8

THE ECONOMY AT
FULL EMPLOYMENT: CHAPTER

THE CLASSICAL MODEL

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 Classical Model: A Preview

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.
Real GDP and Employment

Figure 8.1(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.
Real GDP and Employment

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.
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.
Real GDP and Employment

Figure 8.1(b) illustrates the

production function that
corresponds to the PPF
shown in Figure 8.1(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 Labor Market and 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.
The Labor Market and Potential GDP

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 8.2 shows a
demand for labor curve.
The Labor Market and Potential GDP

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.
The Labor Market and Potential GDP

We calculate the marginal

product of labor as the
change in real GDP
divided by the change in
the quantity of labor
employed.
The Labor Market and Potential GDP

Figure 8.3 shows the

calculation of the marginal
product of labor and
illustrates the relationship
between the marginal
product curve and the
production function.
The Labor Market and Potential GDP

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.
The Labor Market and Potential GDP

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.
The Labor Market and Potential GDP

Figure 8.3(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 Labor Market and Potential GDP

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

Figure 8.4 illustrates a

labor supply curve.
The higher the real wage
rate, the greater is the
quantity of labor supplied.
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 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.
The Labor Market and Potential GDP

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 and Potential GDP

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.
The Labor Market and Potential GDP

Figure 8.5(a) illustrates

labor market equilibrium.
Labor market equilibrium
occurs at a real wage rate
of $35 and an employment
of 200 billion labor hours.
The Labor Market and Potential GDP

Potential GDP
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
Unemployment at Full Employment

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.
Unemployment at Full Employment

Figure 8.6 illustrates the

relationship between the
amount of job search
unemployment and the
real wage rate.
Unemployment at Full Employment

The amount of job search unemployment changes over

time and the main sources of these changes are
 Demographic change
 Unemployment compensation
 Structural change
Unemployment at Full Employment

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 at Full Employment

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.
Unemployment at Full Employment

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

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
Unemployment at Full Employment

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.
Unemployment at Full Employment

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.
Unemployment at Full Employment

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.
Unemployment at Full Employment

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

YD=Y +INT +NFP +TR –T
YD =C+S ……… BANK , FI…….INVESTMENT
S……. I ( interest rate )OC OF 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.
Investment, Saving, and the Interest Rate

Investment Decisions
Business investment decisions are influenced by
 The expected profit rate increase ……. Investment inc
 The real interest rate increase ……….. Investment dec
Investment, Saving, and 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.
Investment, Saving, and the Interest Rate

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, Saving, and the Interest Rate

Investment Demand
Investment demand is
the relationship between
the level of planned
investment and the real
interest rate.
Figure 8.7 illustrates an
investment demand curve.
Investment, Saving, and the Interest Rate

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, Saving, and the Interest Rate

Saving
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.
Investment, Saving, and the Interest Rate

Personal saving is personal disposable income minus

consumption expenditure. Yd – c = s
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.
Investment, Saving, and the Interest Rate

Saving is influenced by
 The real interest rate direct
 Disposable income direct
 Wealth inverse
 Expected future income inverse
Investment, Saving, and the Interest Rate

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.
Investment, Saving, and the Interest Rate

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.
Investment, Saving, and the Interest Rate

Saving Supply
Saving supply is the
relationship between
saving and the real interest
rate, other things
remaining the same.
Figure 8.8 shows a saving
supply curve, which slopes
upward.
Investment, Saving, and the Interest Rate

A fall in the real interest

rate decreases saving.
A rise in the real interest
rate increases saving.
Investment, Saving, and the Interest Rate

Determining the Real

Interest Rate
The real interest rate is
determined by investment
demand and supply of
savings.
In Figure 8.9, ID is the
investment demand curve.
SS is the supply of saving
curve.
Investment, Saving, and the Interest Rate

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.
Investment, Saving, and the Interest Rate

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
The Dynamic Classical Model

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.
The Dynamic Classical Model

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.
The Dynamic Classical Model

Figure 8.10 illustrates in

increase in labor
productivity. The
production function shifts
upward from PF0 to PF1.
The Dynamic Classical Model

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
The Dynamic Classical Model

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.
The Dynamic Classical Model

Figure 8.11(a) illustrates

these effects in the labor
market.
The Dynamic Classical Model

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 $43.33--$13 trillion
divided by 300 billion.
The Dynamic Classical Model

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.
The Dynamic Classical Model

Figure 8.12(a) illustrates

these effects.
The labor demand curve
shifts rightward.
The real wage rate rises.
The equilibrium quantity of
labor increases.
The Dynamic Classical Model

Figure 8.12(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.
The Dynamic Classical Model

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.
THE END