© The University of Queensland 2024
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ECON7021
Workshop 2
Topic 2 - Classical Model of Closed Economy
Reminder: Class Expectations
2
Please contribute to class activities
and discussions in English.
Raise hand
to speak
Mobile
devices on
silent
No media
consumption
No talking while the
lecturer is speaking or
when a student is asking/
answering questions.
Contents
3
Topic 1 Recap
Topic 2 - Classical Model of Closed Economy
Looking Ahead
Topic 1 Recap
4
Topic 1 Revision: Question 1
To compare the economic growth of Australia and New Zealand, which
of the following variables should we use in the economic growth
calculation?
a. GDP in current local currency units (LCU)
b. GDP in constant local currency units (LCU)
c. GDP per capita in current US$
d. GDP per capita in constant 2015 US$
5
Topic 1 Revision: Question 2
You are asked to report inflation for Australia in 2022 and find the following
CPI values on the Australian Bureau of Statistics (ABS) website.
What was Australia’s average consumer inflation in 2022?
a. 7.8%
b. 6.6%
c. 127.3
d. 130.8 6
Consumer Price Index (CPI) 2021 2022
Quarter 1 117.9 123.9
Quarter 2 118.8 126.1
Quarter 3 119.7 128.4
Quarter 4 121.3 130.8
Important Note
• Do you know the difference between per cent (%), basis points and percentage
points?
• Michael Janda, the author of this ABC News article on the unemployment rate,
knows the difference!
• The increase in the Australian cash rate from 0.1% in early 2022 to 4.1% in June
2023 is not a 4% increase.
‒ Instead, it is a 400 basis points increase or a four (4) percentage point increase.
• The increase in the percentage of people 15 years and older who were employed
from 62.4% in March 2020 to 64.5% in June 2023 is not a 2.1% increase.
‒ Instead, it is a 2.1 percentage point increase.
7
Topic 1 Reminder: Mastering Economic Models
To master an economic model, you must know the following.
1. Its assumptions.
2. Which of its variables are endogenous, and which are exogenous.
3. The following details of each curve in the model diagram.
a. Definition
b. Intuition for slope
c. All the factors that can shift the curve
4. How to use the model to analyse the effects of each item in 3c.
8
Topic 2: Classical Model
of Closed Economy
9
Reminder: Outline of ECON7021
Topic 1: Introductory material
Largely a review of some basic concepts from introductory macroeconomics.
Topics 2, 5 & 6: Classical Theory
How the economy works in the long run with flexible prices.
Topics 3 & 4: Growth Theory
Economic growth and standard of living over the very long run.
Topics 7, 8, 9, 10 & 11: Business Cycle Theory
How the economy works in the short run with sticky prices.
Topic 12: Aggregate Supply and Phillips Curve
Relaxing the assumption that all prices are sticky in the short run
10
UQ Extend: Topic 2 Survey
11
Respondents as of 8 am on Monday, 26 February: 28 students
Topic 2 on UQ Extend
• What determines an economy’s supply of goods and services?
• What determines the demand for goods and services?
12
Topic 2 on UQ Extend
• What determines how income is distributed across the different
factors of production (labour and capital)?
13
Topic 2 on UQ Extend
• What are the assumptions of the classical model of a closed economy?
14
Topic 2 on UQ Extend
• How is equilibrium determined in the following markets?
‒ Goods and services
‒ Financial (loanable funds)
15
Topic 2 on UQ Extend
• What is the impact of a change in saving or investment demand?
16
Classical Model of Closed Economy: Application
1. Impact of increase in government spending
2. Impact of a decrease in unemployment benefits (transfer payments)
3. Impact of an increase in investment demand
4. Answer the question posed in the last UQ Extend video
17
1. Impact of Increase in Government Spending
18
Consider an increase in : Δ ҧ > 0
• Change in saving: Δ ҧ = −Δ ҧ < 0
• Supply of loanable funds falls (shifts left).
• Impact: Increase in real interest rate (Δ > 0)
and decrease in investment expenditure.
Δ = Δ ҧ < 0
• Since national output is fixed, the increase in
government spending is offset by the decrease
in investment.
= −Δ ҧ

Market for Loanable Funds
,
2. Impact of Decrease in Unemployment Benefits
19
Consider a decrease in :
• Δ < 0 ⇒ Δ = Δ − Δ > 0 ⇒ Δ < 0
• Δ ҧ = Δത − Δ ҧ > 0
• Supply of loanable funds increases.
• Impact: Decrease in real interest rate (Δ < 0)
and increase in investment expenditure.
Δ = Δ ҧ > 0
• Since national output is fixed, the decrease in
consumption due to the lower unemployment
benefits is offset by an increase in investment.
= −Δ ҧ

Market for Loanable Funds
,
3. Impact of Increase in Investment Demand
20
Consider an increase in investment demand:
• Demand for loanable funds increases.
• Supply of loanable funds remains fixed by
national saving.
• Impact: Increase in real interest rate (Δ > 0),
but actual investment expenditure remains
unchanged.
Δ = Δ ҧ = 0

Market for Loanable Funds
,
4. Impact of Increase in Investment
Demand when S depends on r.
We have seen that our classical model predicts that changes in
investment demand will not impact the actual level of investment. This
comes from the model assumption that saving is not affected by
changes to the real interest rate. That leaves an interesting question for
you to ponder.
Is it reasonable to assume that an increase in interest rate will leave
national saving unchanged?
If we allow national saving to react to interest rate changes, how will
this affect our model’s predictions?
21
4. Impact of Increase in Investment
Demand when S depends on r.
• Allow consumption to be affected not only by
disposable income but also interest rates, with
consumption negatively related to the real
interest rate:
= (ത − ത, )
• Then, national saving and the supply of loanable
funds will increase when the real interest rate
rises:
↑ = ത −↓ ത − ത, ↑ − ҧ
• Result: Upward-sloping supply curve in the
market for loanable funds.
• Impact: An increase in investment demand
causes both higher interest rates and higher
investment expenditure (as a reduction in
consumption frees up resources for investment).
22
Market for Loanable Funds
,
Additional Information
• Constant returns to scale
• Cobb-Douglas production function
• Growing gap between rich and poor
23
Constant Returns to Scale
• A production function has constant returns to scale if:
‒ Increasing all inputs by an equal percentage (e.g. %Δ = %Δ = 10%)
increases output by the same percentage (%Δ = 10%).
‒ Mathematically, for any > 0,
= , .
‒ For example, suppose a bakery currently employs and units of capital and
labour, respectively, and produces loaves of bread. If the bakery’s
production function has constant returns to scale, doubling both inputs (to 2
and 2, respectively) will double output to 2.
• Many production functions exhibit constant returns to scale.
24
Cobb-Douglas Production Function
• Cobb-Douglas production function:
= (, ) = 1−
• Note: The parameter > 0 represents the level of technology.
• Properties of the Cobb-Douglas production function:
‒ Constant returns to scale
• For any > 0: , = 1− = 1− = (, )
‒ Constant factor shares
• = Capital’s share of income; 1 − = Labour’s share of income
• Capital income = × =
• Labour income = × = 1 −
25
• Marginal product of capital:
=
(, )
= −11−
• Rearranging:
1 =
1−
=
2 =
1−
26
Cobb-Douglas Function:
is proportional to average capital
productivity
.
Diminishing marginal productivity of capital:
As ↑, labour per unit of capital falls
↓ ;
thus, falls as well.
Reminder:
= , = 1−
• Marginal product of labour:
=
,
= 1 − −
• Rearranging:
1 =
(1−) 1−
= (1 − )
2 = (1 − )
27
Cobb-Douglas Function:
is proportional to average labour
productivity
.
Diminishing marginal productivity of
labour: As ↑, capital per hour worked
falls
↓ ; thus, falls as well.
Reminder:
= , = 1−
Cobb-Douglas Function: Constant Shares
• Since =
and =
, capital income is:
× =
‒ The capital share of real income is .
• Since = (1 − )
and =
, labour income is:
× = (1 − )
‒ The labour share of real income is 1 − .
28
Falling Labour Share
La Cava, G. (2019, March). The labour and capital shares of income in Australia. Reserve Bank of Australia Bulletin. 29
Rising Capital Share
• In recent decades, the capital share of income seems to be trend
upwards, and the labour share of income 1 − downwards, contributing
to rising inequality.
‒ The change in the capital and labour shares of income is a hot research topic.
‒ Possible explanations of the changing shares:
• Technological progress – production could have become more capital-intensive.
• Changes in market factors not captured by the production model – e.g. labour
markets becoming less competitive as unions recede in influence and firms gain
bargaining power over wages.
30
Looking Ahead
31
Next Week
What about changes in capital, the labour force and technology?
• In Week 2, we will look at the effect of capital accumulation when we start
investigating growth theory in Topic 3: Economic Growth I.
– UQ Extend content will be released on Tuesday, 27 February, at 9 am.
• Note: In Week 3, we will look at the effect of population growth and
technological progress on economic growth in Topic 4: Economic
Growth II.
32
CRICOS 00025B • TEQSA PRV12080
© The University of Queensland 2024
This content is protected and may not be shared, uploaded, or distributed.
Dr Annari de Waal
Contact
Lecturer, School of Economics
econ7021@uq.edu.au