"Classical" is a term used to describe economic doctrine
before Keynes. Classical economists were mainly interested in understanding
long-term changes in national economies, rather than the short-term fluctuations
that the Keynesian income-expenditure describes. No classical economist
actually wrote down this model -- rather, it's an effort by recent textbook
writers to encapsulate Classical views in a simple mathematical form that
can be compared to the income-expenditure model. The following treatment
is adapted from Mankiw's *Macroeconomics.*

Here is our model:

Y = C + I + G (equilibrium condition,
in which total output equals the demand for it)

C = C(Y - T) (consumption function
-- C is function of disposable income)

I = I(r) (investment function
-- r is the interest rate, and investment rises as r falls, falls as r
rises. This is bcause firms that want to undertake cpital investment
have to finance it by borrowing from the bank.)

G = some fixed amount (government
expenditure is exogenous)

T = some fixed amount (taxes
are exogenous)

Y = some fixed amount (output is fixed
at full employment)

Here is a specific numerical example of this model, of the kind we will work with in class:

Y = C + I + G

Y = 1,000

G = 250

T = 200

C = 100 + .5(Y - T)

I = 500 - 25r

1. Figure out C, I, and personal S, and make up a flow picture. Figure out equilibrium r.

2. Now balance the budget by raising T. Figure out C, I, and personal S, and make up a flow picture. Figure out equilibrium r.

3. Instead of balancing the budget, spend like crazy and double G. Figure out C, I, and personal S, and make up a flow picture. Figure out equilibrium r.

4. Try something else. Starting again with the assumptions in (1), lower both G and T to 100. Figure out C, I, and personal S, and make up a flow picture. Figure out equilibrium r.

5. How about this. Starting with the assumptions in (1), change the investment function to I = 750 - 25r (imagine that businesses suddenly want to buy more machines). Figure out C, I, and personal S, and make up a flow picture. Figure out equilibrium r.

6. And finally try this. Suppose that the marginal
propensity to consume rose from .5 to .75 so that the new consumption function
is C = 100 + .75(Y - T). Work out the results.

How/why things change in thsi model: the interest rate adjusts to equilibrate the flow of national savings with the flow of investment.

Key features: There is always full employment in this
model, by assumption. The interest rate is the great equilibrator
-- if people

decide to spend less and save more (lowering C) r will
fall to raise I, so that AD will never be insufficient. In other
words output is not

demand-constrained. This is a model in which you
will get complete crowding-out of investment by any increase in government
spending. There also is no point in doing macro policy to raise employment
in this model.