The Classical Model of the Closed

Economy in the LR (Ch3)

MGEB06
 Outline of Topics
1) Where does the Supply of output come from (in the
Long-Run)? [i.e., Output as value-added production]
2) Who earns what share of output as Income (in the
Long-Run)? [i.e., Output as aggregate income]
3) Where does the Demand for output come from (in the
Long-Run)? [i.e., Output as aggregate expenditure]
4) Long-Run Equilibrium & Experiments (i.e., impacts
of shocks to LR equilibrium, if any)

2
The Aggregate Production Function
We assume that we can write down one function
that answers question #1, namely:

Y  A  F ( K , L)
Where:
K = the aggregate real stock of productive capital
L = the aggregate real stock (or supply) of labour
F( ) is a production function that transforms
inputs (K&L) into real output (Y = real GDP)
3
The A Term: TFP or Solow Residual

Y  A  F ( K , L)
The A term picks up (models) the impact (or effect)
of all left out inputs & technological features. Since
it acts as a residual collecting up all these left out
terms it has often been called the Solow Residual.
Another common name is Total Factor
Productivity (or TFP) since it picks up (models)
the productivity of all inputs in total (not one by one
in average or marginal terms).
4
The A Term: TFP or Solow Residual

Y  A  F ( K , L)
Normally the A term is assumed to be fixed.
The A term will/can change whenever:
- There is a change in energy prices;
- There is a change in weather (away from normal);
- There is a change in rules & regulations;
- There is a change in management practises; or
- There is a change in technology.
5
 The Production Function
In the Long-Run, the supply of output is
determined by the inputs (K & L) and technology
(A & F( ) ).

Y  A  F ( K , L)
S

Of course this means that Taxes (T), Government

spending on goods & services (G), the nominal
Money supply (M), and many other economic
variables have no direct bearing or influence on the
(equilibrium) level of Y in the LR. 6
 The Production Function
In the Long-run, i) the average price level is
perfectly flexible, and ii) capital & technology are
both fixed.
K S  K , A & F( ) are all fixed

If we also assume that the supply if labour is also

fixed, LS
 L , then as a result the supply of
output is also fixed (in the LR).

Y  Y  A  F (K , L )
S

7
 The Production Function

Y Y
We call the level of output such that: S

- The natural rate level of output;

- The full employment level of output;
- The level of Potential output;
- The long-run equilibrium level of output;
&/or
- The non-accelerating inflation rate level
of output (NAIRU).
8
F(K,L) – Mathematical Assumptions
1) Signs of the first partial derivatives
2) Signs of the second (own & cross) partial
derivatives
3) Impacts of equi-proportionate changes in all inputs.
Returns to Scale – i.e., What return to output is
experienced if we scale all inputs up (or down) by the
same percentage?

Y  A  F ( K , L)
9
 First Derivatives of F(K,L)
We assume that the signs of BOTH first partial
derivatives of the prod’n function are POSITIVE.
Y F ( K , L)
 A  MPK  0
K K
Y F ( K , L)
 A  MPL  0
L L
We are assuming that both inputs are always useful
inputs, as they always have a Positive Marginal
Product.
MPL = Marginal Product of Labour
MPK = Marginal Product of Capital 10
 Second Derivatives of F(K,L)
We assume that the signs of BOTH second own
partial derivatives of the prod’n function are
NEGATIVE. 2
Y   Y  MPK
   0
K 2
K  K  K
 2Y   Y  MPL
   0
L 2
L  L  L
We are assuming that both inputs contribute less and
less additional output as their use is increased
(holding all other inputs & technology fixed). That
is, both inputs exhibit what is know as Diminishing
Marginal Product. 11
 Second Derivatives of F(K,L)
We assume that the sign the second cross partial
derivatives of the prod’n function is POSITIVE.

 2Y   Y  MPL MPK  2Y
     0
KL K  L  K L LK

We are assuming that (on average) both inputs

Complement each other in the production process.
- A little bit more (less) K causes the Marginal
Product of Labour to rise (fall).
- A little bit more (less) L causes the Marginal
Product of Capital to rise (fall). 12
 Returns to Scale
We assume the production function exhibits Constant
Returns to Scale (CRTS).

That is, if all inputs (K&L) are scaled up (or down)

by the same percentage then as a result (the level
of) output moves up (or down) by the exact same
percentage.
  Y  A  F (  K ,   L), for any   0
For example:
If λ = 2, doubling the use of both K & L causes Y to double as well.
If λ = 1.035, using 3.5% more K & L causes Y to rise by exactly 3.5%.
If λ = 0.885, using 11.5% less K & L causes Y to fall by exactly 11.5%. 13
 Ex: Cobb-Douglas Production Function
A commonly used functional form is the so-called
Cobb-Douglas Production Function (shown
below).
 1
Y  A K  L
Where 0 < α < 1
This function exhibits all our assumed properties:
- Positive Marginal Products (of L & K)
- Diminishing Marginal Products (for L & K)
- Complementarity between L & K and CRTS 14
 Ex: Cobb-Douglas Production Function

Y  
MPL   (1   )  A  K  L  0
L
 
K  K
MPL  (1   )  A      (1   )  A     0
L  L
Y 
MPL  1        0
L
This function exhibits Positive Marginal Products
Note: This is due to the fact that A, K & L are all positive &
the assumption that 0 < α < 1 15
 Ex: Cobb-Douglas Production Function

MPL  Y 2
  1
 2   (1   )  A  K  L  0
L L
MPK  Y
2
 2 1
  (  1)  A  K  L  0
K K 2

Note: Since (-α) < 0 & (α-1) < 0

Then this function exhibits Diminishing Marginal

Products
16
 Ex: Cobb-Douglas Production Function

MPL Y 2
 1 
   (1   )  A  K  L  0
K KL
MPK Y
2
 1 
  (1   )  A  K  L  0
L LK
Note: Since (α) > 0 & (1-α) > 0

Then this function exhibits Complementarity between

the Labour & Capital inputs
17
 Ex: Cobb-Douglas Production Function
Note: If this holds, then the function exhibits CRTS

 1
  Y  A  (  K )  (  L )
  1 1
 A  K  L
It holds.
 1  1
  A K  L
So CRTS
has been
established

  Y
Since the powers on K & L add to one, this function
clearly exhibits Constant Returns to Scale (CRTS)
18
 Some additional assumptions

We now introduce (use) the following bundle of 3

(additional) assumptions:

1) Constant Returns to Scale (CRTS)

2) Perfect Competition (PC)

3) Profit Maximization

19
 Perfect Competition (PC)

The assumption of PC brings with it a number of

implications (as seen in MGEA02 for example).

One implication is that we have price taking

behaviour (rather than price making behaviour).
All market participants have no power over prices
& let markets determine them.

P = Nominal price of (real) output = GDP deflator

W = Nominal wage rate for labour
R = Nominal rental price of capital
20
 Profit Maximization – Nominal Form

Nominal Eco Profit = (Nominal TR) – (Nominal TC)

Nominal Eco Profit = Nominal GDP – Nom cost of L&K

Π = P•Y - W•L - R•K
Π = P•A•F(K,L) - W•L - R•K

Max Π = P•A•F(K,L) - W•L - R•K

K&L
given P, W, R, A & F( )

21
Profit Maximization – FOCs (Nom form)

 F ( K , L)
 P  A W  0 To Max eco
L L Profit we need
to set:

Nom MR (of

 F ( K , L) an input)

 P  A R  0 =
K K
Nom MC (of
that input)

22
 Profit Maximization – Real Form

Real Eco Profit = (Real TR) – (Real TC)

Real Eco Profit = Real GDP – Real cost of L&K

Real Eco Profit = (Nominal Eco Profit)/(GDP Deflator)
(Π/P) = Y – (W/P)•L – (R/P)•K
(Π/P) = A•F(K,L) – (W/P)•L – (R/P)•K

Max (Π/P) = A•F(K,L) – (W/P)•L – (R/P)•K

K&L
given P, W, R, A & F( )
23
Profit Maximization – FOCs (Real form)

 ( / P) F ( K , L)  W 
 A  0 To Max eco
L L P  Profit we need
to set:

Real MR (of

 ( / P) F ( K , L)  R  an input)

 A  0
K K
=
P Real MC (of
that input)

24
 Profit Maximization – FOCs (Real form)

 ( / P) W 
 MPL   0
The profit
maximizing
L P  demand
curve for
labour
(capital) is
 ( / P) R given by the
 MPK     0 MPL (MPK)

K P
curve.

In LR equilibrium: The marginal product of an

input is equal to the real rental price of that input.
25
 (Profit Maximizing) Labour Demand
W  The labour demand curve is in the positive
 
P quadrant due to the assumption of positive MPL.

The labour demand curve is downward sloping

due to the assumption of diminishing MPL.

MPL  L d

L
26
 (Profit Maximizing) Labour Demand
W 
 
P

W 
 
 P 1
W 
 
 P 2
MPL  L
d

L1 L2 L
27
 Labour Market (rental market for L)
W 
  The assumptions that we have a
P S
L fixed supply of labour & perfectly
flexible real wage implies that at the
LR equilibrium real wage there is full
employment in the labour market.
*
W 
 
P
MPL  L d

L L
28
 Labour Market (rental market for L)
W  Suppose the level of total factor
 
P S productivity (TFP) suddenly rises
L (an improvement in technology).
As a result the labour demand curve
shifts up to the right. At the resulting
** new LR equilibrium the real wage
W 
  has increased (we still have full
P employment).
*
W 
 
P
MPL  L d

L L
29
 Labour Market (rental market for L)
W  Suppose the supply of labour
 
P S suddenly rises (say due to
L immigration). As a result the labour
supply curve shifts to the right. At the
resulting new LR equilibrium the
real wage has decreased & the level
of employment has risen (again we
* still have full employment).
W 
 
P

MPL  L d
**
W 
 
P

L L
30
 CRTS: Euler’s Theorem (Income side)
Euler’s theorem say’s that if we have a function,
say, Y = A•F(K,L), that exhibits Constant Returns
to Scale, then the following is true:
Y Y
Y  K  L
K L
Y  MPK  K  MPL  L
R W 
Y    K    L
P  P
This implies that in LR equilibrium there is zero
economic profit (for the whole economy).
31
 CRTS: Euler’s Theorem (Income side)
We have: R W 
Y    K    L
P  P
If we divide each side by Y, we get:
 R    W  
 P  K   P  L 
1        
 Y   Y 
   

Where:  R  
 P  K 
    Capitals Income Share
 Y 
 
32
 CRTS: Euler’s Theorem (Income side)
Suppose we have a Cobb-Douglas production
function:  1
Y  A K  L
Then:  1 1
MPK    A  K L
But profit maximization implies R
MPK   
P

So this implies  R   K  MP  K    A  K  1  L1  K    Y

  K
P
 R  
 P  K 
    Capitals Income Share  
 Y 
  33
 Demand for Output (goods & services)
We can interpret the right hand side of the National
Income Identity (NII) as output demanded:
Y = C + I + G + NX Goods Mkt Equil.
The assumption of a closed economy implies
NX = 0, so we get: Yd = C + I + G

Rather than build a single model of output demand

we instead create three separate models (one for
each of C, I & G) and use the NII to get arrive at
the level of output demanded.
34
 The Consumption Function
The Consumption Function explains the demand
by the private sector for goods & services to be
consumed.

C  C0  C1  (Y  T )
Where:
C0 = the level of autonomous consumption
C1 = the Marginal Propensity to Consume (MPC)
= the slope of the consumption function
35
 The Consumption Function

C
C = C0 + C1•(Y-T)

C C
Slope = C1  
Y  Y  T 
C0

(Y-T)

36
 The Investment Function
The Investment Function explains the demand in
the economy (by all sectors) for investment
spending (i.e. the spending of funds to build new K
or to maintain it).
I  I 0  I1  r
Where:
r = the real interest rate
I0 = the level of autonomous investment
I1 = the real interest rate sensitivity of investment
37
 The Investment Function

r
I = I0 – I1•r
 
r  1   1 
Slope =   
I   I     I1 
  r  
 

I0 I
38
 The Real Interest Rate
The Fisher Equation shows the relationship
between the real interest rate, the nominal interest
rate and the rate of inflation (for the same window of

i  r 
time).

Where:
i = the nominal interest rate
r = the real interest rate
π = the rate of inflation
39
 The Real Interest Rate
The Fisher Equation shows the relationship
between the real interest rate, the nominal interest
rate and the rate of inflation (for the same window of

i  r 
time).

So,

r  i 
40
 The Government Sector (G & T)
We do not make our model explain the
government’s decisions with respect to it’s levels
of expenditure on goods & services (G) and
taxes net of transfers (T).

That is we treat government fiscal policy as

exogenous.

G = G0 = net gov’t spending on goods & services

T = T0 = (tax revenue) – (transfers to agents)

= taxes net of transfers
41
 Saving in the Economy
In our closed economy saving comes in two forms
saving by the private sector and by the government.

Private Saving = (Y – T - C) = SPVT

Government Saving = (T – G) = SGOVT

Combining these two we get economy wide saving,

which is called national saving.

National Saving = SNAT = SPVT + SGOVT = (Y – C – G)

42
 Private Saving (SPVT)
Saving by the private sector is called:

Private Saving = (Y – T - C) = SPVT

We take the current real income of the private sector

(Y) minus the real taxes net of transfers (T) to arrive
at real disposable income (Y – T). Then whatever is
left over after paying for (current) consumption
spending is saved.

Private saving is usually positive, but it is possible

for it to be zero or negative.
43
 Government Saving (SGOVT)
Saving undertaken by the public sector or the
government is called:

Government Saving = GBB = (T – G) = SGOVT

We take the current income of the government (T)

and subtract the current consumption spending of the
government (G).

Also called the Government Budget Balance (GBB).

If SGOVT > 0 the govt is running a Budget Surplus
If SGOVT = 0 the govt is running a Balanced Budget
If SGOVT < 0 the govt is running a Budget Deficit 44
 Output Market (goods & services)
The National Income Identity (NII) shows
r
YS Y = C + I + G (closed economy so NX = 0)

(Supply of Output) = (Demand for Output)

In the LR, YS = A•F(K,L) = Ybar

while Yd = (C + I + G). Given A, K, L, F( ),

C0, I0, G0, T0, C1 & I1 the real interest rate
r* varies until we arrive at LR equilibrium.

Yd

Y Y
45
 Output Market (goods & services)
The National Income Identity (NII) shows

Y = C + I + G (closed economy so NX = 0)

(Supply of Output) = (Demand for Output)

Subtract both C & G from both sides, we get: (Y – C – G) = I

But (Y – C – G) is the definition of National Saving

So we have SNAT = I
SNAT = the Supply of Loanable Funds
I = the Demand for Loanable Funds
46
 Output Market (goods & services)
In the LR, whenever YS = Yd
r (Goods Market Equilibrium), we
S NAT also must have SNAT = I (Loanable
Funds Market Equilibrium).

So given A, K, L, F( ), C0, I0, G0,

T0, C1 & I1, in the LR, the real
r* interest rate varies until we
arrive at LR equilibrium.

S S, I
47
 Long-Run Equilibrium
Given A, K, L, F( ), C0, I0, G0, T0, C1 & I1, in the LR, the real
interest rate (r) varies until we arrive at LR equilibrium SNAT = I
(Loanable Funds Market Equilibrium).

Given A, K, L, F( ), in the LR, the real wage (W/P) varies until

we arrive at LR equilibrium LS = LBar = MPL = Ld
(Labour Market Equilibrium).

Given A, K, L, F( ), in the LR, the real rental price of capital

(R/P) varies until we arrive at LR equilibrium
KS = KBar = MPK = Kd
(Equilibrium in the Rental Market for Capital).

48
 LR impact of shocks

Now we consider the LR impact of various shocks:

1) Change in the (nominal) money supply (Monetary Policy)
2) Change in government spending on G&S (Fiscal Policy)
3) Change of taxes net of transfers (Fiscal Policy)
4) Shift of the investment curve
5) Impact of a pandemic (like Covid)

49