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

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.

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

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

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

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.

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

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

Labor Supply Curve

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

Labor Market Equilibrium

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

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

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

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

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

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

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.

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)

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)

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

Supply of Loanable Funds

Equilibrium in Loan Market

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

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

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

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