The Long-Run Macroeconomic Model

I.          The Long-Run Macroeconomic Model

A. Key Assumption: Flexible wages, prices, and interest rates.  Markets work, always at full employment and there is no need for government intervention. Government intervention → inflation.

B.        Derive the long-run aggregate supply curve (LRAS)

1.         Four-quadrant model

a.         Labor market (real wages and labor)

i.          Labor demand

ii.         Labor supply

iii.        Equilibrium real wage and employment

b.         Production function

i.          Y=A F(L, K, H, N)

ii.         Graph

2.         Derive the LRAS: Combinations of P and Y

a.         P →w

b.         ¯P → ¯w

c.         %Δ in P → = %Δ in w → constant real wage

d.         Always at full employment.  Unemployment rate = natural rate of unemployment

e.         vertical long-run aggregate supply curve: Always at full employment → natural rate of unemployment

C.        Derive the aggregate demand curve = AD = C + I + G + X - M

1.         Equation of exchange

a.         MV = PY: money received in money spent

b.         Assume M and V constant:

            P = MV(1/Y) → rectangular hyperbola

c.         Becomes AD curve: inverse relationship between P and Y

D.        Long-run equilibrium: Intersection of LRAS and AD

III.       Shocks to the long-run model: Use the 4-quadrant model

A.        Supply Shocks: Shifts in the LRAS 

1.         ΔL

2.         ΔH

3.         ΔK

4.         ΔN

5.         ΔA

B.        Demand shocks: Shifts in AD

1.         Fiscal policy: ΔG and/or ΔT → ↑AD

a.         Perfect crowding out

b.         No ΔY_f.  Only change in P.

2.         Monetary policy: ΔM

a.         M → P but no Δ in Y_f

b.         Classical Quantity theory of money

i.          Theory of inflation

ii.         Equation of exchange

iii.        Assumptions

n         Y is constant

n         V is constant

iv.        ΔM → No Δ in Y_f.  ΔM → Δ P.  %Δ M = %Δ P 

C.        Conclude: shifts in LRAS affects Y_f but shifts in AD doesn’t affect Y_f

II.        Economic growth:

A.        Economic growth → LRAS →

1.         L

2.         K

3.         H

4.         N

5.         A

B.        Productivity

1.         = amount of goods and services produced from each hour of worker time

2.         Productivity depends on K, H, A, and N

C.        Preconditions for economic growth

1.         Economic freedom

2.         Property rights

3.         Markets

D.        Government actions to economic growth

1.         saving and investment

2.         Foster education

3.         Maintain property rights and political stability

4.         Allow free trade.  Free trade → competition → efficiency & innovation

5.         Control population growth

6.         Promote R&D