing Marginal Returns

assumes that there are diminishing marginal returns to resources in the economy labor resources increase, GDP declines increasing at a deceasing rate

Market Clearing

assumes wages, prices, and interest rates are flexible enough so that the markets always clear

Fiscal Policy

changes in government spending or taxes to influence some macroeconomic variable

Labor Market

consists of labor demand and labor supply firms must compare the additional benefits of hiring one more worker with the additional costs

Rational Self-Interest

decisions are made with a purpose and not arbitrarily

Aggregate Demand Curve

dependent on the money supply circulate enough times to purchase all of the goods and services produced in nominal GDP

No Money Illusion

economic decisions are based on read variables, not nominal variables

Profit Maximization

general firms will continue to hire a resource as long as it adds more revenue than it adds to the cost

Classical Dichotomy

idea that real variables can be separated from nominal variables in the classical model real variables depend on real variables nominal variables depend on nominal variables

Ways labor supply increases

immigration increases in human capital through education and training make more people eligible to work changes in household preferences or day care availability

Increase in labor productivity will lead to an increase in...

marginal product of labor and the demand for labor

Crowding out effect

occurs when an increase in gov't spending is exactly offset by declines in private spending, so that the aggregate demand curve remains unchanged

Equilibrium in loanable funds market

occurs where saving is equal to investment if interest rate is too high there will be a surplus in loans if interest rate is too low there will be a shortage of loans

Classical Model

provides a self-adjusting economy w markets that are flexible enough to keep the economy at full employment

Determinants of economic growth

quantity of labor marginal product of labor quantity of capital marginal product of capital technology

Labor Demand

quantity of labor that firms in the economy want to hire at different wages rates in order to maximize profits

Labor Supply

quantity of labor that households in the economy want to provide to firms to maximize their happiness

Aggregate Supply Curve

quantity of output that firms and workers are willing and able to produce at different price levels increase/decrease in price level does not affect the level of real GDP Vertical at the level of full employment

assumed real interest rate is flexible

real interest rates adjust so that saving is equal to investment in the loanable funds market changes in either savings or investment lead to changes in real interest rates that create counteracting changes to spending; unchanged

Production Function

relationship between quantity of labor employed in the economy and the amount of real GDP produces

Say's Law

supply creates its own demand believed the overproduction was impossible since production would create income to purchase that output