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THE ECONOMY AT FULL EMPLOYMENT: THE CLASSICAL MODEL

8. THE ECONOMY AT FULL EMPLOYMENT: THE CLASSICAL MODEL. CHAPTER. What’s Next?. Our Initial Roadmap: Review Basic Economic Principles – DONE Introduce the Key Indicators of Macroeconomic Performance – DONE

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THE ECONOMY AT FULL EMPLOYMENT: THE CLASSICAL MODEL

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  1. 8 THE ECONOMY AT FULL EMPLOYMENT: THE CLASSICAL MODEL CHAPTER

  2. What’s Next? Our Initial Roadmap: Review Basic Economic Principles – DONE Introduce the Key Indicators of Macroeconomic Performance – DONE Apply Economic Principles to Model the Determination of the Key Indicators of Macroeconomic Performance

  3. Our Economy’s Compass • Our economy follows a path like that of an explorer probing new terrain. • Sometimes the explorer strays of course. • But the explorer has a compass that helps keep getting back on the main track. • Our economy wanders around its main course—its full employment trend—but like the explorer, has a compass that keeps bringing it back. • The classical model is the compass and you’ll learn about it in this chapter.

  4. The Classical Model: A Preview • Economists have made progress in understanding how the economy works by dividing the variables that describe macroeconomic performance into two lists: • Real variables • Nominal variables • Real variables like real GDP, employment, and the real wage rate describe what is happening to living standards • Nominal variables like the price level and nominal wage rate tell us how dollar values and the value of money are changing.

  5. The Classical Model: A Preview • The two lists of variables form the basis of a huge discovery called the classical dichotomy, which states: • At full employment, the forces that determine real variables are independent of those that determine nominal variables. • For example, we can explain why real GDP in the United States is 20 times that of Nigeria by looking only at real variables. We don’t need to look at the price levels in the two countries.

  6. The Classical Model: A Preview • The classical model is a model of the economy that determines the real variables—real GDP, employment and unemployment, the real wage rate, consumption, saving, investment, and the real interest rate—at full employment. • Most economists believe that the economy is rarely at full employment but that the classical model provides a benchmark against which to measure the actual state of the economy.

  7. The Essential Stocks and Flows in the Macroeconomy Labor (L) and Capital (K) are combined via the available Technology (A) to produce Output (Y). Part of that output is Consumed (C). The remainder is Saved (S) and gets added to the economy’s capital stock as Investment (I). Thus, I = S.

  8. The Main Questions • What determines L and, therefore, Y? (Given K and A, L determines Y) 2. What determines S and I and, therefore K and C? (Given Y, S determines C; Given K, I determines the future K). 3. What determines A?

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