1. 23 At Full Employment: The Classical Model
CHAPTER
At Full Employment: The Classical Model
Notes and teaching tips: 8, 21, 26, and 43
To view a full-screen figure during a class, click the red “expand” button.
To return to the previous slide, click the red “shrink” button.
To advance to the next slide, click anywhere on the full screen figure.

2. After studying this chapter you will be able to
Explain the purpose of the classical model
Describe the relationship between the quantity of labor employed and real GDP
Explain what determines the full-employment level of employment and real wage rate and potential GDP
Explain what determines unemployment when the economy is at full employment

3. After studying this chapter you will be able to
Explain how borrowing and lending decisions interact to determine the real interest rate, saving, and investment
Apply the classical model to explain changes and international differences in potential GDP and the standard of living

4. What is the economy’s compass?
Our Economy’s Compass
What is the economy’s compass?
What are the forces that prevent the economy from straying too far from full employment?
What determines the level of unemployment at full employment?
What determines employment, the real wage rate, and the real interest rate when the economy is at full employment?

5. 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.

6. 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.

7. Real GDP and Employment
To produce more real GDP, we must use more labor or more capital or develop technologies that are more productive.
It takes time to change the quantity of capital and develop new technologies, so to change real GDP quickly, we must change the quantity of labor.
What is the relationship between the quantity of labor employed and real GDP?

8. 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.
Building and using a toolkit. As you introduce the tradeoff between goods (real GDP) and leisure time, use the opportunity to remind the students that learning economics is like building and using a toolkit. And here we use the PPF tool yet again. Keep reminding your students that economics is not a subject that you memorize (and forget after the exam). It is more like learning to drive a car—something that eventually comes naturally and is never forgotten.
Making it personal. This topic is one that can benefit from drawing on the personal experiences of students who have jobs and who make some choices with respect to hours per week to work, study, and take leisure. They get the PPF for leisure and GDP quickly.
Simple examples. Changes in labor productivity are conveniently illustrated with simple concrete examples. To see how physical capital increases productivity, contrast building a dam using shovels and buckets, then shovels and wheelbarrows, then a front-end loader and a truck. To see how human capital increases productivity, contrast the speed with which a student who has learned to type can produce an essay with the speed at which a two-finger typist can accomplish the same task.

9. Real GDP and Employment
Figure 23.1(a) illustrates a PPF 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.

11. 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.

12. Real GDP and Employment
The Production Function
The production function is the relationship between real GDP and the quantity of labor employed, other things remaining the same.
One more hour of labor employed means one less hour of leisure, therefore the production function is the mirror image of the leisure time-real GDP PPF.

13. Real GDP and Employment
Figure 23.1(b) illustrates the production function that corresponds to the PPF in Figure 23.1(a).
Along the production function, an increase in labor hours brings an increase in real GDP.

15. The Labor Market and Potential GDP
The labor market is the market in which households supply labor services and firms demand labor services.
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.

16. 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.

17. The Labor Market and Potential GDP
Figure 23.2 shows that the lower the real wage rate, the greater is the quantity of labor demanded.
A rise in the real wage rate decreases the quantity of labor demanded.
A fall in the real wage rate increases the quantity of labor demanded.

19. 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 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.

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

21. 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.
Figure 23.3 shows the calculation.
Marginal product of labor. Although you are teaching a macroeconomics course, you can’t neglect some crucial microeconomic underpinnings. And the marginal product of labor is one of these underpinnings. You can though avoid being too technical and can focus on the intuition. Some of your students might have completed the principles of microeconomics and seen the concept of marginal productivity before. This background enables you to encourage their participation in a classroom discussion on this topic. Also, drawing on the life experience of students with jobs whose work hours change from day to day or week to week can be useful. Get the students to see intuitively that it is not worth while for a firm to hire an hour of labor unless the value of the production of that labor at least covers the wage cost to the firm.

23. The Labor Market and Potential GDP
A 100 billion hour increase in labor from 100 billion to 200 billion hours brings a $4 trillion increase in real GDP.
The marginal product of labor is $40 an hour.
At 150 billion (between 100 billion and 200 billion), marginal product is $40 at point A.

24. The Labor Market and Potential GDP
A 100 billion hour increase in labor from 200 billion to 300 billion hours brings a $3 trillion increase in real GDP.
The marginal product of labor is $30 an hour.
At 250 billion (between 200 billion and 300 billion), marginal product is $30.
The marginal product of labor curve is downward sloping.

25. 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.

26. 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
Labor supply. Your main goal in teaching this topic is to explain why in total, hours increase as the real wage rate increases. Again, drawing on the life experience of students with jobs whose work hours change from day to day or week to week can be useful. The two key points are: even though some workers might have a backward-bending labor supply curves (playing golf on weekday afternoons when the wage rate rises enough), most have upward-sloping labor supply curves, and the labor force participation rate increases as the real wage rate increases. These two features of individual behavior imply that the supply curve to labor in aggregate—the supply of aggregate hours—increases as the real wage rate rises, other things remaining the same.

27. The Labor Market and Potential GDP
The Supply of Labor Curve
The supply of labor 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.

28. The Labor Market and Potential GDP
Figure 23.4 shows the higher the real wage rate, the greater is the quantity of labor supplied.
A fall in the real wage rate decreases the quantity of labor supplied.
A rise in the real wage rate increases the quantity of labor supplied.

30. 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

31. 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.

32. 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.

33. 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.

34. The Labor Market and Potential GDP
Figure 23.5(a) illustrates labor market equilibrium.
Labor market equilibrium occurs at a real wage rate of $35 an hour and 200 billion hours employed.
At a real wage rate above $35 an hour, there is a surplus of labor and the real wage rate falls.

36. The Labor Market and Potential GDP
At a real wage rate below $35 an hour, there is a shortage of labor and the real wage rate rises.
At the labor market equilibrium, the economy is at full employment.

37. The Labor Market and Potential GDP
The quantity of real GDP produced when the economy is at full employment is potential GDP.
When the full-employment quantity of labor is 200 billion hours, potential GDP is $12 trillion.

39. 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.
The PPF shows the limits to production and the economy cannot produce more real GDP and take more leisure than the PPF permits.
Potential GDP is one point on the PPF.

40. The Labor Market and Potential GDP
Potential GDP is Production Efficient
Production efficiency occurs at all points on the PPF.
Production is inefficient at all points inside the PPF because resource are unused or misallocated.
Potential GDP occurs on the PPF, so production is efficient.

41. The Labor Market and Potential GDP
Allocative Efficiency at Potential GDP
Allocative efficiency occurs at the one point on the PPF where we cannot produce more of any good without producing less of some other good that we value more highly.
At the equilibrium real wage rate (full employment), the quantity of labor demanded by equals the quantity of labor supplied and the marginal benefit from leisure equals the marginal cost of leisure, so resources are allocated efficiently.

42. 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.

43. Unemployment at Full Employment
At $35 an hour, the job search that takes place generates the natural unemployment rate.
If the real wage rate exceeds $35 an hour, job search increases and unemployment exceeds the natural rate.
If the real wage rate is below $35 an hour, job search decreases and unemployment is below the natural rate.
Where is unemployment in the demand and supply diagram? Thoughtful students often ask about the relationship between the (microeconomic-based) labor demand and labor supply model and unemployment. They can’t “see” any unemployment in labor market equilibrium. Where is it, they want to know.
Explain that in the labor market, people use their time in two economically productive ways: they work and they job search. Working is supplying labor and this is the activity that the demand-supply model shows. It shows the quantity of labor demanded and supplied and the price (real wage rate) that equates the quantities demanded and supplied. The demand and supply model does not determine the quantity of job-search activity. People supply job-search activity because firms have imperfect information about job seekers and workers have imperfect knowledge about available jobs. During the time spent on job search, people are unemployed. You can draw a diagram if you wish that shows the quantity of job search on the x-axis and the real wage rate on the y-axis. The higher the real wage rate, other things remaining the same, the greater is the amount of job search activity. The equilibrium wage rate determined by demand and supply in the labor market determines the point on the job search curve at which the labor market operates and determines the quantity of job-search unemployment.
Only if there were no uncertainty would the supply of job search (and unemployment) be zero. In such a case, a person out of work would not need to search for a new job. He or she would simply report to the new job on the day the worker knew that the job started! Thus, workers would never be unemployed because they would never search for jobs. Clearly, this happy state of affairs is not a description of reality.

45. Unemployment at Full Employment
The amount of job search unemployment changes over time and the main sources are
Demographic change
Structural change
Unemployment compensation

46. Unemployment at Full Employment
Demographic Change
As “baby boom” joined the labor force in the 1970s and searched for jobs, the natural unemployment rate increased.
As the birth rate declined, the bulge moved into higher age groups, entry declined and the natural unemployment rate decreased in the 1980s.

47. Unemployment at Full Employment
Structural Change
Sometimes technological change brings a structural slump, which increases unemployment, increases job search, and increases the natural unemployment rate.
Unemployment Compensation
Because unemployment compensation lowers the opportunity cost of unemployment, it lowers the cost of job search.
With a more generous unemployment compensation, unemployed workers will job search longer.

48. Unemployment at Full Employment
Job Rationing
Job rationing is the practice of paying a real wage rate that exceeds the equilibrium level and then rationing jobs by some method.
Two reasons why the real wage rate might be set above the equilibrium level are
Efficiency wage
Minimum wage

49. Unemployment at Full Employment
An efficiency wage is a real wage rate that is set above the equilibrium real wage rate that balances the costs and benefits of this higher wage rate to maximize the firm’s profit.
A minimum wage is the lowest wage rate at which a firm may legally hire labor.
Most economists agree that efficiency wages and minimum wages increase the natural unemployment rate.

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

51. Loanable Funds and the Real Interest Rate
The Market for Loanable Funds
The market for loanable funds is the market in which households, firms, governments, and financial institutions borrow and lend.
Demand for Loanable Funds
The quantity of loanable funds demanded depends on
The real interest rate
The expected profit rate
Government and international factors

52. Loanable Funds and the Real Interest Rate
The Demand for Loanable Funds Curve
The demand for loanable funds is the relationship between the quantity of loanable funds demanded and the real interest rate when all other influences on borrowing plans remain the same.
Business investment is the main item that makes up the demand for loanable funds.

53. Loanable Funds and the Real Interest Rate
Figure 23.8 shows the demand for loanable funds curve.
A fall in the real interest rate increases the quantity of loanable funds demanded.
A rise in the real wage rate decreases the quantity of loanable funds demanded.

55. 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.

56. 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 international factors

57. Loanable Funds and the Real Interest Rate
The Supply of Loanable Funds Curve
The supply of loanable funds 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.

58. Loanable Funds and the Real Interest Rate
Figure 23.9 shows the supply of loanable funds curve.
A fall in the real interest rate decreases the quantity of loanable funds supplied.
A rise in the real wage rate increases the quantity of loanable funds supplied.

60. Loanable Funds and the Real Interest Rate
Equilibrium in the Loanable Funds Market
The loanable funds market is in equilibrium at the real interest rate at which the quantity of loanable funds demanded equals the quantity of loanable funds supplied.

61. Loanable Funds and the Real Interest Rate
Figure illustrates the loanable funds market.
At 8 percent a year, there is a surplus of funds and the real interest rate falls.
At 4 percent a year, there is a shortage of funds and the real interest rate rises.
Equilibrium occurs at a real interest rate of 6 percent a year.

63. 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 2005.
It was also close to full employment in 1986.
The figures on the next slide illustrate the forces that moved the economy from one full-employment equilibrium to another.

64. Using the Classical Model
Figure 23.11(a) illustrates the labor market.
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.

66. Using the Classical Model
Figure 23.11(b) illustrates the effects on potential GDP.
The increase in labor productivity shifted the production function upwards and …
the increase in equilibrium employment increased potential GDP.

68. THE END