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