Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 6-1 CHAPTER 6 Building Blocks of the Flexible-Price Model

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 6-2 Questions What is a full-employment analysis? What keeps the economy at full employment when wages and prices are flexible? What determines the level of consumption spending? What determines the level of investment spending?

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 6-3 Questions What determines the level of net exports? What determines the level of the exchange rate?

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 6-4 Full-Employment Analysis We will now look at the economy over the short-run –a period in which its productive resources are fixed We will assume that wages and prices are flexible so that all markets clear –supply equals demand in the labor market –full-employment analysis

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 6-5 Flexible-Price Model Two sets of factors determine the levels of potential output and real wages –the production function –the balance of supply and demand in the labor market

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 6-6 The Production Function Potential output (Y*) is determined by –the size of the labor force (L) –the economy’s capital stock (K) –the efficiency of labor (E) –a parameter indicating how quickly returns to investment diminish ()

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 6-7 Figure The Production Function

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 6-8 Flexible-Price Model The assumption that wages and prices are flexible was commonly made by “classical” economists Thus, this assumption is often called the classical assumption –guarantees that markets work –guarantees full employment –guarantees that actual output is equal to potential output

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 6-9 Flexible-Price Model The flexible-price assumption is not always a good one –a market economy does not always produce full employment The “Keynesian” model assumes that wages and prices are sticky –this will be covered in Section III of text The Classical assumption simplifies the analysis of the economy

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Table Classical Flexible-Price versus Keynesian Sticky-Price Analyses

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved The Labor Market Assume there are K identical firms –each firm owns one unit of the economy’s capital stock –each firm hires L workers and pays them the same wage W –each firm sells Y units of output at a per- unit price of P –no firm has control over the price it receives or the wage it pays these are determined by the market

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved The Labor Market To determine how many workers to hire, the firm follows two rules –hire workers to boost output –stop hiring when the extra revenue from the output hired by the last worker just equals his or her wage

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved The Labor Market The value of the output produced by the last worker hired is the product price (P) multiplied by the marginal product of labor (MPL) The cost of hiring the last worker is his or her wage (W) The firm will keep hiring until

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved The Labor Market The marginal product of labor is the difference between what the firm can produce with its current labor force (L firm ) and what it could produce if it hired one more worker At its current labor force, the output of the firm will be

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved The Labor Market Therefore, the marginal product of labor (MPL) must be equal to

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Figure The Firm’s Output as a Function of the Firm’s Employment

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved The Labor Market Using the Cobb-Douglas form of the production function Since K firm =1

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved The Labor Market The term in the brackets is a growth rate of a variable raised to a power

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved The Labor Market The firm hires workers up to the point where the product price multiplied by the marginal product of labor equals the wage Substituting for MPL

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Figure The Typical Firm’s Hiring Policy

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved The Labor Market The typical firm’s demand for labor is Because there are K firms in the economy, total economy-wide employment will be

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved The Labor Market If there are more workers than firms want to hire at the current wage –some of the unemployed will underbid their fellow employed workers –those who are employed will respond by accepting a lower wage to keep their jobs –real wages will fall and firms will hire more workers

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved The Labor Market If there are fewer workers than firms want to hire at the current wage –some firms will try to bid workers away by offering higher wages –the real wage will rise and firms will reduce the quantity of labor demanded Equilibrium occurs in the labor market when labor demand is equal to the labor force

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Figure Equilibrium in the Labor Market

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved The Labor Market Equilibrium in the labor market means that This means that the equilibrium real wage is equal to

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved The Labor Market When the labor market is in equilibrium, the typical firm produces an output level equal to Total output will be K multiplied by the typical firm’s output

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved The Labor Market Simplifying, we get the Cobb-Douglas production function If markets work well, the actual level of output in the economy (Y) will be equal to the economy’s potential output (Y*)

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Figure In a Full-Employment Economy, Real GDP Equals Potential Output

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Domestic Spending National income can be divided into four components –consumption spending (C) –investment spending (I) –government purchases (G) –net exports (NX)

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Figure The Four Components of Spending Add Up to Real GDP

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Consumption Spending Households use income (Y) in three ways –pay net taxes (T) assume that T = t  Y, where t is an average tax rate disposable income is equal to income minus taxes [Y D = Y-T = (1-t)Y] –save (S H ) –consume (C)

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Figure From National Income to Consumption Spending

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Consumption Spending Consumption spending can be broken down into two components –a baseline level of consumption (C 0 ) the amount that households would spend on consumption goods if they had no income –a fraction of disposable income (C y  Y D ) C y is the marginal propensity to consume, amount by which consumption spending rises in response to a $1 increase in disposable income

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Consumption Spending Consumption is assumed to be a linear function of real GDP (Y) There are other factors that affect consumption besides disposable income –assumed to affect baseline consumption (C 0 ) only

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Figure Other Determinants of Consumption Spending

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Consumption Spending C y is the marginal propensity to consume 0<C y <1 –if incomes rise, households will use some of their extra income to increase their consumption spending –as incomes rise, households will also increase their saving

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Figure The Consumption Function

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Consumption Spending Example –the tax rate (t) = 25%, national income (Y) = $10 trillion, the baseline level of consumption (C 0 ) = $2 trillion, and the marginal propensity to consume (C y ) = 0.6

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Investment Spending Fluctuations in investment spending have two sources –the interest rate a higher real interest rate makes investment projects more expensive and lowers investment –business managers’ and investors’ confidence the higher their confidence, the higher is investment spending

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Investment Spending Firms invest because their managers believe that the investment projects will be profitable –this means that the discounted returns on the investments must be greater than the investments’ costs –the most relevant interest rate for determining the profitability of an investment is the long-term, real, risky interest rate

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Investment Spending Investment spending has two components –the baseline level of investment (I 0 ) –the responsiveness of investment to changes in the interest rate (I r )

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Figure The Investment Function

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Investment Spending Example –the baseline level of investment (I 0 ) = $2 trillion, the interest-sensitivity of investment (I r ) = $10 trillion, and the real interest rate = 5%

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Investment Spending An alternative way of looking at investment is to see the level of investment as a function of the level of the stock market The same things that determine the value of the stock market also determine the level of investment –expected future profits (confidence) –the real interest rate

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Government Purchases Government purchases (G) include purchases of labor and other goods and services by federal, state, and local governments Government purchases do not include transfer payments –transfer payments are negative taxes Economists do not inquire into what determines G (or the tax rate t)

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Figure Government Purchases, Transfer Payments, and Taxes

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved International Trade Net exports (NX) is the difference between gross exports (GX) and imports (IM)

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Figure Gross Exports, Imports, and Net Exports

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Gross Exports The volume of gross exports (GX) depends on two variables –the real GDP of the country’s trading partners (Y f ) –the real exchange rate () –X yf is the increase in exports generated by an increase in foreign GDP –X  is the increase in exports from an increase in the real exchange rate

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Figure Gross U.S. Exports and the Real Exchange Rate,

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Gross Exports In the real world, there are substantial lags that occur between changes in the real exchange rate and changes in the level of gross exports –a change in the real exchange rate this year will have little or no effect on gross exports this year, but will have effects on gross exports one, two, and three years into the future

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Figure The J-Curve in the 1980s

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Gross Imports The value of demand for imports depends on domestic real GDP (Y) The quantity of imports demanded depends also on the real exchange rate () –however, the value of imports is largely independent of the real exchange rate –gross imports will be a constant share of real GDP

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Net Exports Net exports (NX) are the difference between gross exports (GX) and imports (IM) Net exports depend on three things –the real exchange rate () –the level of real GDP abroad (Y f ) –the level of real GDP at home (Y)

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved The Exchange Rate The lives of foreign exchange speculators are ruled by fear and greed –a higher U.S. interest rate means that an individual can profit from buying U.S. bonds the greater this interest differential, the higher the greed factor –if the U.S. real exchange rate rises, profits from holding U.S. bonds will be lower the higher the greed factor, the lower must be the exchange rate in order for fear to offset the greed

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Figure Greed and Fear in Foreign Exchange Markets

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved The Exchange Rate The real exchange rate is determined by two components –the average foreign exchange trader’s opinion of what the exchange rate should be if there was no interest differential ( 0 ) –the sensitivity of the exchange rate ( r ) to the interest rate differential between domestic real interest rates (r) and foreign real interest rates (r f )

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Net Exports Substituting in for the real exchange rate, we get Having the definition of net exports in this form tells us directly how domestic and foreign interest rates affect net exports

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Chapter Summary When the economy is at full employment, the level of real GDP is equal to potential output--the level of output generated by the aggregate production function, given the current stocks of labor and capital and the current level of the efficiency of labor

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Chapter Summary When wages and prices are flexible, the working of the labor market keeps the economy at full employment –if labor demand is less than the labor force, falling wages raise employment –if labor demand is greater than the labor force, rising wages soon curb labor demand

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Chapter Summary The level of consumption spending is determined by many things, but the most important of them is the level of disposable income The level of investment spending is primarily determined by business managers’ degree of optimism and by the real interest rate

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Chapter Summary The stock market is a useful indicator of the likely future level of investment spending because its value depends on the same factors that determine investment spending –the general degree of optimism about future profits –the real interest rate

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Chapter Summary The exchange rate is determined by two factors –foreign exchange traders’ view of the long-run equilibrium level of the exchange rate –the interest rate differential between investments at home and abroad

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Chapter Summary The level of net exports has three determinants –the level of the exchange rate –the level of real GDP at home determines the level of imports –the level of real GDP abroad affects the level of exports