Lecture 13: Expanding the Model with Labour Supply

1. Lecture 13: Expanding the Model with Labour Supply L11200 Introduction to Macroeconomics 2009/10 Reading: Barro Ch.8 22 February 2010

2. Introduction • Last time: • Asked whether permanent shocks to technology might explain the cyclical pattern of GDP • Tested the idea by what it implied for other key variables – evidence supports hypothesis • Today • Model has assumed fixed labour supply • Now relax this assumption and draw new conclusions

3. Variations in Labour Input • More realistic model allows labour supply • Households choose how much labour to supply instead of L being fixed • L now becomes Ls, a choice variable instead of a fixed variable • So households choose how many hours to work and how many hours to spend at leisure

4. Work vs Leisure • Now household faces a work / leisure decision • As with consumption, decision involves income and substitution effects • If w/P increases, the return on work is greater, so households substitute work for leisure • If w/P increases, households have higher income and so demand more leisure

5. Which effect dominates • Net result depends on whether higher wage is temporary or permanent • If increased wage is temporary, then impact on lifetime income is small, impact on current leisure demand is small relative to substitution effect • If increased wage is permanent, demand for leisure increases 1:1 with the increased wage • So temporary increases in wages are likely to increase time spent working

6. Intertemporal Substitution Effects • Changes in i generate a work now vs work later choice • Increases in i raised future consumption relative to current consumption because future consumption is cheaper • Increases in i have same effect on leisure: future leisure cheaper so demand less now and more later • Increases current labour supply

7. Empirical Evidence • Can we explain the empirical evidence with this model • Two type of evidence: employment and hours • The pattern of employment relative to GDP • The pattern of hours worked relative to GDP • Both are strongly procyclical

8. How would the model explain this? • If changes in GDP are driven by changes in A, this implies • When A rises, MPL rises and demand for labour increases • Now wage and employment response depends on elasticity of labour supply • If substitution effect > income effect then labour supply is upward sloping

9. Outcome • Implies positive changes in A lead to increase in w/P and increase in hours worked • This depends on upward-sloping labour supply curve • For this to be the case, change in A must be non-permanent. • If change were permanent, labour supply would not increase by as much or decrease

10. Assessing the Model • Our macroeconomic model appears to fit the data quite well • Hypothesised that fluctuations in A might be driving fluctuations in GDP • In the model fluctuations in A imply certain behaviour for consumption, investment, wages, rental costs, interest rates and employment • The data is consistent with the predictions of the model

11. Problem • This is an equilibrium model so there is no place for unemployment of capital or labour • ‘equilibrium’ model means markets are always in equilibrium • E.g. labour market: people don’t work because they choose not to, zero unemployment • Capital market: capital is always fully employed.

12. Voluntary Unemployment? • In the model, all changes in employment are voluntary • In reality, we observe that unemployment rises sharply during recessions • Remember: unemployment is wanting to work but not being able to find a job • Are the unemployed just not willing to work at the going wage rate?

13. Summary • Developed model with flexible hours of work • Households face choice over work (income, consumption) versus leisure • Income, substitution and intertemporal substitution effects • Model fits data well • Next time: try to explain unemployment of both capital (next time) and labour.