Lecture 13: Expanding the Model with Labour Supply L11200 Introduction to Macroeconomics 2009/10 Reading: Barro Ch.8 22 February 2010

Introduction Last time: – Asked whether permanent shocks to technology might explain the cyclical pattern of GDP – Tested the idea by what it implied for other key variables – evidence supports hypothesis Today – Model has assumed fixed labour supply – Now relax this assumption and draw new conclusions

Variations in Labour Input More realistic model allows labour supply – Households choose how much labour to supply instead of L being fixed – L now becomes L s, a choice variable instead of a fixed variable – So households choose how many hours to work and how many hours to spend at leisure

Work vs Leisure Now household faces a work / leisure decision As with consumption, decision involves income and substitution effects – If w/P increases, the return on work is greater, so households substitute work for leisure – If w/P increases, households have higher income and so demand more leisure

Which effect dominates Net result depends on whether higher wage is temporary or permanent – If increased wage is temporary, then impact on lifetime income is small, impact on current leisure demand is small relative to substitution effect – If increased wage is permanent, demand for leisure increases 1:1 with the increased wage – So temporary increases in wages are likely to increase time spent working

Intertemporal Substitution Effects Changes in i generate a work now vs work later choice – Increases in i raised future consumption relative to current consumption because future consumption is cheaper – Increases in i have same effect on leisure: future leisure cheaper so demand less now and more later – Increases current labour supply

Empirical Evidence Can we explain the empirical evidence with this model – Two type of evidence: employment and hours – The pattern of employment relative to GDP – The pattern of hours worked relative to GDP – Both are strongly procyclical

How would the model explain this? If changes in GDP are driven by changes in A, this implies – When A rises, MPL rises and demand for labour increases – Now wage and employment response depends on elasticity of labour supply – If substitution effect > income effect then labour supply is upward sloping

Outcome Implies positive changes in A lead to increase in w/P and increase in hours worked – This depends on upward-sloping labour supply curve – For this to be the case, change in A must be non- permanent. – If change were permanent, labour supply would not increase by as much or decrease

Assessing the Model Our macroeconomic model appears to fit the data quite well – Hypothesised that fluctuations in A might be driving fluctuations in GDP – In the model fluctuations in A imply certain behaviour for consumption, investment, wages, rental costs, interest rates and employment – The data is consistent with the predictions of the model

Problem This is an equilibrium model so there is no place for unemployment of capital or labour – ‘equilibrium’ model means markets are always in equilibrium – E.g. labour market: people don’t work because they choose not to, zero unemployment – Capital market: capital is always fully employed.

Voluntary Unemployment? In the model, all changes in employment are voluntary – In reality, we observe that unemployment rises sharply during recessions – Remember: unemployment is wanting to work but not being able to find a job – Are the unemployed just not willing to work at the going wage rate?

Summary Developed model with flexible hours of work – Households face choice over work (income, consumption) versus leisure – Income, substitution and intertemporal substitution effects – Model fits data well Next time: try to explain unemployment of both capital (next time) and labour.