BU.220.610 Chap.2 Long-Run Output and the Loanable Funds Market
Long-Run Output and the Loanable Funds Market
Module 2 builds the first complete model of the economy and sets it on the horizon businesses use for strategy: five to ten years, long enough to open a plant, enter a market or add a product line. Over that horizon wages, rents and prices have time to adjust fully, so every available worker and every unit of capital is employed. That single assumption drives the chapter's conclusions.
On the supply side, output comes from a production function that combines capital and labor with a given technology. The course assumes constant returns to scale, meaning that scaling both inputs by the same proportion scales output by that proportion too, while each input on its own has diminishing marginal returns.
Competitive firms hire labor until its marginal product equals the real wage, the nominal wage expressed in units of output, and rent capital until its marginal product equals the real rental rate. Because factor supplies are fixed and prices flexible, output settles at its potential level whatever happens to spending. The demand side needs three behavioral rules for a closed economy.
Consumption rises with disposable income according to the marginal propensity to consume. Investment falls as the real interest rate rises, because the rate is the cost of borrowing or the return foregone on internal cash. Government purchases and taxes are set by policy.
Put together, the goods market clears only if the real interest rate adjusts so that planned spending equals potential output, and investment is the component that gives way. The same condition can be read as a financial market. National saving, output minus consumption minus government purchases, is the supply of loanable funds; investment is the demand; and the real interest rate is the price that clears them.
In the simplest version saving does not depend on the rate, so the supply line is vertical, but the logic survives if consumption of durables makes it slope upward. This diagram is the chapter's main tool for policy questions. A rise in government purchases or a tax cut reduces national saving, raises the real rate and crowds out private investment; a spending cut or tax rise does the reverse and crowds investment in.
A burst of business optimism shifts investment demand and, with fixed saving, only raises the rate. The practical message for a firm is that in the long run fiscal policy changes the cost of capital and the composition of output rather than the total. The chapter ends with the one question the model leaves open, how the price level is set, which Chapter 4 answers.
What this chapter covers
- 01
Production function and constant returns to scale
- 02
Marginal product and the real wage
- 03
Consumption, investment and fiscal policy
- 04
Goods-market equilibrium at potential output
- 05
The loanable funds diagram
- 06
Crowding out and crowding in
Worked example · free
Find the real-rate effect of a tax cut
- 2Before: C = 200 + 0.7(3,200) = 2,440, so national saving is 4,000 minus 2,440 minus 900 = 660.
- 3Clear the market: 1,000 minus 40r = 660 gives r = 8.5%. After the cut, C = 2,510 and saving falls to 590, so r = 10.25%.
- 2Interpret: saving fell by the MPC times the tax cut, 70, and investment falls by the same 70.
Key terms
- Potential Output
- The output an economy produces when all its capital and labor are employed at flexible prices; the long-run model treats it as fixed.
- Marginal Product of Labor
- The extra output from one more unit of labor with capital held constant; competitive firms hire until it equals the real wage.
- Marginal Propensity to Consume
- The increase in consumption from one extra dollar of disposable income, the slope of the consumption function.
- Crowding Out
- The fall in private investment when government borrowing reduces national saving and pushes up the real interest rate.
Long-Run Output and the Loanable Funds Market FAQ
Why does fiscal policy not change output in the long-run model?
Output is fixed by capital, labor and technology once prices are flexible and every resource is employed. Fiscal policy can only reallocate that output between consumption, investment and government use, and the real interest rate carries the adjustment.
Why is the saving line vertical in the loanable funds diagram?
In the basic model output, taxes, government purchases and consumption are all independent of the real interest rate, so national saving is too. If durable spending responded to borrowing costs, the line would slope upward instead.
What happens to investment when firms turn optimistic?
Investment demand shifts to the right. With saving fixed, the real interest rate rises until the quantity of investment returns to the unchanged level of saving, so firms pay more for funds but do not get more of them.
Is the real wage set by firms or by the market?
Each firm takes the real wage as given and chooses employment. Across the economy, identical firms share one labor demand curve, and the real wage settles where that curve meets the fixed labor supply.
Exam move
Practise the same four-line routine on every loanable funds question: write national saving, write investment, solve for r, then state what happened to consumption, investment and government use of output. Keep a list of which shocks shift saving and which shift investment demand, and rehearse the direction of r for each.
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