8 THE ECONOMY AT FULL EMPLOYMENT: THE CLASSICAL MODEL CHAPTER.

8 THE ECONOMY AT FULL EMPLOYMENT: THE CLASSICAL MODEL CHAPTER

Objectives After studying this chapter, you will able to
Describe the relationship between the quantity of labor employed and real GDP Explain what determines the demand for labor and the supply of labor and how labor market equilibrium determines employment, the real wage rate, and potential GDP This chapter provides the best coverage of the labor market’s link to the aggregate supply side of the economy of any introductory text on the market. It clearly explains to students how potential GDP is determined, what changes potential GDP and why there is ever-persistent unemployment in our economy. One way to motivate students in the study of the labor underpinnings of the macroeconomy is to address the topic of wages. Students readily understand the difference in money wages versus real wage rates. Ask them how much they think their money wages have increased during the past 12 months. Their answers provide an opportunity to work out the percentage change in their wages and then compare it to the percentage change in the CPI or GDP deflator. Use your own percentage increase in wages as an opening example if that’s not too depressing. If you’re like most professors, your real wage rate is falling! This real wage rate discussion then allows you to ask the class: why has your real wage rate fallen and why have real wage rates for some of the students and in other occupations gone up? And, on average, do they think real wage rates are going up or down? These questions always generate some interest, particularly if you pose another question about the future trend of real wage rates. They also let you introduce the idea that in macroeconomics, we’re concerned with the averages and aggregates rather than the details of the distribution. You can move from these introductory ideas to set up the need for the model in this chapter.

Objectives After studying this chapter, you will able to
Explain how business investment decisions and household saving decisions are made Explain how investment and saving interact to determine the real interest rate Use the classical model to explain the forces that change potential GDP

Our Economy’s Compass Our economy follows a path like that of an explorer probing new terrain. Sometimes the explorer strays of course. But the explorer has a compass that helps keep getting back on the main track. Our economy wanders around its main course—its full employment trend—but like the explorer, has a compass that keeps bringing it back. The classical model is the compass and you’ll learn about it in this chapter.

The Classical Model: A Preview
Economists have made progress in understanding how the economy works by dividing the variables that describe macroeconomic performance into two lists: Real variables Nominal variables Real variables like real GDP, employment, and the real wage rate describe what is happening to living standards Nominal variables like the price level and nominal wage rate tell us how dollar values and the value of money are changing.

The two lists of variables form the basis of a huge discovery called the classical dichotomy, which states: At full employment, the forces that determine real variables are independent of those that determine nominal variables. For example, we can explain why real GDP in the United States is 20 times that of Nigeria by looking only at real variables. We don’t need to look at the price levels in the two countries.

The classical model is a model of the economy that determines the real variables—real GDP, employment and unemployment, the real wage rate, consumption, saving, investment, and the real interest rate—at full employment. Most economists believe that the economy is rarely at full employment but that the classical model provides a benchmark against which to measure the actual state of the economy.

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. 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.

Figure 24.1(a) illustrates a production possibility frontier between leisure time and real GDP. The more leisure time forgone, the greater is the quantity of labor employed and the greater is the real GDP.

The PPF showing the relationship between leisure time and real GDP is bowed-out, which indicates an increasing opportunity cost. Opportunity cost is increasing because the most productive labor is used first and as more labor is used it is increasingly less productive.

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.

Figure 24.1(b) illustrates the production function that corresponds to the PPF shown in Figure 24.1(a). Along the production function, an increase in labor hours brings an increase in real GDP.

The Labor Market and Potential GDP
To understand how potential GDP is determined, we study: The demand for labor The supply of labor Labor market equilibrium Potential GDP

The Demand for Labor The quantity of labor demanded is the labor hours hired by all firms in the economy. The demand for labor is the relationship between the quantity of labor demanded and the real wage rate, other things remaining the same. 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.

To calculate the real wage rate, we divide the money wage rate by the GDP deflator and multiply by 100. It is the real wage rate, not the money wage rate, that determines the quantity of labor demanded. Figure 24.2 shows a demand for labor curve.

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, but the quantity of capital and technology remain the same, the marginal product of labor decreases.

We calculate the marginal product of labor as the change in real GDP divided by the change in the quantity of labor employed.

Figure 24.3 shows the calculation of the marginal product of labor and illustrates the relationship between the marginal product curve and the production function. 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.

A 100 billion hour increase in labor from 100 to 200 billion hours brings a $4 trillion increase in real GDP—the marginal product of labor is $40 an hour.

A 100 billion hour increase in labor from 200 to 300 billion hours brings a $3 trillion increase in real GDP—the marginal product of labor is $30 an hour. The marginal product of labor is the slope of the production function.

Figure 24.3(b) shows the same information on the marginal product curve, MP. At 150 (midway between 100 and 200), marginal product is $40. At 250 (midway between 200 and 300), marginal product is $30.

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 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 supply of labor is the relationship between the quantity of labor supplied and the real wage rate, all other things remaining the same. 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. 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.

Figure 24.4 illustrates a labor supply curve. The higher the real wage rate, the greater is the quantity of labor supplied.

The quantity of labor supplied increases as the real wage rate increases for two reasons: Hours per person increase Labor force participation increases

Hours per person increase because the real wage rate is the opportunity cost of not working. But a higher real wage rates increase 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.

Labor force participation increases because higher real wage rates induce some people who choose not to work at lower real wage rates to enter the labor force. The labor supply response to an increase in the real wage rate is positive but small. A large 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 is in equilibrium at the real wage rate at which the quantity of labor demanded equals the quantity of labor supplied. Labor market equilibrium is full-employment equilibrium. The level of real GDP at full employment is potential GDP.

Figure 24.5(a) illustrates labor market equilibrium. Labor market equilibrium occurs at a real wage rate of $35 and an employment of 200 billion labor hours.

At a full employment level of 200 billion hours, potential GDP is 10 trillion dollars.

Unemployment at Full Employment
The unemployment rate at full employment is called the natural rate of unemployment. Unemployment always is present for two broad reasons Job search Job rationing

Job Search Job search is the activity of workers looking for an acceptable vacant job. All unemployed workers search for new jobs, and while they search many are unemployed.

Figure 24.6 illustrates the relationship between the amount of job search unemployment and the real wage 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.

The amount of job search unemployment changes over time and the main sources of these changes are Demographic change Unemployment compensation Structural change

Demographic change As more young workers entered the labor force in the 1970s, the amount of frictional unemployment increased as they searched for jobs. Frictional unemployment may have fallen in the 1980s as those workers aged. Two-earner households may increase search, because one member can afford to search longer if the other has an income.

Unemployment compensation The more generous unemployment benefit payments become, the lower the opportunity cost of unemployment, so the longer workers search for better employment rather than any job. More workers are covered now by unemployment insurance than before, and the payments are relatively more generous.

Structural change An increase in the pace of technological change that reallocates jobs between industries or regions increases the amount of search.

Job Rationing Job rationing occurs when employed workers are paid a wage that creates an excess supply of labor. Job rationing can occur for two reasons Efficiency wage Minimum wage

An efficiency wage is a real wage rate that is set above the full-employment equilibrium wage that balances the costs and benefits of this higher wage rate to maximize the firm’s profit. The cost of a higher wage is direct. The benefit of a higher wage is indirect: it enables a firm to attract high-productivity workers, stimulates greater work effort, lowers the quit rate, and lowers recruiting costs.

A minimum wage is the lowest wage rate at which a firm may legally hire labor. If the minimum wage is set below the equilibrium wage rate, it has no effect. If the minimum wage is set above the equilibrium wage rate, it does affect the labor market.

Job Rationing and Unemployment If the real wage rate is above the equilibrium wage, regardless of the reason, there is a surplus of labor that adds to unemployment and increases the natural unemployment rate. Most economists agree that efficiency wages and minimum wages increase the natural unemployment rate. David Card and Alan Krueger have challenged this view and argue that an increase in the minimum wage works like an efficiency wage, making workers more productive and less likely to quit.

Dan Hamermesh argues that firms anticipated increases in the minimum wage and cut employment before the minimum wage increased. Therefore, looking at the effects of minimum wage changes after the change occurs misses the effects—an example of the post hoc fallacy. Finis Welch and Kevin Murphy say Card and Krueger failed to take into account some regional differences in economic growth that hide the effects of the change in the minimum wage—an example of ceteris paribus not holding.

Investment, Saving, and the Interest Rate
Investment and Capital The capital stock is the total amount of plant, equipment, buildings, and inventories, physical capital. Gross investment is the purchase of new capital. Depreciation is the wearing out of the capital stock. Net investment equals gross investment minus depreciation, and net investment is the addition to the capital stock. Definitions and the meaning of investment in economics. The student has met the key definitions of this section in Chapter 19, but to be absolutely sure that they are remembered, this chapter repeats them. It is worth emphasizing that in economics, “capital” and “investment” without any qualification mean physical capital and purchase of newly produced physical capital goods. Everyday usage of investment as the purchase of stocks or bonds can lead to confusion. So it is worth getting these matters clear right from the start.

Investment Decisions Business investment decisions are influenced by The expected profit rate The real interest rate Confusing saving and investment. Some of your students will confuse saving and investment. And this confusion will lead them to be puzzled by the slope of the investment demand curve. You can help all your students avoid this confusion by hitting it head on. Ask them the following question: “If the interest rate rises, I’m going to put more money in my savings account, stock market, or whatever. So why do we say that a higher interest rate decreases investment?” In the ensuing discussion, get the students to see that placing funds in a savings account, stock market, or whatever, is saving, which does increase if the interest rate rises (other things remaining the same). Remind them that investment demand refers to the demand by firms (and households) for physical capital goods. By explicitly tackling this source of confusion, you can simultaneously explain why investment and saving respond in opposite directions to a change in the interest rate.

The Expected Profit Rate The expected profit rate is relatively high during business cycle expansions and relatively low during recessions. Advances in technology can increase the expected profit rate. Taxes affect the expected profit rate because firms are concerned about after-tax profits.

The Real Interest Rate The real interest rate is the opportunity cost of the funds used to finance investment. Regardless of whether a firm borrows or uses its own financial resources, it faces this opportunity cost. Either it pays the interest or it forgoes interest on its own funds.

Investment Demand Investment demand is the relationship between the level of planned investment and the real interest rate. Figure 24.7 illustrates an investment demand curve.

The investment demand curve slopes downward. A fall in the real interest rate increases planned investment along investment demand curve. A rise in the real interest rate decreases planned investment along investment demand curve.

Investment is financed by national saving and borrowing from the rest of the world. Saving is current income minus current expenditure, and in part finances investment. The U.S. saving rate. The low U.S. saving rate, described in this chapter, is very interesting to stuents. They are also intrigued by the low level of personal saving and the high level of business saving. It is worth emphasizing that part of the reason for the low personal saving rate is that payroll deductions for employment pension plans are business savings.

Personal saving is personal disposable income minus consumption expenditure. Business saving is retained profits and additions to pension funds by businesses. Government saving is the government’s budget surplus. Any of these components can be negative. National saving is the sum of private saving and government saving. Households divide their disposable income between consumption expenditure and saving.

Saving is influenced by The real interest rate Disposable income Wealth Expected future income

Real Interest Rate The higher the real interest rate, the greater is a household’s opportunity cost of consumption and so the larger is the amount of saving. Disposable Income The higher the disposable income, the greater is a household’s saving. The book is very clear on why the real interest rate, disposable income, wealth, and expected future income should all influence saving and how. A potential problem is that brighter students who have fully understood substitution and income effects will see that an increase in the real interest rate raises the opportunity cost of consumption now, but also raises current and expected future disposable income for those with net financial assets, so the overall impact on saving is theoretically ambiguous. The best response is probably to simply assert that empirically we have reason to believe that, in the United States at least, the substitution effect outweighs the income effect and the saving supply schedule can be confidently presumed to be upward sloping, although perhaps fairly inelastic – as Figure 24.8 suggests.

Wealth The greater is a household’s wealth, other things remaining the same, the greater is its consumption and the less is its saving. Expected Future Income The higher a household’s expected future income, the greater is its current consumption and the lower is its current saving.

Saving Supply Saving supply is the relationship between saving and the real interest rate, other things remaining the same. Figure 24.8 shows a saving supply curve, which slopes upward.

A fall in the real interest rate decreases saving. A rise in the real interest rate increases saving.

Determining the Real Interest Rate The real interest rate is determined by investment demand and supply of savings. In Figure 24.9, ID is the investment demand curve. SS is the supply of saving curve.

If the interest rate is above its equilibrium level, SS exceeds ID. There is a surplus of funds and the interest rate falls. If the interest rate is below its equilibrium level, ID exceeds SS. There is a shortage of funds and the interest rate rises.

The equilibrium real interest rate is 6 percent. At the equilibrium real interest rate, there is neither a shortage nor surplus of saving.

The Dynamic Classical Model
Changes in Productivity Labor productivity is real GDP per hour of labor. Three factors influence labor productivity. Physical capital Human capital Technology

Human capital is the knowledge and skill that has been acquired from education and on-the-job training. Learning-by-doing is the activity of on-the-job education that can greatly increase labor productivity.

Shifts in the Production Function Any influence that increases labor productivity increases real GDP at each level of labor hours and shifts the production function upward. An increase in physical capital, human capital, or a technological advance all increase labor productivity.

Figure illustrates in increase in labor productivity. The production function shifts upward from PF0 to PF1.

Real GDP increases if The economy recovers from a recession Potential GDP increases. Two factors that increase potential GDP are An increase in population An increase in labor productivity

An Increase in Population An increase in population increases the supply of labor. The equilibrium real wage rate falls and the equilibrium quantity of labor increases. The increase in the equilibrium quantity of labor increases potential GDP. The potential GDP per hour of work decreases. Is immigration bad for us? Many people think that immigration is bad for existing citizens and lowers their living standard. Part of the popular political discussion, especially in Europe during 2002, has a racist dimension, which you will want to avoid. But the raw economic dimension is worth examining. When you show your students the effects of an increase in population in Figure 24.8, you will conclude that an increase in population, ceteris paribus, increases real GDP but lowers real GDP per person and lowers the real wage rage. You might then ask: does this outcome mean that immigration is bad for us? The answer, of course, is absolutely not. Historically, immigrants have brought capital and entrepreneurship, and been some of the most creative sources of technological change. When you combine the effects of capital accumulation and technological change with an increase in population, you see that real GDP increases but the change in the wage rate is ambiguous. Add the historical fact that capital accumulation and technological change have outstripped population growth, and you reach the conclusion that immigration has been (and probably continues to be) a positive economic force.

Figure 24.11(a) illustrates these effects in the labor market. Note that in the first printing of the text, Figures and were reversed. It is unlikely that you have this version but in case you do, beware!

Potential GDP increases. Potential GDP per hour of work decreases. Initially, potential GDP per hour of work was $50--$10 trillion divided by 200 billion. In the new equilibrium, potential GDP per hour of work is $ $13 trillion divided by 300 billion.

An Increase in Labor Productivity Three factors increase labor productivity An increase in physical capital An increase in human capital An advance in technology An increase in labor productivity shifts the production function upward and increases the demand for labor. The equilibrium real wage rate, quantity of labor, and potential GDP all increase. Why the Luddites were wrong. This chapter provides you with a wonderful opportunity to explain to your students why the Luddites were wrong—and why the modern neo-Luddite movement is wrong. (You can learn more than you need to know about Luddism and the Luddites, ancient and modern, at Work through the example illustrated in Figure Explain that more capital and more productive capital that uses new technologies increases productivity, shifts the production function upward, and shifts the demand for labor curve rightward. Real GDP increases and on the average, the real wage rate rises. You might then spend a few minutes agreeing that capital accumulation and technological change decrease the demand for the labor that the new capital replaces. But it increases the demand for other types of labor—complementary labor. People must acquire more skill—some people learn to work with the new capital, some learn how to maintain it in good condition, some learn how to build it, some learn how to market and sell it, some learn to design new ways of using it, some work on thinking up new goods and services to produce with it, and so on. All of these people are more productive that they were before. New technologies that create new products have even more obvious effects on productivity. The development of the CD in the early 1980s is a good example. Suddenly thousands of people became very productive converting the heritage of recorded music into digital format, cleaning up the sound, and making and selling millions of CDs. The same type of thing is now happening with the DVD. If you want to get side-tracked into philosophical disputes about man and machines, I can’t help you in that area!

Figure 24.12(a) illustrates these effects. The labor demand curve shifts rightward. The real wage rate rises. The equilibrium quantity of labor increases.

Figure 24.12(b) shows the change in the production function. The production function shifts upward and the quantity of labor employed increases. Both changes increase potential GDP.

Population and Productivity in the United States Population and productivity in the United States have increased over time. Between 1981 and 2001, both years close to full employment: The working age population increased from 170 million to 212 million–a 25 percent increase. Labor hours increased from 159 billion to 231 billion—a 45 percent increase.

Population and productivity in the United States have increased over time. Between 1981 and 2001, both years close to full employment: The capital stock increased from $15 trillion (1996 dollars) to $25 trillion—a 67 percent increase. Technology advanced—most notably the information revolution and the widespread computerization of production processes.

The percentage increase in labor hours exceeded the percentage increase in the population because the increase in capital and technological advances increased labor productivity, which increased the real wage rate, which in turn increased the labor force participation rate.

8 THE ECONOMY AT FULL EMPLOYMENT: THE CLASSICAL MODEL CHAPTER.

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