Title: THE ECONOMY AT FULL EMPLOYMENT: THE CLASSICAL MODEL
18
THE ECONOMY AT FULL EMPLOYMENT THE CLASSICAL
MODEL
CHAPTER
2Objectives
- 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
3Objectives
- 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
4Our 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.
5The 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.
6The 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.
7The 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.
8Real 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.
9Real 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.
10Real 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.
11Real 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.
12Real 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.
13The 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
14The 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.
15The 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.
16The 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.
17The 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.
18The 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.
19The 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.
20The 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.
21The 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.
22The 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.
23The 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.
24The 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.
25The 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
26The 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.
27The 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.
28The 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.
29The 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.
30The Labor Market and Potential GDP
- Potential GDP
- At a full employment level of 200 billion hours,
potential GDP is 10 trillion dollars.
31Unemployment 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
32Unemployment 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.
33Unemployment at Full Employment
- Figure 8.6 illustrates the relationship between
the amount of job search unemployment and the
real wage rate.
34Unemployment 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
35Unemployment 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.
36Unemployment 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.
37Unemployment 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.
38Unemployment 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
39Unemployment 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.
40Unemployment 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.
41Unemployment 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.
42Unemployment 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.
43Investment, 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.
44Investment, Saving, and the Interest Rate
- Investment Decisions
- Business investment decisions are influenced by
- The expected profit rate
- The real interest rate
45Investment, 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.
46Investment, 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.
47Investment, 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.
48Investment, 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.
49Investment, 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.
50Investment, 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.
51Investment, Saving, and the Interest Rate
- Saving is influenced by
- The real interest rate
- Disposable income
- Wealth
- Expected future income
52Investment, 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.
53Investment, 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.
54Investment, 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.
55Investment, Saving, and the Interest Rate
- A fall in the real interest rate decreases
saving. - A rise in the real interest rate increases saving.
56Investment, 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.
57Investment, 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.
58Investment, 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.
59The 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
60The 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.
61The 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.
62The Dynamic Classical Model
- Figure 8.10 illustrates in increase in labor
productivity. The production function shifts
upward from PF0 to PF1.
63The 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
64The 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.
65The Dynamic Classical Model
- Figure 8.11(a) illustrates these effects in the
labor market.
66The 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.
67The 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.
68The 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.
69The 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.
70The 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.
71The 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.
72The 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.
73THE END