At Full Employment: The Classical Model

1. 23 CHAPTER At Full Employment: The Classical Model

2. 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

3. 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

4. Our Economy’s Compass • What is the economy’s 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?

5. 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-being—real 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 changing—the price level, the inflation rate, nominal GDP, nominal wage rate, and the nominal interest rate.

6. 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.

7. 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?

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. • 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.

9. 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.

10. 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.

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 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.

13. 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.

14. 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.

15. 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.

16. 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.

17. 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.

18. 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.

19. 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.

20. 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.

21. 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.

22. 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

23. 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.

24. 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.

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 • 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.

27. 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.

28. 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.

29. 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.

30. 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.

31. 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.

32. 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.

33. 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.

34. 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.

35. 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.

36. 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.

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

38. 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.

39. 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.

40. 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

41. 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 firm’s 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.

42. 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.

43. 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

44. 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.

45. 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.

46. 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.

47. 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

48. 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.

49. 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.

50. 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.