CH.%208:%20THE%20ECONOMY%20AT%20FULL%20EMPLOYMENT:%20THE%20CLASSICAL%20MODEL

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CH. 8 THE ECONOMY AT FULL EMPLOYMENT THE
CLASSICAL MODEL

• Describe the relationship between the quantity of
  labor employed and real GDP
• Explain what determines
• the demand for labor
• the supply of labor
• employment, the real wage rate,
• productivity
• potential GDP
• Saving, Investment, and Interest rates

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Objectives

• 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

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The Classical Model A Preview

• The classical dichotomy
• At full employment, the forces that determine
  real variables are independent of those that
  determine nominal variables.
• The classical model
• A model of the economy that determines the real
  variables at full employment.

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Real GDP and Employment

• The PPF illustrates
• Increasing marginal opportunity cost
• Efficient versus inefficient
• Unattainable
• An outward shift is economic growth
• more resources
• improved technology

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Production Function

• The Production Function
• the relationship between real GDP and the
  quantity of labor employed, other things
  remaining the same.

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Production Function

• Marginal product of labor
• Average product of labor (productivity)
• Diminishing returns to labor
• Upward shift of production function
• human capital
• capital
• technology

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Production Function

• Holding production function constant, if
  employment increases, what is the effect on
  marginal product, average product?
• If there is a technological advance shifting
  production function upwards, what is the effect
  on marginal product, average product?

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The Labor Market

• Potential GDP is the level of GDP produced if the
  economy is at full employment.
• Determinants of potential GDP
• The demand for labor
• The supply of labor
• The production function
• capital (human and physical)
• technology

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The Labor Market

• The Demand for Labor
• marginal product of labor
• additional real GDP produced by an additional
  hour of labor, ceteris paribus.
• law of diminishing returns,
• as the quantity of labor increases, the marginal
  product of labor decreases, holding capital and
  technology constant.

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The Labor Market
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The Labor Market

• The marginal product of labor is the slope of the
  production function.
• What does LDMR imply about production function?

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The Labor Market
Because of the law of diminishing marginal
returns, the MP of labor curve is downward
sloping.
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The Labor Market

• A profit maximizing firm will hire additional
  labor until real wage MP
• MP curve is labor demand curve
• Demand vs. Quantity demanded

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The Labor Market

• Factors shifting labor demand
• human capital
• physical capital
• payroll taxes on employers

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The Labor Market

• The Supply of Labor
• quantity of labor supplied
• the number of labor hours that all the households
  in the economy plan to work at a given real wage
  rate.
• supply of labor
• relationship between the quantity of labor
  supplied and the real wage rate, all other things
  remaining the same.

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The Labor Market

• The higher the real wage rate, the greater is the
  quantity of labor supplied.

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The Labor Market

• The quantity of labor supplied increases as the
  real wage rate increases for two reasons
• Hours per person increase
• While income and substitution effects work in
  opposite directions, net effect is generally
  positive in aggregate.
• Labor force participation increases
• Empirical evidence is that the labor supply
  curve is fairly steep.

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The Labor Market

• Factors shifting labor supply
• population
• immigration
• taxes on wages received by employees
• generosity of income support programs
• home technology

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The Labor Market

• Equilibrium
• If wageltequil
• Shortage
• Wage rises
• If wagegtequil
• Surplus
• Wage falls

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The Labor Market

• When the labor market is in equilibrium,
• the economy is at full employment
• natural rate of unemployment.
• frictional and structural, but no cyclical
  unemployment
• no upward or downward pressure on real wages.
• GDP potential GDP

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The Labor Market

• If wage rate gt equilibrium
• economy is below full employment
• unemployment gt natural rate
• downward pressure on real wages.
• If wage rate lt equilibrium
• Economy is beyond full employment (over-heated)
• unemployment lt natural rate
• upward pressure on real wages

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The combination of the labor market equilibrium
and the production function determine the
potential level of GDP.
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The determinants of potential GDP

• How do each of the following affect wages,
  employment, productivity, real GDP?
• An increase in labor supply
• An increase in labor demand
• An upward shift in the production function

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Increase in labor supply
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Increase in labor demand
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Upward shift in production function
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Investment, Saving, and the Interest Rate

• Capital stock
• total amount of plant, equipment, buildings, and
  inventories, physical capital.
• Gross investment
• purchase of new capital.
• Depreciation
• wearing out of the capital stock.
• Net investment
• Gross Investment depreciation.

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Investment, Saving, and the Interest Rate

• Business investment decisions are influenced by
• The expected profit rate (internal rate of
  return)
• The real interest rate nominal interest rate
  inflation rate

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Investment, Saving, and the Interest Rate

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

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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.

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Investment, Saving, and the Interest Rate

• Investment Demand
• the relationship between the level of planned
  investment and the real interest rate.

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Investment, Saving, and the Interest Rate

• Factors shifting Investment Demand
• technological innovation
• taxes on investment income
• expected future profitability of investments

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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.

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Investment, Saving, and the Interest Rate

• Personal saving
• personal disposable income minus consumption
  expenditure.
• Business saving
• retained profits and additions to pension funds
  by businesses.
• Government saving
• governments budget surplus.
• National saving
• sum of private saving and government saving.
• Any of these components can be negative.

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Investment, Saving, and the Interest Rate

• Why do people save?
• Permanent income hypothesis.
• Permanent income average income received per
  year over life-time
• If a person wants to consumption smooth, can
  spend permanent income each year for entire life.
• If current income gt permanent income ? save
• If current income lt permanent income ? dissave
• Young versus old?
• Temporary decline in income?
• Volatility of saving versus consumption?

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Investment, Saving, and the Interest Rate

• Saving Supply
• relationship between saving and the real interest
  rate, other things remaining the same.
• As the real interest rate rises, the level of
  saving increases.
• Substitution effect save more
• Wealth effect
• Borrowers save more
• Savers save less
• Cancels out across borrowers and lenders.

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Investment, Saving, and the Interest Rate

• Factors shifting savings curve
• Disposable income
• Wealth
• Expected future income
• Tax incentives
• Social Security
• Government budget deficit
• Foreign savings

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Investment, Saving, and the Interest Rate
Equilibrium Interest Rate
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Investment, Saving, and the Interest Rate

• Effect of each of the following on saving,
  investment and interest rates
• News that income will fall next year.
• Technological advance that creates new
  profitable investment projects.
• Tax cuts on corporate profits.
• Personal income tax
• permanent versus temporary tax cut.

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Why is investment more volatile than consumption?
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Why is durable spending more volatile than
nondurable spending?