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Parkin-Bade Chapter 29

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23 CHAPTER At Full Employment: The Classical Model After studying this chapter you will be able to Explain the purpose of the classical model Describe the ... – PowerPoint PPT presentation

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Title: Parkin-Bade Chapter 29


1
23
CHAPTER
At Full Employment The Classical Model
2
After studying this chapter you will be able to
  • Explain the purpose of the classical model
  • Describe the relationship between the quantity of
    labor employed and real GDP
  • Explain what determines the full-employment level
    of employment and real wage rate and potential
    GDP
  • Explain what determines unemployment when the
    economy is at full employment

3
After studying this chapter you will be able to
  • Explain how borrowing and lending decisions
    interact to determine the real interest rate,
    saving, and investment
  • Apply the classical model to explain changes and
    international differences in potential GDP and
    the standard of living

4
Our Economys Compass
  • What is the economys compass?
  • What are the forces that prevent the economy from
    straying too far from full employment?
  • What determines the level of unemployment at full
    employment?
  • What determines employment, the real wage rate,
    and the real interest rate when the economy is at
    full employment?

5
The Classical Model A Preview
  • To understand macroeconomic performance,
    economists distinguish between real variables and
    nominal variables.
  • Real variables measure quantities that tell us
    what is happening to economic well-beingreal
    GDP, employment and unemployment, the real wage
    rate, consumption, saving, investment, and the
    real interest rate.
  • Nominal variables measure objects that tell us
    how dollar values and the cost of living are
    changingthe price level, the inflation rate,
    nominal GDP, nominal wage rate, and the nominal
    interest rate.

6
The Classical Model A Preview
  • The separation of macroeconomic performance into
    a real part and a nominal part is the basis of
    the classical dichotomy.
  • The classical dichotomy states
  • 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.

7
Real GDP and Employment
  • To produce more real GDP, we must use more labor
    or more capital or develop technologies that are
    more productive.
  • It takes time to change the quantity of capital
    and develop new technologies, so to change real
    GDP quickly, we must change the quantity of
    labor.
  • What is the relationship between the quantity of
    labor employed and real GDP?

8
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.
  • To study the relationship between the quantity of
    labor employed and real GDP, we begin with a
    special PPF one that shows the boundary between
    leisure and real GDP.

9
Real GDP and Employment
  • Figure 23.1(a) illustrates a PPF between leisure
    and real GDP.
  • Time can be allocated to leisure or to labor,
    which produces real GDP.
  • The more leisure time forgone, the greater is the
    quantity of labor employed and the greater is the
    real GDP.

10
Real GDP and Employment
  • When 250 billion hours of leisure are taken and
    200 billion hours allocated to labor, real GDP
    produced is 12 trillion.
  • The opportunity cost of each extra unit of real
    GDP costs an increasing amount of leisure
    forgone.
  • The PPF is bowed outward.

11
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.

12
Real GDP and Employment
  • Figure 23.1(b) illustrates the production
    function that corresponds to the PPF in Figure
    23.1(a).
  • Along the production function, an increase in
    labor hours brings an increase in real GDP.

13
The Labor Market and Potential GDP
  • The labor market is the market in which
    households supply labor services and firms demand
    labor services.
  • The labor market determines the labor hours
    employed.
  • The quantity of labor employed and the production
    function determine the quantity of real GDP
    supplied.
  • The Demand for Labor
  • The quantity of labor demanded is the labor hours
    hired by all firms in the economy.

14
The Labor Market and Potential GDP
  • The quantity of labor demanded depends on
  • 1. The real wage rate
  • 2. The marginal product of labor
  • Demand for Labor 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.

15
The Labor Market and Potential GDP
Figure 23.2 shows that the lower the real wage
rate, the greater is the quantity of labor
demanded. A rise in the real wage rate decreases
the quantity of labor demanded. A fall in the
real wage rate increases the quantity of labor
demanded.
16
The Labor Market and Potential GDP
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. Real wage (Money wage rate GDP
deflator) 100. The real wage rate, not the
money wage rate, determines the quantity of labor
demanded.
17
The Labor Market and Potential GDP
  • Marginal Product of Labor
  • 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, and the
    quantity of capital and technology remain the
    same, the marginal product of labor decreases.

18
The Labor Market and Potential GDP
  • Marginal Product Calculation
  • Marginal product of labor is the change in real
    GDP divided by the change in the quantity of
    labor employed.
  • The marginal product of labor is the slope of the
    production function.
  • Figure 23.3 shows the calculation.

19
The Labor Market and Potential GDP
  • A 100 billion hour increase in labor from 100
    billion to 200 billion hours brings a 4 trillion
    increase in real GDP.
  • The marginal product of labor is 40 an hour.
  • At 150 billion (between 100 billion and 200
    billion), marginal product is 40 at point A.

20
The Labor Market and Potential GDP
  • A 100 billion hour increase in labor from 200
    billion to 300 billion hours brings a 3 trillion
    increase in real GDP
  • The marginal product of labor is 30 an hour.
  • At 250 billion (between 200 billion and 300
    billion), marginal product is 30.
  • The marginal product of labor curve is downward
    sloping.

21
The Labor Market and Potential GDP
  • Diminishing Marginal Product and the Demand for
    Labor
  • 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.

22
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 quantity of labor supplied depends on
  • 1. The real wage rate
  • 2. The working-age population
  • 3. The value of other activities

23
The Labor Market and Potential GDP
  • The Supply of Labor Curve
  • The supply of labor is the relationship between
    the quantity of labor supplied and the real wage
    rate when all other influences on the quantity of
    labor supplied remain the same.

24
The Labor Market and Potential GDP
  • Figure 23.4 shows the higher the real wage rate,
    the greater is the quantity of labor supplied.
  • A fall in the real wage rate decreases the
    quantity of labor supplied.
  • A rise in the real wage rate increases the
    quantity of labor supplied.

25
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

26
The Labor Market and Potential GDP
  • Hours per Person
  • The real wage rate is the opportunity cost of not
    working, so as the real wage rate rises, more
    people choose to work.
  • But a higher real wage rate increases 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.

27
The Labor Market and Potential GDP
  • Labor Force Participation
  • Higher real wage rate induces some people who
    choose not to work at lower real wage rates to
    enter the labor force.
  • The response to a rise in the real wage rate is
    positive but small.
  • As the real wage rate rises, a given 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.

28
The Labor Market and Potential GDP
  • Labor Market Equilibrium
  • The labor market is in equilibrium at the real
    wage rate at which the quantity of labor demanded
    equals the quantity of labor supplied.

29
The Labor Market and Potential GDP
  • Figure 23.5 illustrates labor market equilibrium.
  • Labor market equilibrium occurs at a real wage
    rate of 35 an hour and 200 billion hours
    employed.
  • At a real wage rate above 35 an hour, there is
    a surplus of labor and the real wage rate falls.

30
The Labor Market and Potential GDP
  • At a real wage rate below 35 an hour, there is a
    shortage of labor and the real wage rate rises.
  • At the labor market equilibrium, the economy is
    at full employment.

31
The Labor Market and Potential GDP
  • Potential GDP
  • The quantity of real GDP produced when the
    economy is at full employment is potential GDP.
  • When the full-employment quantity of labor is 200
    billion hours, potential GDP is 12 trillion.

32
The Labor Market and Potential GDP
  • Potential GDP Not Physical Limit
  • Potential GDP is not the largest real GDP that
    the economy cab produce.
  • Potential GDP is the real GDP produced when the
    economy is at full employment.
  • The PPF shows the limits to production and the
    economy cannot produce more real GDP and take
    more leisure than the PPF permits.
  • Potential GDP is one point on the PPF.

33
The Labor Market and Potential GDP
  • Potential GDP is Production Efficient
  • Production efficiency occurs at all points on the
    PPF.
  • Production is inefficient at all points inside
    the PPF because resource are unused or
    misallocated.
  • Potential GDP occurs on the PPF, so production is
    efficient.

34
The Labor Market and Potential GDP
  • Allocative Efficiency at Potential GDP
  • Allocative efficiency occurs at the one point on
    the PPF where we cannot produce more of any good
    without producing less of some other good that we
    value more highly.
  • At the equilibrium real wage rate (full
    employment), the quantity of labor demanded by
    equals the quantity of labor supplied and the
    marginal benefit from leisure equals the marginal
    cost of leisure, so resources are allocated
    efficiently.

35
Unemployment at Full Employment
  • When the economy is at full employment,
    unemployment is always present for two broad
    reasons
  • Job search
  • Job rationing
  • Job Search
  • Job search is the activity of looking for a
    suitable vacant job.
  • The amount of job search depends on a number of
    factors, one of which is the real wage rate.

36
Unemployment at Full Employment
  • At 35 an hour, the job search that takes place
    generates the natural unemployment rate.
  • If the real wage rate exceeds 35 an hour, job
    search increases and unemployment exceeds the
    natural rate.
  • If the real wage rate is below 35 an hour, job
    search decreases and unemployment is below the
    natural rate.

37
Unemployment at Full Employment
  • The amount of job search unemployment changes
    over time and the main sources are
  • Demographic change
  • Structural change
  • Unemployment compensation

38
Unemployment at Full Employment
  • Demographic Change
  • As baby boom joined the labor force in the
    1970s and searched for jobs, the natural
    unemployment rate increased.
  • As the birth rate declined, the bulge moved into
    higher age groups, entry declined and the natural
    unemployment rate decreased in the 1980s.

39
Unemployment at Full Employment
  • Structural Change
  • Sometimes technological change brings a
    structural slump, which increases unemployment,
    increases job search, and increases the natural
    unemployment rate.
  • Unemployment Compensation
  • Because unemployment compensation lowers the
    opportunity cost of unemployment, it lowers the
    cost of job search.
  • With a more generous unemployment compensation,
    unemployed workers will job search longer.

40
Unemployment at Full Employment
  • Job Rationing
  • Job rationing is the practice of paying a real
    wage rate that exceeds the equilibrium level and
    then rationing jobs by some method.
  • Two reasons why the real wage rate might be set
    above the equilibrium level are
  • Efficiency wage
  • Minimum wage

41
Unemployment at Full Employment
  • An efficiency wage is a real wage rate that is
    set above the equilibrium real wage rate that
    balances the costs and benefits of this higher
    wage rate to maximize the firms profit.
  • A minimum wage is the lowest wage rate at which a
    firm may legally hire labor.
  • Most economists agree that efficiency wages and
    minimum wages increase the natural unemployment
    rate.

42
Loanable Funds and the Real Interest Rate
  • Potential GDP depends on the quantities of
    factors of production, one of which is capital.
  • The capital stock is total quantity of plant,
    equipment, buildings, and business inventories.
  • The capital stock is determined by investment.
  • The funds that finance investment are obtained in
    the loanable funds market.

43
Loanable Funds and the Real Interest Rate
  • The Market for Loanable Funds
  • The market for loanable funds is the market in
    which households, firms, governments, and
    financial institutions borrow and lend.
  • Demand for Loanable Funds
  • The quantity of loanable funds demanded depends
    on
  • The real interest rate
  • The expected profit rate
  • Government and international factors

44
Loanable Funds and the Real Interest Rate
  • The Demand for Loanable Funds Curve
  • The demand for loanable funds is the relationship
    between the quantity of loanable funds demanded
    and the real interest rate when all other
    influences on borrowing plans remain the same.
  • Business investment is the main item that makes
    up the demand for loanable funds.

45
Loanable Funds and the Real Interest Rate
Figure 23.8 shows the demand for loanable funds
curve. A fall in the real interest rate increases
the quantity of loanable funds demanded. A rise
in the real wage rate decreases the quantity of
loanable funds demanded.
46
Loanable Funds and the Real Interest Rate
  • The Real Interest rate and the Opportunity Cost
    of Loanable Funds
  • The real interest rate is the quantity of goods
    and services that a unit of capital earns.
  • The nominal interest rate is the number of
    dollars that a unit of capital earns.
  • The real interest rate is approximately equal to
    the nominal interest rate minus the inflation
    rate.
  • The real interest rate is the opportunity cost of
    loanable funds.

47
Loanable Funds and the Real Interest Rate
  • Supply of Loanable Funds
  • The quantity of loanable funds supplied depends
    on
  • The real interest rate
  • Disposable income
  • Wealth
  • Expected future income
  • Government international factors

48
Loanable Funds and the Real Interest Rate
  • The Supply of Loanable Funds Curve
  • The supply of loanable funds is the relationship
    between the quantity of loanable funds supplied
    and the real interest rate when all other
    influences on lending plans remain the same.
  • Saving is the main item that makes up the supply
    of loanable funds.

49
Loanable Funds and the Real Interest Rate
Figure 23.9 shows the supply of loanable funds
curve. A fall in the real interest rate decreases
the quantity of loanable funds supplied. A rise
in the real wage rate increases the quantity of
loanable funds supplied.
50
Loanable Funds and the Real Interest Rate
  • Equilibrium in the Loanable Funds Market
  • The loanable funds market is in equilibrium at
    the real interest rate at which the quantity of
    loanable funds demanded equals the quantity of
    loanable funds supplied.

51
Loanable Funds and the Real Interest Rate
  • Figure 23.10 illustrates the loanable funds
    market.
  • At 8 percent a year, there is a surplus of funds
    and the real interest rate falls.
  • At 4 percent a year, there is a shortage of funds
    and the real interest rate rises.
  • Equilibrium occurs at a real interest rate of 6
    percent a year.

52
Using the Classical Model
  • The U.S. Economy Through the Eye of the Classical
    Model
  • The U.S. economy was close to full employment in
    2005.
  • It was also close to full employment in 1986.
  • The figures on the next slide illustrate the
    forces that moved the economy from one
    full-employment equilibrium to another.

53
Using the Classical Model
  • Figure 23.11(a) illustrates the labor market.
  • Advances in technology and investment increased
    labor productivity and increased the demand for
    labor.
  • The population expanded and increased the supply
    of labor.
  • The real wage rate rose and equilibrium
    employment increased.

54
Using the Classical Model
  • Figure 23.11(b) illustrates the effects on
    potential GDP.
  • The increase in labor productivity shifted the
    production function upwards and
  • the increase in equilibrium employment increased
    potential GDP.

55
THE END
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