Long-Run Classical Model

Question 1

What determines output?

Answer 1

• Real forces of productivity, amount of capital (K), labor force (L), technology, and raw material cost
o Mainly supply, capital, and labor

Question 2

What determines prices?

Answer 2

• Flexible wages and prices (money)

Question 3

What determines interest rates?

Answer 3

• Supply and demand for loanable funds [same thing as S and I]
o Savings and investments determine real interest rates

Question 4

What is the loanable funds theory?

Answer 4

• Loanable funds theory
(used in a classical market analysis to describe the supply, demand, and interest rates for loans in the market for loanable funds)
o Explains why saving equals investment in the long-run and why Say’s law always holds

Question 5

What is Say’s law?

Answer 5

(supply creates its own demand hence no unemployment)

o Except structural and frictional but no cyclical

Question 6

What is the quantity theory?

Answer 6

• Quantity theory of money
(direct relationship between the quantity of money in an economy ad the level of prices of goods and services sold)
o Explains the role of money in the long-run classical model which is only to determine the price level and the nominal values
• MV=PY

Question 7

What is the natural rate of unemployment (NAIRU)?

Answer 7

• NAIRU
(Non-Accelerating Inflation Rate of Unemployment)
o Specific level of unemp that exists in an economy that does not cause inflation to increase
• Natural rat of unemployment
o ‘full employment’ unemp rate there is structural and frictional but not cyclical
• Structural and frictional no cyclical

Question 8

What is the relation between the nominal and real interest rates and inflation? (fisher’s equation)

Answer 8

• Nominal and Real interest rates
o Nominal interest rate is the percentage you pay the lender for the money borrowed
o Real interest rate is the percentage increase on purchasing power the lender receives when the borrower repays the loan with interest
• Inflations role
o Nominal interest rates do not take inflation into account, unadjusted for inflation
o Real interest rate is the actual percentage taking inflation into consideration
• Fisher’s equation
(provides the link between nominal and real interest rates)
o Real interest rate= nominal interest rate – inflation rate

Question 9

What causes inflation in the long-run?

Answer 9

• Demand and Supply shocks self-limiting
o Prices up the stop, unless D continues to increase
• Increase in the money supply
o Printing money

Question 10

What causes unemployment in the long-run?

Answer 10

• Natural rate of unemployment, so full employment

o Except structural or frictional

Question 11

What is crowding out?

Answer 11

(when gov must finance its spending with taxes and/or with deficit spending leaving business with less money and effectively ’crowding them out’)
o Government spending up and Investment down

Question 12

How does fiscal policy affect the economy in the long-run?

Answer 12

• Leads to complete crowding out of investment (bad) and thus has no impact on agg D or anything else (other than I)
• It is not needed and not effective in the long-run

Question 13

How does monetary policy affect the economy in the long-run?

Answer 13

• Only changes prices (and other nominal variables like the nominal interest rate, nominal wage rate, etc.)
• It is not useful or effective for stabilization in the long-run

Question 14

What is the long-run Philips curve and what does it imply? What makes the short-run curve shift to the right?

Answer 14

•	LR Phillips curve
o	Vertical curve
o	Implies no tradeoff between inflation and unemployment
•	SR Phillips curve
o	Shift cause by agg D increase

Question 15

What role do inflationary expectations play in inflation and the Phillips curve?

Answer 15

• Inflationary expectations
(expectations that consumers have concerning future inflation)
o Expansionary efforts to decrease unemployment below the natural rate of unemployment will result in inflation
o Changes inflation expectations of workers, who adjust nominal wages to meet expectations of future
o Leading to a shift in the short-run Phillips curve

Question 16

What is the debate between rules and discretion in monetary policy?

Answer 16

• The question of whether monetary policy should be guided by legislature rules or left to the discretion of the policy maker

Question 17

What is the time-inconsistency problem as related to monetary policy?

Answer 17

• The problem that arises when a decision maker, specifically a policy maker prefers one policy in advance but a different one when time arrives
• Knowing this others will not find the commitment to the first policy credible

Question 18

What is meant by the classical dichotomy/neutrality of money?

Answer 18

• An economic theory that states that changes in the agg MS only affect nominal variables rather than real
• An increase in MS would increase all prices and wages but have no effect on real economic growth (GDP), unemp levels, or real prices

Question 19

What monetary growth rule has been suggested by Friedman and others, and why?

Answer 19

• Quantity theory of money

o Economist agree that the QTM holds true in the long-run

Question 20

What is meant by rational expectations? What does it imply about business cycles? About fiscal and monetary policy?

Answer 20

• Rational expectations
o The necessary condition to obtain internal consistency in stochastic, dynamic models in economics
• Business cycles shift the agg S drive in economy
o Implies that the business cycle will be affected due to rational expectations
• If company believes that the price for its product will be higher in the future, it will stop or slow production until price rises
• Company weakens supply while demand stays same, price will increase
• Fiscal policy and Monetary policy
o Supposedly stimulus in time of recession and restrain in times of boom
o Improve the general performance of the economy over the long term and make people better off
o Rational expectation frustrate gov attempts to successfully purse activist demand management policies