THE ECONOMY AT FULL EMPLOYMENT: THE CLASSICAL MODEL

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THE ECONOMY AT FULL EMPLOYMENT THE CLASSICAL
MODEL
CHAPTER
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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

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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

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Our Economys 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 courseits
  full employment trendbut like the explorer, has
  a compass that keeps bringing it back.
• The classical model is the compass and youll
  learn about it in this chapter.

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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.

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The Classical Model A Preview

• 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 dont need to
  look at the price levels in the two countries.

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The Classical Model A Preview

• The classical model is a model of the economy
  that determines the real variablesreal GDP,
  employment and unemployment, the real wage rate,
  consumption, saving, investment, and the real
  interest rateat 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.

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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.

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Real GDP and Employment

• 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.

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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.

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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.

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Real GDP and Employment

• 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.

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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

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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.

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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 24.2 shows a demand for labor
curve.
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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.

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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.

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The Labor Market and Potential GDP

• 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.

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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 GDPthe marginal product of labor is 40
  an hour.

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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 GDPthe marginal product of labor is 30
  an hour.
• The marginal product of labor is the slope of the
  production function.

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The Labor Market and Potential GDP
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.
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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.

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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.

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The Labor Market and Potential GDP

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

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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

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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.

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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.

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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.

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The Labor Market and 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.

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The Labor Market and Potential GDP

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

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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

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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.

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Unemployment at Full Employment

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

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Unemployment at Full Employment
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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

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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.

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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.

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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.

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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

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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 firms 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.

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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.

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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.

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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
  effectsan 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 wagean
  example of ceteris paribus not holding.

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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.

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Investment, Saving, and the Interest Rate

• Investment Decisions
• Business investment decisions are influenced by
• The expected profit rate
• The real interest rate

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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.

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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.
• Either it pays the interest or it forgoes
  interest on its own funds.

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Investment, Saving, and the Interest Rate
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Investment, Saving, and the Interest Rate
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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 24.7 illustrates an investment demand
  curve.

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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.

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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 is personal disposable income
  minus consumption expenditure.
• Business saving is retained profits and additions
  to pension funds by businesses.
• Government saving is the governments 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.

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Investment, Saving, and the Interest Rate

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

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Investment, Saving, and the Interest Rate

• Real Interest Rate
• The higher the real interest rate, the greater is
  a households opportunity cost of consumption and
  so the larger is the amount of saving.
• Disposable Income
• The higher the disposable income, the greater is
  a households saving.

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Investment, Saving, and the Interest Rate

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

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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 24.8 shows a saving supply curve, which
  slopes upward.

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Investment, Saving, and the Interest Rate

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

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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 24.9, ID is the investment demand
  curve.
• SS is the supply of saving curve.

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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.
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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.

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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

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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.

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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.

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The Dynamic Classical Model

• Figure 24.10 illustrates in increase in labor
  productivity. The production function shifts
  upward from PF0 to PF1.

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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

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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.

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The Dynamic Classical Model

• Figure 24.11(a) illustrates these effects in the
  labor market.

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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.

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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.

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The Dynamic Classical Model

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

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The Dynamic Classical Model

• 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.

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The Dynamic Classical Model

• 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 milliona 25 percent increase.
• Labor hours increased from 159 billion to 231
  billiona 45 percent increase.

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The Dynamic Classical Model

• 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 trilliona 67 percent
  increase.
• Technology advancedmost notably the information
  revolution and the widespread computerization of
  production processes.

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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.