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PaulSchneiderman,Ph.D.

,ProfessorofFinance&Economics,Southern
NewHampshireUniversity
2008SouthWestern

InThisLecture..
SaysLaw
ClassicalEconomistson
Markets,Wages,andPrices
ThreeStatesoftheEconomy
TheInstitutionaland
PhysicalProduction
PossibilitiesFrontiers
TheSelfRegulatingEconomy

SaysLaw
Supplycreatesitsowndemand.Production
createsdemandsufficienttopurchaseall
goodsandservicesproduced.
Sayslawimpliesthattherecannotbeeither
(1)ageneraloverproductionofgoods
(wheresupplyintheeconomyisgreater
thandemandintheeconomy)or
(2)ageneralunderproductionofgoods
(wheredemandintheeconomyisgreater
thansupplyintheeconomy).

SaysLawinaMoneyEconomy
Ifconsumptiondropsandsavingrises,
economicforcesareatworkproducingan
equalincreaseininvestment.

C S iI

TheClassicalViewoftheCredit
Market
Inclassicaltheory,theinterest
rateisflexibleandadjustsso
thatsavingequalsinvestment.
Ifsavingincreasesandthe
savingcurveshiftsrightward
theincreaseinsaving
eventuallyputspressureonthe
interestrateandmovesit
downward.
Anewequilibriumis
establishedwhereonceagain
theamounthouseholdssave
equalstheamountfirmsinvest.

SaysLawinaMoneyEconomy

SelfTestQuestions
ExplainSayslawintermsofabarter
economy.
Accordingtoclassicaleconomists,if
savingrisesandconsumptionspending
falls,willtotalspendingintheeconomy
decrease?Explainyouranswer.
Whatistheclassicalpositiononprices
andwages?

ThreeStatesoftheEconomy
RealGDPislessthanNaturalRealGDP
(recessionarygap).
RealGDPisgreaterthanNaturalReal
GDP(inflationarygap).
RealGDPisequaltoNaturalRealGDP
(longrunequilibrium).

LongrunEquilibrium
Theconditionwherethe
RealGDPtheeconomyis
producingisequaltothe
NaturalRealGDPand
theunemploymentrate
isequaltothenatural
unemploymentrate.

LongrunEquilibrium
Theeconomyiscurrently
operatingataRealGDPlevel
ofQ1,whichisequaltoQN.
Inotherwords,the
economyisproducingits
NaturalRealGDPor
potentialoutput.
Whenthiscondition(Q1=
QN)exists,theeconomyis
saidtobeinlongrun
equilibrium.

Recessionary(Contractionary)
Gap
Theconditionwherethe
RealGDPtheeconomyis
producingislessthanthe
NaturalRealGDPand
theunemploymentrateis
greaterthanthenatural
unemploymentrate.

Recessionary(Contractionary)
Gap
Theeconomyiscurrentlyin
shortrunequilibriumata
RealGDPlevelofQ1.
QNisNaturalRealGDPor
thepotentialoutputofthe
economy.
NoticethatQ1< QN.When
thiscondition(Q1< QN)
exists,theeconomyissaidto
beinarecessionarygap.

Inflationary(Expansionary)Gap
Theconditionwherethe
RealGDPtheeconomyis
producingisgreaterthan
theNaturalRealGDP
andtheunemployment
rateislessthanthe
naturalunemployment
rate.

Inflationary(Expansionary)Gap
Theeconomyiscurrently
inshortrunequilibriumata
RealGDPlevelofQ1.
QNisNaturalRealGDPor
thepotentialoutputofthe
economy.
NoticethatQ1>QN.When
thiscondition(Q1>QN)
exists,theeconomyissaidto
beinaninflationarygap.

EconomyandLaborMarket

PhysicalandInstitutionalPPFs
ThephysicalPPF illustrates
differentcombinationsofgoods
theeconomycanproducegiven
thephysicalconstraintsoffinite
resourcesand(2)thecurrent
stateoftechnology.
TheinstitutionalPPF illustrates
differentcombinationsofgoods
theeconomycanproducegiven
thephysicalconstraintsf(1)
finiteresources,(2)thecurrent
stateoftechnology,and(3)any
institutionalconstraints.

PhysicalandInstitutionalPPFs
Theeconomyisatthenatural
unemploymentrateifitislocated
onitsinstitutionalPPF,suchasat
pointsA,B,orC.
Aneconomycanneveroperate
beyonditsphysicalPPF,butitis
possibleforittooperatebeyondits
institutionalPPFbecause
institutionalconstraintsarenot
alwaysequallyeffective.
Iftheeconomydoesoperate
beyonditsinstitutionalPPF(i.e.
minimumwage),suchasatpoint
D,thentheunemploymentratein
theeconomyislowerthanthe
naturalunemploymentrate.

SelfTestQuestions
Whatisarecessionarygap?an
inflationarygap?
Whatisthestateofthelabormarketwhen
theeconomyisinarecessionarygap?in
aninflationarygap?
Iftheeconomyisinaninflationarygap,
locateitspositionintermsofthetwoPPFs
discussedinthissection.

SelfRegulatingEconomy
ClosingtheRecessionary(Contractionary)Gap
TheeconomyisatP1
andRealGDPof$9
trillion.
BecauseRealGDPis
lessthanNaturalReal
GDP($10trillion),the
economyisina
recessionarygapand
theunemploymentrate
ishigherthanthe
naturalunemployment
rate.

SelfRegulatingEconomy
ClosingtheRecessionary(Contractionary)Gap
Wageratesfall,andthe
shortrunaggregatesupply
curveshiftsfromSRAS1to
SRAS2.
Asthepricelevelfalls,the
realbalance,interestrate,
andinternationaltrade
effectsincreasethequantity
demandedofRealGDP.
Ultimately,theeconomy
movesintolongrun
equilibriumatpoint2.

SelfRegulatingEconomy
ClosingtheInflationary(Expansionary)Gap
TheeconomyisatP1
andRealGDPof$11
trillion.
BecauseRealGDPis
greaterthanNatural
RealGDP($10trillion),
theeconomyisinan
inflationarygapandthe
unemploymentrateis
lowerthanthenatural
unemploymentrate.

SelfRegulatingEconomy
ClosingtheInflationary(Expansionary)Gap
Wageratesrise,andthe
shortrunaggregate
supplycurveshiftsfrom
SRAS1toSRAS2.
Asthepricelevelrises,
therealbalance,interest
rate,andinternational
tradeeffectsdecreasethe
quantitydemandedof
RealGDP.
Ultimately,theeconomy
movesintolongrun
equilibriumatpoint2.

SelfRegulatingEconomy
ASummary

PolicyImplication
Laissezfaire
Classical,newclassical,andmonetaristeconomists
believethattheeconomyisselfregulating.Forthese
economists,fullemploymentisthenorm:The
economyalwaysmovesbacktoNaturalRealGDP.

Laissezfaire
Apublicpolicyofnotinterfering
withmarketactivitiesintheeconomy.

SelfRegulatingEconomy
FromShortruntoLongrun

SelftestQuestions
Iftheeconomyisselfregulating,what
happensifitisinarecessionarygap?
Iftheeconomyisselfregulating,what
happensifitisinaninflationarygap?
Iftheeconomyisselfregulating,howdo
changesinaggregatedemandaffectthe
economyinthelongrun?