1 Ch. 7. At Full Employment: The Classical Model The relationship between the quantity of labor employed and real GDP What determines the full-employment level of employment, real wage rate and potential GDP What determines unemployment when the economy is at full employment How borrowing and lending decisions interact to 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 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.

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.

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.

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. 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. Real GDP and Employment

The production function that corresponds to the PPF above Along the production function, an increase in labor hours brings an increase in real GDP. Real GDP and Employment

The Labor Market and Potential GDP 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.

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.

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 (nominal) 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.

The Labor Market and Potential GDP Marginal Product of Labor marginal product of labor is the additional real GDP produced by an additional hour of labor when all other influences on production remain the same. law of diminishing returns As the quantity of labor increases, and the quantity of capital and technology remain the same, the marginal product of labor decreases.

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.

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.

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

The Labor Market and Potential GDP The Supply of Labor Curve 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.

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

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.

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.

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.

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. Potential GDP is one point on the PPF.

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.

Unemployment at Full Employment The amount of job search unemployment changes over time and the main sources are  Demographic change  baby boom  More women in labor force  Structural change  New technologies eliminate some jobs, create others  Unemployment compensation  Affects length of job search among unemployed  Job rationing  Minimum wage  Efficiency wage

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 total quantity of plant, equipment, buildings, and business inventories. determined by investment. the funds that finance investment are obtained in the loanable funds market.

Loanable Funds and the Real Interest Rate The Market for Loanable Funds the market in which households, firms, governments, and financial institutions borrow and lend. The quantity of loanable funds demanded depends on  The real interest rate  Investment demand  expected profit rate (internal rate of return)  Government deficit

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.

Loanable Funds and the Real Interest Rate The Demand for Loanable Funds Curve Shows the relationship between the quantity of loanable funds demanded and the real interest rate, ceteris parabus. Changes in interest rate cause movements along curve Changes in other factors (e.g. investment demand, government deficits) can shift the curve.

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 and international factors

Loanable Funds and the Real Interest Rate The Supply of Loanable Funds Curve 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.

Using the Classical Model The U.S. Economy Through the Eye of the Classical Model The U.S. economy was close to full employment in It was also close to full employment in The figures on the next slide illustrate the forces that moved the economy from one full-employment equilibrium to another.

Using the Classical Model Advances in technology and investment increased labor productivity and increased the demand for labor. The population expanded and increased the supply of labor. The real wage rate rose and equilibrium employment increased.

Using the Classical Model The increase in labor productivity shifted the production function upwards and … the increase in equilibrium employment increased potential GDP.

Working with the classical model Analyze effect of the following on real wages, employment, real GDP and productivity. increase in immigration or population growth Technological improvements that enhance productivity of labor Effect on real interest rates? Increased saving Effect on real interest rates? Larger government budget deficits Effect on real interest rates? (Ignore offsetting changes in saving for now)