ParkinBade Chapter 29

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CHAPTER
At Full Employment The Classical Model
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After studying this chapter you will be able to

• Explain the purpose of the classical model
• Describe the relationship between the quantity of
  labor employed and real GDP
• Explain what determines the full-employment level
  of employment and real wage rate and potential
  GDP
• Explain what determines unemployment when the
  economy is at full employment

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After studying this chapter you will be able to

• Explain how borrowing and lending decisions
  interact to determine the real interest rate,
  saving, and investment
• Apply the classical model to explain changes and
  international differences in potential GDP and
  the standard of living

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Our Economys Compass

• What is the economys compass?
• What are the forces that prevent the economy from
  straying too far from full employment?
• What determines the level of unemployment at full
  employment?
• What determines employment, the real wage rate,
  and the real interest rate when the economy is at
  full employment?

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The Classical Model A Preview

• To understand macroeconomic performance,
  economists distinguish between real variables and
  nominal variables.
• Real variables measure quantities that tell us
  what is happening to economic well-beingreal
  GDP, employment and unemployment, the real wage
  rate, consumption, saving, investment, and the
  real interest rate.
• Nominal variables measure objects that tell us
  how dollar values and the cost of living are
  changingthe price level, the inflation rate,
  nominal GDP, nominal wage rate, and the nominal
  interest rate.

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The Classical Model A Preview

• The separation of macroeconomic performance into
  a real part and a nominal part is the basis of
  the classical dichotomy.
• The classical dichotomy states
• At full employment, the forces that determine
  real variables are independent of those that
  determine nominal variables.
• The classical model is a model of an economy that
  determines the real variables.

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Real GDP and Employment

• To produce more real GDP, we must use more labor
  or more capital or develop technologies that are
  more productive.
• It takes time to change the quantity of capital
  and develop new technologies, so to change real
  GDP quickly, we must change the quantity of
  labor.
• What is the relationship between the quantity of
  labor employed and real GDP?

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Real GDP and Employment

• Production Possibilities
• The production possibility frontier (PPF) is the
  boundary between those combinations of goods and
  services that can be produced and those that
  cannot.
• To study the relationship between the quantity of
  labor employed and real GDP, we begin with a
  special PPF one that shows the boundary between
  leisure and real GDP.

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Real GDP and Employment

• Figure 23.1(a) illustrates a PPF between leisure
  and real GDP.
• Time can be allocated to leisure or to labor,
  which produces real GDP.
• The more leisure time forgone, the greater is the
  quantity of labor employed and the greater is the
  real GDP.

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Real GDP and Employment

• When 250 billion hours of leisure are taken and
  200 billion hours allocated to labor, real GDP
  produced is 12 trillion.
• The opportunity cost of each extra unit of real
  GDP costs an increasing amount of leisure
  forgone.
• The PPF is bowed outward.

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Real GDP and Employment

• The Production Function
• The production function is the relationship
  between real GDP and the quantity of labor
  employed, other things remaining the same.
• One more hour of labor employed means one less
  hour of leisure, therefore the production
  function is the mirror image of the leisure
  time-real GDP PPF.

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Real GDP and Employment

• Figure 23.1(b) illustrates the production
  function that corresponds to the PPF in Figure
  23.1(a).
• Along the production function, an increase in
  labor hours brings an increase in real GDP.

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The Labor Market and Potential GDP

• The labor market is the market in which
  households supply labor services and firms demand
  labor services.
• The labor market determines the labor hours
  employed.
• The quantity of labor employed and the production
  function determine the quantity of real GDP
  supplied.
• The Demand for Labor
• The quantity of labor demanded is the labor hours
  hired by all firms in the economy.

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The Labor Market and Potential GDP

• The quantity of labor demanded depends on
• 1. The real wage rate
• 2. The marginal product of labor
• Demand for Labor Curve
• The demand for labor is the relationship between
  the quantity of labor demanded and the real wage
  rate when all other influences on hiring plans
  remain the same.

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The Labor Market and Potential GDP
Figure 23.2 shows that the lower the real wage
rate, the greater is the quantity of labor
demanded. A rise in the real wage rate decreases
the quantity of labor demanded. A fall in the
real wage rate increases the quantity of labor
demanded.
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The Labor Market and Potential GDP
The real wage rate is the quantity of good and
services that an hour of labor earns. The money
wage rate is the number of dollars an hour of
labor earns. Real wage (Money wage rate GDP
deflator) 100. The real wage rate, not the
money wage rate, determines the quantity of labor
demanded.
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The Labor Market and Potential GDP

• Marginal Product of Labor
• The demand for labor depends on the marginal
  product of labor, which is the additional real
  GDP produced by an additional hour of labor when
  all other influences on production remain the
  same.
• The marginal product of labor is governed by the
  law of diminishing returns, which states that
• As the quantity of labor increases, and the
  quantity of capital and technology remain the
  same, the marginal product of labor decreases.

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The Labor Market and Potential GDP

• Marginal Product Calculation
• Marginal product of labor is the change in real
  GDP divided by the change in the quantity of
  labor employed.
• The marginal product of labor is the slope of the
  production function.
• Figure 23.3 shows the calculation.

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The Labor Market and Potential GDP

• A 100 billion hour increase in labor from 100
  billion to 200 billion hours brings a 4 trillion
  increase in real GDP.
• The marginal product of labor is 40 an hour.
• At 150 billion (between 100 billion and 200
  billion), marginal product is 40 at point A.

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The Labor Market and Potential GDP

• A 100 billion hour increase in labor from 200
  billion to 300 billion hours brings a 3 trillion
  increase in real GDP.
• The marginal product of labor is 30 an hour.
• At 250 billion (between 200 billion and 300
  billion), marginal product is 30.
• The marginal product of labor curve is downward
  sloping.

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The Labor Market and Potential GDP

• Diminishing Marginal Product and the Demand for
  Labor
• The marginal product of labor curve is the demand
  for labor curve.
• Firms hire more labor as long as the marginal
  product of labor exceeds the real wage rate.
• With the diminishing marginal product of labor,
  the extra output from an extra hour of labor is
  exactly what the extra hour of labor costs, i.e.
  the real wage rate.
• At this point, the profit-maximizing firm hires
  no more labor.

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The Labor Market and Potential GDP

• The Supply of Labor
• The quantity of labor supplied is the number of
  labor hours that all the households in the
  economy plan to work at a given real wage rate.
• The quantity of labor supplied depends on
• 1. The real wage rate
• 2. The working-age population
• 3. The value of other activities

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The Labor Market and Potential GDP

• The Supply of Labor Curve
• The supply of labor is the relationship between
  the quantity of labor supplied and the real wage
  rate when all other influences on the quantity of
  labor supplied remain the same.

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The Labor Market and Potential GDP

• Figure 23.4 shows the higher the real wage rate,
  the greater is the quantity of labor supplied.
• A fall in the real wage rate decreases the
  quantity of labor supplied.
• A rise in the real wage rate increases the
  quantity of labor supplied.

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The Labor Market and Potential GDP

• The quantity of labor supplied increases as the
  real wage rate increases for two reasons
• Hours per person increase
• Labor force participation increases

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The Labor Market and Potential GDP

• Hours per Person
• The real wage rate is the opportunity cost of not
  working, so as the real wage rate rises, more
  people choose to work.
• But a higher real wage rate increases income,
  which increases the demand for normal goods,
  including leisure.
• An increase in the quantity of leisure demanded
  means a decrease in the quantity of labor
  supplied.
• The opportunity cost effect is usually greater
  than the income effect, so a rise in the real
  wage rate brings an increase in the quantity of
  labor supplied.

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The Labor Market and Potential GDP

• Labor Force Participation
• Higher real wage rate induces some people who
  choose not to work at lower real wage rates to
  enter the labor force.
• The response to a rise in the real wage rate is
  positive but small.
• As the real wage rate rises, a given percentage
  increase in the real wage rate brings a small
  percentage increase in the quantity of labor
  supplied.
• The labor supply curve is relatively steep.

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The Labor Market and Potential GDP

• Labor Market Equilibrium
• The labor market is in equilibrium at the real
  wage rate at which the quantity of labor demanded
  equals the quantity of labor supplied.

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The Labor Market and Potential GDP

• Figure 23.5(a) illustrates labor market
  equilibrium.
• Labor market equilibrium occurs at a real wage
  rate of 35 an hour and 200 billion hours
  employed.
• At a real wage rate above 35 an hour, there is
  a surplus of labor and the real wage rate falls.

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The Labor Market and Potential GDP

• At a real wage rate below 35 an hour, there is a
  shortage of labor and the real wage rate rises.
• At the labor market equilibrium, the economy is
  at full employment.

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The Labor Market and Potential GDP

• Potential GDP
• The quantity of real GDP produced when the
  economy is at full employment is potential GDP.
• When the full-employment quantity of labor is 200
  billion hours, potential GDP is 12 trillion.

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The Labor Market and Potential GDP

• Potential GDP Not Physical Limit
• Potential GDP is not the largest real GDP that
  the economy cab produce.
• Potential GDP is the real GDP produced when the
  economy is at full employment.
• The PPF shows the limits to production and the
  economy cannot produce more real GDP and take
  more leisure than the PPF permits.
• Potential GDP is one point on the PPF.

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The Labor Market and Potential GDP

• Potential GDP is Production Efficient
• Production efficiency occurs at all points on the
  PPF.
• Production is inefficient at all points inside
  the PPF because resource are unused or
  misallocated.
• Potential GDP occurs on the PPF, so production is
  efficient.

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The Labor Market and Potential GDP

• Allocative Efficiency at Potential GDP
• Allocative efficiency occurs at the one point on
  the PPF where we cannot produce more of any good
  without producing less of some other good that we
  value more highly.
• At the equilibrium real wage rate (full
  employment), the quantity of labor demanded by
  equals the quantity of labor supplied and the
  marginal benefit from leisure equals the marginal
  cost of leisure, so resources are allocated
  efficiently.

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Unemployment at Full Employment

• When the economy is at full employment,
  unemployment is always present for two broad
  reasons
• Job search
• Job rationing
• Job Search
• Job search is the activity of looking for a
  suitable vacant job.
• The amount of job search depends on a number of
  factors, one of which is the real wage rate.

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Unemployment at Full Employment

• At 35 an hour, the job search that takes place
  generates the natural unemployment rate.
• If the real wage rate exceeds 35 an hour, job
  search increases and unemployment exceeds the
  natural rate.
• If the real wage rate is below 35 an hour, job
  search decreases and unemployment is below the
  natural rate.

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Unemployment at Full Employment

• The amount of job search unemployment changes
  over time and the main sources are
• Demographic change
• Structural change
• Unemployment compensation

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Unemployment at Full Employment

• Demographic Change
• As baby boom joined the labor force in the
  1970s and searched for jobs, the natural
  unemployment rate increased.
• As the birth rate declined, the bulge moved into
  higher age groups, entry declined and the natural
  unemployment rate decreased in the 1980s.

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Unemployment at Full Employment

• Structural Change
• Sometimes technological change brings a
  structural slump, which increases unemployment,
  increases job search, and increases the natural
  unemployment rate.
• Unemployment Compensation
• Because unemployment compensation lowers the
  opportunity cost of unemployment, it lowers the
  cost of job search.
• With a more generous unemployment compensation,
  unemployed workers will job search longer.

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Unemployment at Full Employment

• Job Rationing
• Job rationing is the practice of paying a real
  wage rate that exceeds the equilibrium level and
  then rationing jobs by some method.
• Two reasons why the real wage rate might be set
  above the equilibrium level are
• Efficiency wage
• Minimum wage

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Unemployment at Full Employment

• An efficiency wage is a real wage rate that is
  set above the equilibrium real wage rate that
  balances the costs and benefits of this higher
  wage rate to maximize the firms profit.
• A minimum wage is the lowest wage rate at which a
  firm may legally hire labor.
• Most economists agree that efficiency wages and
  minimum wages increase the natural unemployment
  rate.

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Loanable Funds and the Real Interest Rate

• Potential GDP depends on the quantities of
  factors of production, one of which is capital.
• The capital stock is total quantity of plant,
  equipment, buildings, and business inventories.
• The capital stock is determined by investment.
• The funds that finance investment are obtained in
  the loanable funds market.

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Loanable Funds and the Real Interest Rate

• The Market for Loanable Funds
• The market for loanable funds is the market in
  which households, firms, governments, and
  financial institutions borrow and lend.
• Demand for Loanable Funds
• The quantity of loanable funds demanded depends
  on
• The real interest rate
• The expected profit rate
• Government and international factors

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Loanable Funds and the Real Interest Rate

• The Demand for Loanable Funds Curve
• The demand for loanable funds is the relationship
  between the quantity of loanable funds demanded
  and the real interest rate when all other
  influences on borrowing plans remain the same.
• Business investment is the main item that makes
  up the demand for loanable funds.

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Loanable Funds and the Real Interest Rate
Figure 23.8 shows the demand for loanable funds
curve. A fall in the real interest rate increases
the quantity of loanable funds demanded. A rise
in the real wage rate decreases the quantity of
loanable funds demanded.
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Loanable Funds and the Real Interest Rate

• The Real Interest rate and the Opportunity Cost
  of Loanable Funds
• The real interest rate is the quantity of goods
  and services that a unit of capital earns.
• The nominal interest rate is the number of
  dollars that a unit of capital earns.
• The real interest rate is approximately equal to
  the nominal interest rate minus the inflation
  rate.
• The real interest rate is the opportunity cost of
  loanable funds.

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Loanable Funds and the Real Interest Rate

• Supply of Loanable Funds
• The quantity of loanable funds supplied depends
  on
• The real interest rate
• Disposable income
• Wealth
• Expected future income
• Government international factors

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Loanable Funds and the Real Interest Rate

• The Supply of Loanable Funds Curve
• The supply of loanable funds is the relationship
  between the quantity of loanable funds supplied
  and the real interest rate when all other
  influences on lending plans remain the same.
• Saving is the main item that makes up the supply
  of loanable funds.

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Loanable Funds and the Real Interest Rate
Figure 23.9 shows the supply of loanable funds
curve. A fall in the real interest rate decreases
the quantity of loanable funds supplied. A rise
in the real wage rate increases the quantity of
loanable funds supplied.
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Loanable Funds and the Real Interest Rate

• Equilibrium in the Loanable Funds Market
• The loanable funds market is in equilibrium at
  the real interest rate at which the quantity of
  loanable funds demanded equals the quantity of
  loanable funds supplied.

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Loanable Funds and the Real Interest Rate

• Figure 23.10 illustrates the loanable funds
  market.
• At 8 percent a year, there is a surplus of funds
  and the real interest rate falls.
• At 4 percent a year, there is a shortage of funds
  and the real interest rate rises.
• Equilibrium occurs at a real interest rate of 6
  percent a year.

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Using the Classical Model

• The U.S. Economy Through the Eye of the Classical
  Model
• The U.S. economy was close to full employment in
  2005.
• It was also close to full employment in 1986.
• The figures on the next slide illustrate the
  forces that moved the economy from one
  full-employment equilibrium to another.

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Using the Classical Model

• Figure 23.11(a) illustrates the labor market.
• Advances in technology and investment increased
  labor productivity and increased the demand for
  labor.
• The population expanded and increased the supply
  of labor.
• The real wage rate rose and equilibrium
  employment increased.

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Using the Classical Model

• Figure 23.11(b) illustrates the effects on
  potential GDP.
• The increase in labor productivity shifted the
  production function upwards and
• the increase in equilibrium employment increased
  potential GDP.

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