Ch. 7. At Full Employment: The Classical Model

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Ch. 7. At Full Employment The Classical Model

• The relationship between the quantity of labor
  employed and real GDP
• Determinants of potential GDP, employment, and
  real wage rate
• Determinants of the natural rate of unemployment
• How borrowing and lending decisions determine the
  real interest rate, saving, and investment
• Use classical model to explain changes and
  international differences in potential GDP and
  the standard of living

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The Classical Model A Preview

• Real versus Nominal Variables
• Real variables
• measure quantities independent of prices Reflect
  a base year set of prices.
• e.g. Real GDP, employment and unemployment, real
  wage rate, consumption, saving, investment, and
  the real interest rate.
• Nominal variables
• Measures reflecting current prices
• Nominal GDP, nominal wage rate, and the nominal
  interest rate.
• The classical dichotomy
• At full employment, the forces that determine
  real variables are independent of those that
  determine nominal variables.
• The classical model is a model of an economy that
  determines the real variables.

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Parts of the classical model

• Production Function
• Labor market
• Labor demand
• Labor supply
• Loan market
• Supply of loanable funds
• Demand for loanable funds

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Production Function

• Shows relationship between labor and real GDP
• Slope of line to origin productivity (output
  per labor hour)
• Slope of tangent marginal product of labor
• Law of diminishing marginal returns implies
• MP decreases as L increases
• PF flattens out as L increases

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Production Function

• Shifts in the production function caused by
• More capital
• More productive workers
• Better technology
• Movements along production function caused by
  changes in level of employment

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The Labor Market and Potential GDP
Real wage rate the quantity of good and services
that an hour of labor earns. Money (nominal) wage
rate number of dollars an hour of labor
earns. Real wage Money wage rate (GDP
deflator/100) The real wage rate, not the money
wage rate, determines the quantity of labor
demanded when compared to MP of labor.
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The Labor Market and Potential GDP

• Labor Demand Curve
• The demand for labor is the relationship between
  the quantity of labor demanded and the real wage
  rate when all other influences on hiring plans
  remain the same.
• Marginal product of labor curve is same as labor
  demand curve
• Firms will always hire workers if MPgt real wage
• Profit maximizing firm hires until MP real wage

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The Labor Market and Potential GDP

• Labor supply curve
• shows quantity of labor supplied for each real
  wage rate.
• Quantity of labor supplied increases as the real
  wage rate increases for two reasons
• Hours per person increase (assuming IEltSE)
• Income effect (work less if real wage increases)
• Substitution effect (work more if real wage
  increases)
• Labor force participation increases

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Labor Supply Curve
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Labor Supply Curve

• Shifts in labor supply caused by
• population growth
• immigration
• taxes on wages
• home technology
• generosity of transfer programs

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Labor Market Equilibrium
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If the U.S. allowed more immigration, the new
equilibrium in the labor market would result in
_____ wages and ____ employment

1. Higher higher.
2. Higher lower
3. Lower higher
4. Lower lower

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If there were technological innovations making
labor more productive, this would lead to ____
wages and _____ employment

1. Higher higher.
2. Higher lower.
3. Lower lower.
4. Lower higher.

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A less generous welfare program would likely lead
to ____ wages and _____ employment.

1. Higher higher.
2. Higher lower.
3. Lower lower.
4. Lower higher.

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The Labor Market and Potential GDP
RW
LS
Potential GDP RGDP when economy is at full
employment
LD
Employment
RGDP
PF
Employment
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Suppose that there more immigration is allowed
into the U.S. This will cause potential GDP to
_____ and productivity to ______.

1. Rise rise.
2. Rise fall.
3. Fall rise.
4. Fall fall

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Suppose that there is new capital added to the
economy. This will cause potential GDP to _____
and real wages to ______.

1. Rise rise.
2. Rise fall.
3. Fall rise.
4. Fall fall

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Loanable Funds, Investment and the Real Interest
Rate

• Potential GDP depends on amounts of labor,
  capital, and other resources.
• Capital stock
• total quantity of plant, equipment, buildings,
  and business inventories.
• determined by investment.
• the funds that finance investment are obtained
  in the loanable funds market.

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Demand for loanable funds

• Demand for loan funds depends on
• The real interest rate (nominal) interest rate
  - inflation
• Investment demand
• expected profit rate (internal rate of return)

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Demand for loanable funds

• Changes in real interest rate cause movements
  along loan demand curve
• Shifts in loan demand
• Changes in investment demand
• government budget deficit adds to loan demand
• Foreign demand for loans can also add to loan
  demand (trade surplus)

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Supply of Loanable Funds

• Supply of Loanable Funds Curve.
• Saving is the main item that makes up the
  supply of loanable funds.
• The quantity of loanable funds supplied depends
  on
• The real interest rate (moves along the curve)
• Disposable income
• Wealth
• Expected future income
• Government budget
• Surplus increases supply of loans
• Foreign supply of loans to U.S.
• Trade surplus

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Supply of Loanable Funds
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Equilibrium in Loan Market
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Suppose that households decide to save more of
their incomes. This should lead to

1. an increase in the supply of loans and lower
   interest rates.
2. An increase in the supply of loans and higher
   interest rates.
3. A decrease in the demand for loans and lower
   interest rates.
4. An increase in the demand for loans and higher
   interest rates.

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Suppose that households decide to save more of
their incomes. This should lead to

1. Lower interest rates and more investment
2. Lower interest rates and less investment
3. Higher interest rates and more investment
4. Higher interest rates and less investment.

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Suppose that the federal government increases its
budget deficit. This should lead to

1. an increase in the supply of loans and lower
   interest rates.
2. A decrease in the supply of loans and higher
   interest rates.
3. A decrease in the demand for loans and lower
   interest rates.
4. An increase in the demand for loans and higher
   interest rates.

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Suppose that the federal government increases its
budget deficit. This should lead to

1. Lower interest rates and less investment
2. Lower interest rates and more investment
3. Higher interest rates and less investment
4. Higher interest rates more investment.