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Title: THE ECONOMY AT FULL EMPLOYMENT: THE CLASSICAL MODEL


1
8
THE ECONOMY AT FULL EMPLOYMENT THE CLASSICAL
MODEL
CHAPTER
2
Objectives
  • After studying this chapter, you will able to
  • Describe the relationship between the quantity of
    labor employed and real GDP
  • Explain what determines the demand for labor and
    the supply of labor and how labor market
    equilibrium determines employment, the real wage
    rate, and potential GDP

3
Objectives
  • After studying this chapter, you will able to
  • Explain how business investment decisions and
    household saving decisions are made
  • Explain how investment and saving interact to
    determine the real interest rate
  • Use the classical model to explain the forces
    that change potential GDP

4
Our Economys Compass
  • Our economy follows a path like that of an
    explorer probing new terrain.
  • Sometimes the explorer strays of course.
  • But the explorer has a compass that helps keep
    getting back on the main track.
  • Our economy wanders around its main courseits
    full employment trendbut like the explorer, has
    a compass that keeps bringing it back.
  • The classical model is the compass and youll
    learn about it in this chapter.

5
The Classical Model A Preview
  • Economists have made progress in understanding
    how the economy works by dividing the variables
    that describe macroeconomic performance into two
    lists
  • Real variables
  • Nominal variables
  • Real variables like real GDP, employment, and the
    real wage rate describe what is happening to
    living standards
  • Nominal variables like the price level and
    nominal wage rate tell us how dollar values and
    the value of money are changing.

6
The Classical Model A Preview
  • The two lists of variables form the basis of a
    huge discovery called the classical dichotomy,
    which states
  • At full employment, the forces that determine
    real variables are independent of those that
    determine nominal variables.
  • For example, we can explain why real GDP in the
    United States is 20 times that of Nigeria by
    looking only at real variables. We dont need to
    look at the price levels in the two countries.

7
The Classical Model A Preview
  • The classical model is a model of the economy
    that determines the real variablesreal GDP,
    employment and unemployment, the real wage rate,
    consumption, saving, investment, and the real
    interest rateat full employment.
  • Most economists believe that the economy is
    rarely at full employment but that the classical
    model provides a benchmark against which to
    measure the actual state of the economy.

8
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.

9
Real GDP and Employment
  • Figure 8.1(a) illustrates a production
    possibility frontier between leisure time and
    real GDP.
  • The more leisure time forgone, the greater is the
    quantity of labor employed and the greater is the
    real GDP.

10
Real GDP and Employment
  • The PPF showing the relationship between leisure
    time and real GDP is bowed-out, which indicates
    an increasing opportunity cost.
  • Opportunity cost is increasing because the most
    productive labor is used first and as more labor
    is used it is increasingly less productive.

11
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.

12
Real GDP and Employment
  • Figure 8.1(b) illustrates the production function
    that corresponds to the PPF shown in Figure
    8.1(a).
  • Along the production function, an increase in
    labor hours brings an increase in real GDP.

13
The Labor Market and Potential GDP
  • To understand how potential GDP is determined, we
    study
  • The demand for labor
  • The supply of labor
  • Labor market equilibrium
  • Potential GDP

14
The Labor Market and Potential GDP
  • The Demand for Labor
  • The quantity of labor demanded is the labor hours
    hired by all firms in the economy.
  • The demand for labor is the relationship between
    the quantity of labor demanded and the real wage
    rate, other things remaining the same.
  • 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.

15
The Labor Market and Potential GDP
To calculate the real wage rate, we divide the
money wage rate by the GDP deflator and multiply
by 100. It is the real wage rate, not the money
wage rate, that determines the quantity of labor
demanded. Figure 8.2 shows a demand for labor
curve.
16
The Labor Market and Potential GDP
  • 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, but the quantity
    of capital and technology remain the same, the
    marginal product of labor decreases.

17
The Labor Market and Potential GDP
  • We calculate the marginal product of labor as the
    change in real GDP divided by the change in the
    quantity of labor employed.

18
The Labor Market and Potential GDP
  • Figure 8.3 shows the calculation of the marginal
    product of labor and illustrates the relationship
    between the marginal product curve and the
    production function.

19
The Labor Market and Potential GDP
  • A 100 billion hour increase in labor from 100 to
    200 billion hours brings a 4 trillion increase
    in real GDPthe marginal product of labor is 40
    an hour.

20
The Labor Market and Potential GDP
  • A 100 billion hour increase in labor from 200 to
    300 billion hours brings a 3 trillion increase
    in real GDPthe marginal product of labor is 30
    an hour.
  • The marginal product of labor is the slope of the
    production function.

21
The Labor Market and Potential GDP
Figure 8.3(b) shows the same information on the
marginal product curve, MP. At 150 (midway
between 100 and 200), marginal product is 40. At
250 (midway between 200 and 300), marginal
product is 30.
22
The Labor Market and Potential GDP
  • 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.

23
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 supply of labor is the relationship between
    the quantity of labor supplied and the real wage
    rate, all other things remaining the same.

24
The Labor Market and Potential GDP
  • Figure 8.4 illustrates a labor supply curve.
  • The higher the real wage rate, the greater is the
    quantity of labor supplied.

25
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

26
The Labor Market and Potential GDP
  • Hours per person increase because the real wage
    rate is the opportunity cost of not working.
  • But a higher real wage rates increase 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.

27
The Labor Market and Potential GDP
  • Labor force participation increases because
    higher real wage rates induce some people who
    choose not to work at lower real wage rates to
    enter the labor force.
  • The labor supply response to an increase in the
    real wage rate is positive but small.
  • A large 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.

28
The Labor Market and Potential GDP
  • The labor market is in equilibrium at the real
    wage rate at which the quantity of labor demanded
    equals the quantity of labor supplied.
  • Labor market equilibrium is full-employment
    equilibrium.
  • The level of real GDP at full employment is
    potential GDP.

29
The Labor Market and Potential GDP
  • Figure 8.5(a) illustrates labor market
    equilibrium.
  • Labor market equilibrium occurs at a real wage
    rate of 35 and an employment of 200 billion
    labor hours.

30
The Labor Market and Potential GDP
  • Potential GDP
  • At a full employment level of 200 billion hours,
    potential GDP is 10 trillion dollars.

31
Unemployment at Full Employment
  • The unemployment rate at full employment is
    called the natural rate of unemployment.
  • Unemployment always is present for two broad
    reasons
  • Job search
  • Job rationing

32
Unemployment at Full Employment
  • Job Search
  • Job search is the activity of workers looking for
    an acceptable vacant job.
  • All unemployed workers search for new jobs, and
    while they search many are unemployed.

33
Unemployment at Full Employment
  • Figure 8.6 illustrates the relationship between
    the amount of job search unemployment and the
    real wage rate.

34
Unemployment at Full Employment
  • The amount of job search unemployment changes
    over time and the main sources of these changes
    are
  • Demographic change
  • Unemployment compensation
  • Structural change

35
Unemployment at Full Employment
  • Demographic change
  • As more young workers entered the labor force in
    the 1970s, the amount of frictional unemployment
    increased as they searched for jobs.
  • Frictional unemployment may have fallen in the
    1980s as those workers aged.
  • Two-earner households may increase search,
    because one member can afford to search longer if
    the other has an income.

36
Unemployment at Full Employment
  • Unemployment compensation
  • The more generous unemployment benefit payments
    become, the lower the opportunity cost of
    unemployment, so the longer workers search for
    better employment rather than any job.
  • More workers are covered now by unemployment
    insurance than before, and the payments are
    relatively more generous.

37
Unemployment at Full Employment
  • Structural change
  • An increase in the pace of technological change
    that reallocates jobs between industries or
    regions increases the amount of search.

38
Unemployment at Full Employment
  • Job Rationing
  • Job rationing occurs when employed workers are
    paid a wage that creates an excess supply of
    labor.
  • Job rationing can occur for two reasons
  • Efficiency wage
  • Minimum wage

39
Unemployment at Full Employment
  • An efficiency wage is a real wage rate that is
    set above the full-employment equilibrium wage
    that balances the costs and benefits of this
    higher wage rate to maximize the firms profit.
  • The cost of a higher wage is direct.
  • The benefit of a higher wage is indirect it
    enables a firm to attract high-productivity
    workers, stimulates greater work effort, lowers
    the quit rate, and lowers recruiting costs.

40
Unemployment at Full Employment
  • A minimum wage is the lowest wage rate at which a
    firm may legally hire labor.
  • If the minimum wage is set below the equilibrium
    wage rate, it has no effect.
  • If the minimum wage is set above the equilibrium
    wage rate, it does affect the labor market.

41
Unemployment at Full Employment
  • Job Rationing and Unemployment
  • If the real wage rate is above the equilibrium
    wage, regardless of the reason, there is a
    surplus of labor that adds to unemployment and
    increases the natural unemployment rate.
  • Most economists agree that efficiency wages and
    minimum wages increase the natural unemployment
    rate.
  • David Card and Alan Krueger have challenged this
    view and argue that an increase in the minimum
    wage works like an efficiency wage, making
    workers more productive and less likely to quit.

42
Unemployment at Full Employment
  • Dan Hamermesh argues that firms anticipated
    increases in the minimum wage and cut employment
    before the minimum wage increased.
  • Therefore, looking at the effects of minimum wage
    changes after the change occurs misses the
    effectsan example of the post hoc fallacy.
  • Finis Welch and Kevin Murphy say Card and Krueger
    failed to take into account some regional
    differences in economic growth that hide the
    effects of the change in the minimum wagean
    example of ceteris paribus not holding.

43
Investment, Saving, and the Interest Rate
  • Investment and Capital
  • The capital stock is the total amount of plant,
    equipment, buildings, and inventories, physical
    capital.
  • Gross investment is the purchase of new capital.
  • Depreciation is the wearing out of the capital
    stock.
  • Net investment equals gross investment minus
    depreciation, and net investment is the addition
    to the capital stock.

44
Investment, Saving, and the Interest Rate
  • Investment Decisions
  • Business investment decisions are influenced by
  • The expected profit rate
  • The real interest rate

45
Investment, Saving, and the Interest Rate
  • The Expected Profit Rate
  • The expected profit rate is relatively high
    during business cycle expansions and relatively
    low during recessions.
  • Advances in technology can increase the expected
    profit rate.
  • Taxes affect the expected profit rate because
    firms are concerned about after-tax profits.

46
Investment, Saving, and the Interest Rate
  • The Real Interest Rate
  • The real interest rate is the opportunity cost of
    the funds used to finance investment.
  • Regardless of whether a firm borrows or uses its
    own financial resources, it faces this
    opportunity cost.
  • Either it pays the interest or it forgoes
    interest on its own funds.

47
Investment, Saving, and the Interest Rate
  • Investment Demand
  • Investment demand is the relationship between the
    level of planned investment and the real interest
    rate.
  • Figure 8.7 illustrates an investment demand curve.

48
Investment, Saving, and the Interest Rate
  • The investment demand curve slopes downward.
  • A fall in the real interest rate increases
    planned investment along investment demand curve.
  • A rise in the real interest rate decreases
    planned investment along investment demand curve.

49
Investment, Saving, and the Interest Rate
  • Saving
  • Investment is financed by national saving and
    borrowing from the rest of the world.
  • Saving is current income minus current
    expenditure, and in part finances investment.

50
Investment, Saving, and the Interest Rate
  • Personal saving is personal disposable income
    minus consumption expenditure.
  • Business saving is retained profits and additions
    to pension funds by businesses.
  • Government saving is the governments budget
    surplus.
  • Any of these components can be negative.
  • National saving is the sum of private saving and
    government saving.
  • Households divide their disposable income between
    consumption expenditure and saving.

51
Investment, Saving, and the Interest Rate
  • Saving is influenced by
  • The real interest rate
  • Disposable income
  • Wealth
  • Expected future income

52
Investment, Saving, and the Interest Rate
  • Real Interest Rate
  • The higher the real interest rate, the greater is
    a households opportunity cost of consumption and
    so the larger is the amount of saving.
  • Disposable Income
  • The higher the disposable income, the greater is
    a households saving.

53
Investment, Saving, and the Interest Rate
  • Wealth
  • The greater is a households wealth, other things
    remaining the same, the greater is its
    consumption and the less is its saving.
  • Expected Future Income
  • The higher a households expected future income,
    the greater is its current consumption and the
    lower is its current saving.

54
Investment, Saving, and the Interest Rate
  • Saving Supply
  • Saving supply is the relationship between saving
    and the real interest rate, other things
    remaining the same.
  • Figure 8.8 shows a saving supply curve, which
    slopes upward.

55
Investment, Saving, and the Interest Rate
  • A fall in the real interest rate decreases
    saving.
  • A rise in the real interest rate increases saving.

56
Investment, Saving, and the Interest Rate
  • Determining the Real Interest Rate
  • The real interest rate is determined by
    investment demand and supply of savings.
  • In Figure 8.9, ID is the investment demand curve.
  • SS is the supply of saving curve.

57
Investment, Saving, and the Interest Rate
  • If the interest rate is above its equilibrium
    level, SS exceeds ID.
  • There is a surplus of funds and the interest rate
    falls.

If the interest rate is below its equilibrium
level, ID exceeds SS. There is a shortage of
funds and the interest rate rises.
58
Investment, Saving, and the Interest Rate
  • The equilibrium real interest rate is 6 percent.
  • At the equilibrium real interest rate, there is
    neither a shortage nor surplus of saving.

59
The Dynamic Classical Model
  • Changes in Productivity
  • Labor productivity is real GDP per hour of labor.
  • Three factors influence labor productivity.
  • Physical capital
  • Human capital
  • Technology

60
The Dynamic Classical Model
  • Human capital is the knowledge and skill that has
    been acquired from education and on-the-job
    training.
  • Learning-by-doing is the activity of on-the-job
    education that can greatly increase labor
    productivity.

61
The Dynamic Classical Model
  • Shifts in the Production Function
  • Any influence that increases labor productivity
    increases real GDP at each level of labor hours
    and shifts the production function upward.
  • An increase in physical capital, human capital,
    or a technological advance all increase labor
    productivity.

62
The Dynamic Classical Model
  • Figure 8.10 illustrates in increase in labor
    productivity. The production function shifts
    upward from PF0 to PF1.

63
The Dynamic Classical Model
  • Real GDP increases if
  • The economy recovers from a recession
  • Potential GDP increases.
  • Two factors that increase potential GDP are
  • An increase in population
  • An increase in labor productivity

64
The Dynamic Classical Model
  • An Increase in Population
  • An increase in population increases the supply of
    labor.
  • The equilibrium real wage rate falls and the
    equilibrium quantity of labor increases.
  • The increase in the equilibrium quantity of labor
    increases potential GDP.
  • The potential GDP per hour of work decreases.

65
The Dynamic Classical Model
  • Figure 8.11(a) illustrates these effects in the
    labor market.

66
The Dynamic Classical Model
  • Potential GDP increases.
  • Potential GDP per hour of work decreases.
  • Initially, potential GDP per hour of work was
    50--10 trillion divided by 200 billion.
  • In the new equilibrium, potential GDP per hour of
    work is 43.33--13 trillion divided by 300
    billion.

67
The Dynamic Classical Model
  • An Increase in Labor Productivity
  • Three factors increase labor productivity
  • An increase in physical capital
  • An increase in human capital
  • An advance in technology
  • An increase in labor productivity shifts the
    production function upward and increases the
    demand for labor.
  • The equilibrium real wage rate, quantity of
    labor, and potential GDP all increase.

68
The Dynamic Classical Model
  • Figure 8.12(a) illustrates these effects.
  • The labor demand curve shifts rightward.
  • The real wage rate rises.
  • The equilibrium quantity of labor increases.

69
The Dynamic Classical Model
  • Figure 8.12(b) shows the change in the production
    function.
  • The production function shifts upward and the
    quantity of labor employed increases.
  • Both changes increase potential GDP.

70
The Dynamic Classical Model
  • Population and Productivity in the United States
  • Population and productivity in the United States
    have increased over time.
  • Between 1981 and 2001, both years close to full
    employment
  • The working age population increased from 170
    million to 212 milliona 25 percent increase.
  • Labor hours increased from 159 billion to 231
    billiona 45 percent increase.

71
The Dynamic Classical Model
  • Population and productivity in the United States
    have increased over time.
  • Between 1981 and 2001, both years close to full
    employment
  • The capital stock increased from 15 trillion
    (1996 dollars) to 25 trilliona 67 percent
    increase.
  • Technology advancedmost notably the information
    revolution and the widespread computerization of
    production processes.

72
The Dynamic Classical Model
  • The percentage increase in labor hours exceeded
    the percentage increase in the population because
    the increase in capital and technological
    advances increased labor productivity, which
    increased the real wage rate, which in turn
    increased the labor force participation rate.

73
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