1/11/2026

ECONOMICS
DEPARTMENT OF ECONOMICS

CHAPTER 6
THE ECONOMY IN THE LONG RUN

1
 1/11/2026

Learning Objectives
Upon completion of this chapter, students will be able to:
❑ Understand the determinants of total output or national income in the long run.
❑ Analyze the distribution of national income among the factors of production.
❑ Explain how equilibrium in the goods market is achieved.
❑ Explore the long-run relationship between money and inflation.
❑ Interpret the key accounting identities of an open economy, including national
income identity and the saving, investment and net exports relationship.
❑ Evaluate the relationship between net exports (NX) and net foreign investment
(NFI) in the context of global capital flows.
❑ Define and distinguish between the nominal exchange rate and the real exchange
rate.

Chapter contens

6.1. Closed Economy

6.1.1. Production function
6.1.2. Markets for factors of production: labor and capital
6.1.3. Market for goods and services
6.1.4. Money and Inflation
6.2. Open Economy
6.2.1. International flows of capital and goods
6.2.2. Saving and investment in the small open economy
6.2.3. Exchange Rate

2
 1/11/2026

Basic Concepts

❑ Closed economy
❖ Economy that does not interact with other economies in the world
❑ Open economy
❖ Economy that interacts freely with other economies around the world
⮚ It buys and sells goods and services in world product markets
⮚ It buys and sells capital assets such as stocks and bonds in world financial
markets

6.1. Closed economy

❑ In the last chapter we defined and measured some key macroeconomic

variables.
❑ Now we start building theories about what determines these key
variables.
❑ In this lecture we will build up theories that we think hold in the long
run, when prices are flexible and markets clear.
❑ Called Classical theory or Neoclassical.

3
 1/11/2026

The Neoclassical model

In a general equilibrium model:

❑ Involves multiple markets
❑ each with its own supply and demand
❑ Price in each market adjusts to make quantity demanded equal
quantity supplied.

Neoclassical model

The macroeconomy involves three types of markets:

1. Goods (and services) Market
2. Factors Market or Labor market, needed to produce goods and services
3. Financial market

Are also three types of agents in an economy:

1. Households
2. Firms
3. Government

4
 1/11/2026

Three Markets – Three agents

Income Production Factor cost
Factor market

Saving Financial
market

Gov.
Borrowing
Tax
HOUSEHOLDS GOVERNMENT FIRMS

Gov.
spending

Consumption Goods and

sevices Production
market

Neoclassical model

❑ We will develop a set of equations to characterize supply and demand

in these markets

❑ Then use algebra to solve these equations together, and see how they
interact to establish a general equilibrium.

❑ Start with production…

5
 1/11/2026

6.1.1. Supply in goods market: Production

This section aims to answer the question: In the long run, what determines
a nation's total output or income?
Supply in the goods market depends on a production function:
Y = F (K,L)
Where:
K = capital: tools, machines, and structures used in production
L = labor: the physical and mental efforts of workers

The production function

❑ shows how much output (Y ) the economy can produce from

K units of capital and L units of labor.
❑ reflects the economy’s level of technology.
❑ Generally, we will assume it exhibits constant returns to scale.

6
 1/11/2026

Returns to scale

❑ Initially Y1 = F (K1 ,L1 )

❑ Scale all inputs by the same multiple z:
K2 = zK1 and L2 = zL1 for z > 1
(If z = 1.5, then all inputs increase by 50%)
❑ What happens to output, Y2 = F (K2 ,L2 )
❖ If constant returns to scale, Y2 = zY1
❖ If increasing returns to scale, Y2 > zY1
❖ If decreasing returns to scale, Y2 < zY1

Assumptions of the model

1. Technology is fixed.
2. The economy’s supplies of capital and labor are fixed at

𝑲 𝑲 𝒂𝒏𝒅 𝑳 𝑳

7
 1/11/2026

Determining total output

Output is determined by the fixed factor supplies and the fixed

state of technology:
So we have a simple initial theory of supply in the goods market:
𝒀 𝑭 𝑲, 𝑳

6.1.2. Equilibrium in the factors market

This section aims to answer the question: How is the economy's income
distributed among the factors of production? (Who receives income from
the production process?
❑ Equilibrium is where factor supply equals factor demand.
❑ Recall: Supply of factors is fixed.
❑ Demand for factors comes from firms.

8
 1/11/2026

Demand in factors market

Analyze the decision of a typical firm.

❑ It buys labor in the labor market, where price is wage, W.
❑ It rents capital in the factors market, at rate R.
❑ It uses labor and capital to produce the good, which it sells in the goods
market, at price P.

Demand in factors market

❑ Assume the market is competitive:

❖ Each firm is small relative to the market, so its actions do not affect
the market prices.
❖ It takes prices in markets as given - W, R, P.

9
 1/11/2026

Demand in factors market

It then chooses the optimal quantity of Labor and capital to

maximize its profit.
How to write profit:
Profit = revenue - labor costs - capital costs
= PY - WL - RK
= PF(K,L) - WL - RK

Demand in the factors market

❑ Increasing hiring of L will have two effects:

1) Benefit: raise output by some amount
2) Cost: raise labor costs at rate W
❑ To see how much output rises, depending on the marginal
product of labor (MPL)

10
 1/11/2026

Marginal product of labor (MPL)

An approximate definition (used in text):

The extra output the firm can produce using one additional labor
(holding other inputs fixed):
MPL = F (K, L +1) – F (K, L)

The MPL and the production function

Y
output
F (K , L )
MPL
1 As more labor is
MPL added, MPL 
1

Slope of the production

MPL
function equals MPL:
rise over run
1
L
labor

11
 1/11/2026

Diminishing marginal returns

❑ As a factor input is increased, its marginal product falls (other

things equal).
❑ Intuition:
↑L while holding K fixed
⇒ fewer machines per worker
⇒ lower productivity

MPL with calculus

We can give a more precise definition of MPL:

The rate at which output rises for a small amount of additional labor
(holding other inputs fixed):
MPL = [F (K, L + ΔL) – F (K, L)] / ΔL
where Δ is ‘delta’ and represents change

❑ Earlier definition assumed that ΔL = 1.

F (K, L + 1) – F (K, L)
❑ We can consider smaller change in labor.

12
 1/11/2026

Return to firm problem: hiring L

❑ Firm chooses L to maximize its profit.

❑ How will increasing L change profit?
Δ profit = Δ revenue - Δ cost
= P * MPL - W
If this is: > 0 should hire more
< 0 should hire less
= 0 hiring right amount

Firm problem continued

❑ So the firm’s demand for labor is determined by the condition:

P *MPL = W
Hires more and more L, until MPL falls enough to satisfy the
condition.
❑ Also may be written:

MPL = W/P, where W/P is the ‘real wage’

13
 1/11/2026

Real wage

Think about units:

❑ W = $/hour
❑ P = $/good
❑ W/P = ($/hour) / ($/good) = goods/hour
The amount of purchasing power, measured in units of goods,
that firms pay per unit of work

MPL and the demand for labor

Units of
output Each firm hires labor
up to the point where
MPL = W/P
Real
wage

MPL, Labor
demand

Units of labor, L

14
 1/11/2026

Determining the rental rate

❑ We have just seen that MPL = W/P

❑ The same logic shows that MPK = R/P :
❑ Diminishing returns to capital: MPK ↓ as K ↑
❑ The MPK curve is the firm’s demand curve for renting capital.
❑ Firms maximize profits by choosing K such that MPK = R/P .

How income is distributed

We found that if markets are competitive, then factors of production will be

paid their marginal contribution to the production process.
𝑾
Total labor income = 𝑳 𝑴𝑷𝑳 𝑳
𝑷
𝑹
Total capital income = 𝑲 𝑴𝑷𝑲 𝑲
𝑷

15
 1/11/2026

Euler’s theorem

Under our assumptions (constant returns to scale, profit

maximization, and competitive markets)…
Total output is divided between the payments to capital and
labor, depending on their marginal productivities, with no extra
profit left over.
𝒀 𝑴𝑷𝑳 𝑳 𝑴𝑷𝑲 𝑲

national labor capital

income income income

6.1.3. The market for goods & services

This section answers the question: Who consumes the economy’s goods and
services?
In a closed economy, there are three agents that use (demand) goods and
services (Components of aggregate demand):
Y=C+I+G
C = consumer demand for g & s
I = demand for investment goods
G = government demand for g & s
(closed economy: no NX )

16
 1/11/2026

Consumption, C

❑ def: disposable income is total income minus total taxes: Y – T

❑ Consumption function: C = C (Y – T )
Shows that ↑(Y – T ) ⇒ ↑C
❑ def: The marginal propensity to consume (MPC) is the increase in C
caused by an increase in disposable income.
❑ So MPC = derivative of the consumption function with respect to
disposable income.
❑ MPC must be between 0 and 1.

Consumption function graph

C
C (Y –T )

The slope of the

MPC
consumption function
1 is the MPC.

Y–T

17
 1/11/2026

Consumption function cont.

Suppose consumption function:

C = 10 + 0.8Y
MPC = 0.8
For extra dollar of income, spend 0.8 dollars consumption
Marginal propensity to save = 1-MPC

Investment, I

❑ The investment function is I = I (r ),

where r denotes the real interest rate, the nominal interest rate
corrected for inflation.
❑ The real interest rate is
● the cost of borrowing
● the opportunity cost of using one’s own funds
to finance investment spending.
So, ↑r ⇒ ↓I

18
 1/11/2026

Investment function graph

r
Spending on
investment goods
is a downward-sloping
function of the real
interest rate

I (r )

Government spending, G

❑ G includes government spending on goods and services.

❑ G excludes transfer payments
❑ Assume government spending and total taxes are exogenous:

𝑮 𝑮 𝒂𝒏𝒅 𝑻 𝑻

19
 1/11/2026

The market for goods & services

❑ Agg. Demand: 𝑪 𝒀 𝑻 𝑰 𝒓 𝑮
❑ Agg. Supply: 𝒀 𝑭 𝑲, 𝑳
❑ Equilibrium: 𝒀 𝑪 𝒀 𝑻 𝑰 𝒓 𝑮
The real interest rate adjusts to equate demand with supply.
We can get more intuition for how this works by looking at the
loanable funds market

The loanable funds market

A simple supply-demand model of the financial system.

One asset: “loanable funds”
 Demand for funds: investment
 Supply of funds: saving
 “price” of funds: real interest rate

20
 1/11/2026

Demand for funds: Investment

The demand for loanable funds:

• comes from investment:
Firms borrow to finance spending on plant & equipment, new office
buildings, etc. Consumers borrow to buy new houses.
• depends negatively on r , the “price” of loanable funds (the cost of
borrowing).

Loanable funds demand curve

r
The investment
curve is also the
demand curve for
loanable funds.

I (r )

21
 1/11/2026

Supply of funds: Saving

The supply of loanable funds comes from saving:

❑ Households use their saving to make bank deposits, purchase bonds
and other assets. These funds become available to firms to borrow to
finance investment spending.
❑ The government may also contribute to saving if it does not spend
all of the tax revenue it receives.

Types of saving

❑ private saving (sp) = (Y –T ) – C

❑ government saving (sg) = T – G
❑ national saving, S
= sp + sg
= (Y –T ) – C + T – G
=Y–C–G

22
 1/11/2026

Loanable funds supply curve

National saving
does not depend
on r,
so the supply
curve is vertical.

S, I

Loanable funds market equilibrium

r

Equilibrium real
interest rate

I (r )
Equilibrium level S, I
of investment

23
 1/11/2026

The special role of r

r adjusts to equilibrate the goods market and the loanable funds

market simultaneously:
If L.F. market in equilibrium, then
Y–C–G =I
S = (Y – T – C) + (T – G) = I

The special role of r

To see how the interest rate brings financial markets into

equilibrium, substitute the consumption function and the
investment function into the national income accounts identity:
Y – C(Y – T) – G = I(r)
S = I(r)

24
 1/11/2026

6.1.4. Money and Inflation

❑ Money: Definition

Money is the stock

of assets that can be
readily used to make
transactions.

Money: functions

❑ Medium of exchange
we use it to buy stuff
❑ Store of value
transfers purchasing power from the present to the future
❑ Unit of account
the common unit by which everyone measures prices and values

25
 1/11/2026

Money: types

❑ Fiat money
• has no intrinsic value
• example: the paper currency we use
❑ Commodity money
• has intrinsic value
• examples: gold coins,
cigarettes in P.O.W. camps

The Money Supply & Monetary Policy

❑ The money supply is the quantity of money available in the

economy.
❑ Monetary policy is the control over the money supply.

26