1. Ch. 7. At Full Employment: The Classical Model
The relationship between the quantity of labor employed and real GDP
Determinants of potential GDP, employment, and real wage rate
Determinants of the natural rate of unemployment
How borrowing and lending decisions determine the real interest rate, saving, and investment
Use classical model to explain changes and international differences in potential GDP and the standard of living

2. The Classical Model: A Preview
Real versus Nominal Variables
Real variables
measure quantities independent of prices; Reflect a “base year” set of prices.
e.g. Real GDP, employment and unemployment, real wage rate, consumption, saving, investment, and the real interest rate.
Nominal variables
Measures reflecting current prices
Nominal GDP, nominal wage rate, and the nominal interest rate.
The classical dichotomy
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.

3. Parts of the classical model
Production Function
Labor market
Labor demand
Labor supply
Loan market
Supply of loanable funds
Demand for loanable funds

4. Production Function Shows relationship between labor and real GDP
Slope of line to origin = productivity (output per labor hour)
Slope of tangent = marginal product of labor
Law of diminishing marginal returns implies
MP decreases as L increases
PF flattens out as L increases

5. Shifts in the production function caused by
More capital
More productive workers
Better technology
Movements along production function caused by changes in level of employment

6. The Labor Market and Potential GDP
Real wage rate
the quantity of good and services that an hour of labor earns.
Money (nominal) wage rate
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 when compared to MP of labor.

7. The Labor Market and Potential GDP
Labor Demand 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.
Marginal product of labor curve is same as labor demand curve
Firms will always hire workers if MP> real wage
Profit maximizing firm hires until MP= real wage

9. The Labor Market and Potential GDP
Labor supply curve
shows quantity of labor supplied for each real wage rate.
Quantity of labor supplied increases as the real wage rate increases for two reasons:
Hours per person increase (assuming IE<SE)
Income effect (work less if real wage increases)
Substitution effect (work more if real wage increases)
Labor force participation increases

10. Labor Supply Curve

11. Labor Supply Curve Shifts in labor supply caused by population growth
immigration
taxes on wages
home technology
generosity of transfer programs

12. Labor Market Equilibrium

13. Higher; higher. Higher; lower Lower; higher Lower; lower
If the U.S. allowed more immigration, the new equilibrium in the labor market would result in _____ wages and ____ employment
Higher; higher.
Higher; lower
Lower; higher
Lower; lower 30

14. Higher; higher. Higher; lower. Lower; lower. Lower; higher.
If there were technological innovations making labor more productive, this would lead to ____ wages and _____ employment
Higher; higher.
Higher; lower.
Lower; lower.
Lower; higher. 30

15. Higher; higher. Higher; lower. Lower; lower. Lower; higher.
A less generous welfare program would likely lead to ____ wages and _____ employment.
Higher; higher.
Higher; lower.
Lower; lower.
Lower; higher. 30

16. The Labor Market and Potential GDPRW LS
Potential GDP = RGDP when economy is at full employment LD
Employment
RGDP PF
Employment

17. Suppose that there more immigration is allowed into the U. S
Suppose that there more immigration is allowed into the U.S. This will cause potential GDP to _____ and productivity to ______.
Rise; rise.
Rise; fall.
Fall; rise.
Fall; fall 30

18. Suppose that there is new capital added to the economy
Suppose that there is new capital added to the economy. This will cause potential GDP to _____ and real wages to ______.
Rise; rise.
Rise; fall.
Fall; rise.
Fall; fall 30

19. Loanable Funds, Investment and the Real Interest Rate
Potential GDP depends on amounts of labor, capital, and other resources.
Capital stock
total quantity of plant, equipment, buildings, and business inventories.
determined by investment.
the funds that finance investment are obtained in the loanable funds market.

20. Demand for loanable funds
Demand for loan funds depends on
The real interest rate = (nominal) interest rate - inflation
Investment demand
expected profit rate (internal rate of return)

21. Demand for loanable funds
Changes in real interest rate cause movements along loan demand curve
Shifts in loan demand:
Changes in investment demand
government budget deficit adds to loan demand
Foreign demand for loans can also add to loan demand (trade surplus)

22. Supply of Loanable Funds
Supply of Loanable Funds Curve.
Saving is the main item that makes up the supply of loanable funds.
The quantity of loanable funds supplied depends on
The real interest rate (moves along the curve)
Disposable income
Wealth
Expected future income
Government budget
Surplus increases supply of loans
Foreign supply of loans to U.S.
Trade surplus

23. Supply of Loanable Funds

24. Equilibrium in Loan Market

25. Suppose that households decide to save more of their incomes
Suppose that households decide to save more of their incomes. This should lead to
an increase in the supply of loans and lower interest rates.
An increase in the supply of loans and higher interest rates.
A decrease in the demand for loans and lower interest rates.
An increase in the demand for loans and higher interest rates. 30

26. Suppose that households decide to save more of their incomes
Suppose that households decide to save more of their incomes. This should lead to
Lower interest rates and more investment
Lower interest rates and less investment
Higher interest rates and more investment
Higher interest rates and less investment. 30

27. Suppose that the federal government increases its budget deficit
Suppose that the federal government increases its budget deficit. This should lead to
an increase in the supply of loans and lower interest rates.
A decrease in the supply of loans and higher interest rates.
A decrease in the demand for loans and lower interest rates.
An increase in the demand for loans and higher interest rates. 30

28. Suppose that the federal government increases its budget deficit
Suppose that the federal government increases its budget deficit. This should lead to
Lower interest rates and less investment
Lower interest rates and more investment
Higher interest rates and less investment
Higher interest rates more investment. 30