1. Business, Government, and the World Economy Output and Employment

2. Outline of Topics Markets work (move to “equilibrium”) Long run equilibrium vs. short run adjustment What factors measure long run economic performance? Output Employment Prices

3. The Ultimate Goal: Sustainable Economic Growth Long-term consistent increases in output (GDP) is usually considered the most basic benchmark of economic health. Semester goal: Establish how /why economic growth occurs

4. Production Function The amount of output that an economy can produce is believed to be a function of the amount of capital used in a given period of time (K), the number of workers employed (N), and a productivity measure (A) or Y = Af(K,N) Where f( ) is a mathematical function relating capital and labor to output.

5. An Example: The Production Function Cobb Douglas Production Function Y=AK a N (1-a) Where: 0<a<1 a = the share of income received by owners of capital 1-a = the share received by labor a =.3, 1-a =.7 A = total factor productivity

6. Economic Growth Long run growth in output can occur in multiple ways: Increase in amount of labor Increase in amount of capital Shifts in allocation of income (a) Increase in “A” total factor productivity

7. Constraints on Growth Labor and capital exhibit diminishing marginal returns to scale Each additional unit has a smaller impact on output than the previous one Therefore consistent long-run economic growth depends upon increasing productivity.

8. Graphing the production function Often it is helpful to look at the production function based on changes in one variable, keeping the other inputs constant.

9. Production Function

10. Marginal Product of Capital Marginal Product of Capital (MPK) The additional increase in output resulting from a one unit increase in capital. From the graph each additional unit of capital results in a small increase in output.

11. Diminishing MPK 567 391 307

12. Diminishing MPK 567 391 307

13. Approximating MPK 567 391 307

14. MPK Marginal Product of Capital is positive Marginal Product of Capital declines as capital stock increases.

15. Labor The impact of increasing labor input is similar to the impact of increasing capital We can graph the production function based upon keeping the capital stock constant and changing labor (next slide)

16. Production Function (Changing Labor)

17. Supply Shock Supply shocks (like the oil price shock we had before) cause the amount of output produced at a given level of output and labor to increase or decrease. This also impacts the MPK and MPN

18. Adverse Supply (productivity) Shock

19. Productivity Shocks Changes in productivity also impact the marginal productivity of capital and labor Gains in productivity can offset the declining marginal productivity of labor or capital.

20. US Total Factor Productivity

21. Shigehara 1992 The growth record US Total output grew at a 2.54% average rate from 1929 – 48 and a 3.7% rate from 1948 – 1973 However from 1973 – 2001 it grew at an average of 1.9% Why??? A similar decline occurred in other developed economies. One report shows a productivity growth rate of 0.0% from 1973 – 1990.

22. Quantity of Capital and Labor Before investigating productivity in more detail – need to understand how the amount of labor and capital are determined. The labor market The goods market (consumption and investment)

23. Demand for Labor The amount of labor firms want to hire Basic Assumptions Workers are identical Firms view wages as being set by a competitive labor market Firms will demand the amount of labor that maximizes profit (where MPN = real wage) Marginal Cost = wage, benefit = marginal productivity of worker – Or in nominal terms the marginal revenue product of labor)

24. Labor Demand Curve The labor demand curve will have an inverse relationship with the real wage (which equals the MPN)

25. Labor Demand Curve Labor Real Wage

26. Factors that Shift ND An increase inShifts ND to theWhy ProductivityRightMPN increases with positive supply shock Capital StockRightHigher capital stock increases MPN

27. Labor Supply The labor supply curve will have a direct relationship with the current real wage. The economic benefit of working is the real wage. Labor Real Wage

28. Shifts in the NS Curve An increase inNS will shiftWhy WealthLeftCan afford more leisure Expected Future Real Wage LeftCan afford more leisure Working Age Population RightIncrease in Labor Supply Participation RateRightIncrease labor supply

29. Labor Market Equilibrium Labor Real Wage NS ND N

30. Temp Adverse Supply Shock Labor Real Wage NS ND

31. Unemployment The equilibrium level of labor represents the full employment level of labor (which is not zero). Putting the full employment level of labor into the production function provides the level of output at a given level of capital and total factor productivity.

32. Unemployment : NS>ND Labor Real Wage NS ND NS Unemployment

33. Fast Adjustment of Real Wages If unemployment exists, the firm has the ability to offer a lower real wage. This should move the amount of labor demanded to the amount of labor supplied (move the economy toward the full employment level of labor)

34. Measuring Unemployment Household Survey vs. Establishment Survey (indicators next time) Distinguish between unemployed (actively looking for work) and not in the labor force (not looking for work and not employed)

35. Full Employment Output The full employment level of output is then the output produced at the full employment level of N given as – given the current capital stock K and current level of productivity. Note – This is the theoretical level of employment – it does not depend upon the real interest rate level

36. Okun’s Law First stated by Arthur Okun (chairman of Council of Economic Advisors in Johnson Administration) Compares the level of full employment output to current output based on amount of unemployment above the full employment level Should not be considered a “law” more of a general rule…

37. Okun’s Law

38. Okun’s Law restated If the change in real GDP is 3.5% then the change in unemployment is zero In other words 3.5% is a long run sustainable growth rate for the economy. If percentage change in real GDP is zero, Unemployment increases by 1.4%

39. Okun’s Law 1949 - 2008

40. Graphical Representation

41. Policy Questions What if there was a large negative productivity shock that left the economy at below the full employment level of output? (high unemployment) Could unemployment be decreased by undertaking expansionary fiscal policy (increasing government spending)? What are the possible negative outcomes?

42. Theory Questions Why could unemployment persist? (why would wages not drop to bring the labor market to equilibrium? Sticky Nominal Wages and Prices (menu costs) Sticky Real Wages and Prices Sticky Real Wages (insider/outsider models) Sticky Real Wages (government restrictions) Wedges between private and social costs Barriers to firing and unemployment benefits

43. Sticky Nominal Wages and Prices Menu Costs There is a cost associated with changing prices, this keeps nominal prices fixed in the short term. Examples include remarking merchandise, updating web sites, etc More important if markets are not perfect (in perfect competition having the “wrong” has large consequences)

44. Not all products meet the requirements of perfect competition (especially standardization of goods and large number of sellers) “Kinked” demand curves With a small number of competitors, the firms will not change price unless the industry price has changed. Institutional constraints Sticky Nominal Wages and Prices Monopolistic / Oligopolistic Competition

45. Real Wage Rigidity Efficiency Wages Classical Argument – Most unemployment results from short term mismatches between workers and jobs (not all workers are identical) Keynesian Argument - Mismatches are only part of the problems. Unemployment can persist because wages are slow to adjust to a level that would clear the labor market.

46. Unemployment Reasons why Unemployment might persist Legal barriers to decreasing wage Minimum Wages Union Contacts Reduction of Turnover costs Training is expensive Paying a higher wage may increase worker productivity – Efficiency Wage model

47. Efficiency Wage Model Shirking Model If worker is paid only minimum needed, there will not be much concern about being fired (especially if there are many other similar jobs) Employee is more likely to “shirk” responsibilities and be less productive The effort a employee puts forth depends upon the real wage received.

48. S shaped Effort Curve As real wage increases (especially if it increases above the minimum the firm would need to pay, productivity of the worker increases. Staring from a real wage of 0 effort is very low then starts to increase for each increase in real wage At some point there is diminishing effort for each increase in real wage.

49. Effort Curve Effort Real Wage

50. The firm will want to maximize the amount of effort per unit of real wage paid or E/w, In other words maximize the effort per dollar of real wage or the efficiency of the worker The slope of a straight line from the origin will be equal to E/w Assume that the market clearing level of real wage is w A in the next graph However w* is the level that Maximizes E/w

51. Effort Curve Effort Real Wage W*WAWA EAEA E*E* Effort Curve

52. Real Wage Rigidity In the efficiency wage model, the real wage is dependent upon the effort curve, not the levels of labor supply and demand. It is possible for unemployment to persist at the efficiency wage.

53. Unemployment : NS>ND Labor Real Wage NS ND NS Unemployment W*

54. Insider Outsider Relationships Union negotiations pose restrictions on wage rates. They protect those who are a members of the organization (insiders) If wages increase faster than productivity, it is possible for the constraint to force firms to look for other sources of employment.

55. Barriers to market clearing wages An increase in the minimum wage will have little impact if the wage is currently below the market clearing wage, if it increases above equilibrium it can reduce employment. Empirical evidence suggests that there is little evidence between the ration of minimum wages to average wages and inflation.

56. Wedges: Private and Social Costs Taxes, social security etc create a wedge between what the employer pays and what the worker receives (the cost to the employer is much higher than the nominal benefit to the worker) The difference has a larger consequence if the worker does not recognize the benefit received (future pension, healthcare etc) A high level of these cots can create a disincentive to work.

57. Extensions of Sticky Wages and Prices When responding to changes in demand firms react to changes in demand by changing the amount of production, not changing prices If this is the case firms will increase production if demand at a fixed price is higher than expected (This implies that the economy can produce above full employment in the short run)

58. Extensions of Sticky Prices Effective Labor Demand If the firm is willing to meet demand at a given price, you need to look at the effective labor demand curve. Labor demand looks at the quantity of labor needed to produce a level of output at a given productivity level and capital stock.

59. Effective Labor Demand Output Labor N

60. Full Employment Output Revisited The full employment level of output is then the output produced at the full employment level of N given as – given the current capital stock K and current level of productivity. Note – This is the theoretical level of employment – it does not depend upon the real interest rate level

61. The FE line We want to build a model based upon equilibrium in the labor, goods and asset market. Each market will be represented by a line representing equilibrium in the respective market on a graph with output (X axis) and real interest rates (Y Axis).

62. The FE line The FE line is then a vertical line at the real level of output Real Interest Rate, r Output, Y FE Line Y

63. Shifts in the FE line Factors that shift the inputs in the production function will impact the FE line (assuming fast adjustment) FE ShiftsWhy? Beneficial Supply Shock (Productivity  ) RightIf MPN  labor demand   output for same inputs Increase in N s Right  equil employment  Capital StockRight  Output with same labor and productivity

64. The FE Line: Increase in Capital Stock Real Interest Rate, r Output, Y FE 0 Y FE 1

65. FE line with efficiency wages If efficiency wages are correct, the level of output corresponds to the amount of labor demanded at the efficiency wage (There could be large amounts of unemployment for a long period of time) Anything that shifts Labor Supply – will not impact FE because the Efficiency wage is slow to adjust. (productivity etc that move Labor demand still shifts FE)

66. Indicators of Labor Markets Weekly Unemployment Claims Continuing Unemployment Claims Unemployment Rate Household Survey (60,000 Homes) Establishment Survey (400,000 companies and agencies) Help Wanted Advertising Index (conference board) ADP Employment Report (400,00 businesses)