The Supply Side of the Economy

The Supply Side of the Economy Topic 2 1 Macroeconomics 309 - Lecture 2

Goals of Lecture 2 PART 1 Introduce the Supply Side of the Macro Economy. Discuss how countries grow and why some countries grow faster than others. Discuss Productivity and the New Economy PART 2 Determine How Wages are Set in the Labor Market Explain the Differential Unemployment Rates Between the U.S. and Europe. Read: Course Pack Articles 25-31 (Productivity and Growth) 2 Macroeconomics 309 - Lecture 2

Preliminaries: the Production Function It s the mapping of inputs into output. GDP (Y) is produced with capital (K, price weighted) and labor (N, hours): Y = A F(K, N) Sometimes, I will modify the production function such that: Y = A F(K, N, other inputs) where other inputs include energy/oil! Realistic Example is a Cobb-Douglas function for F(K,N): Y = A K α N 1-α = A K.3 N.7 A is Total Factor Productivity (TFP), an index of efficiency in the use of inputs (technology). 0 < α < 1 capital share. READ: Chapters 3, 6 of Text 3 Macroeconomics 309 - Lecture 2

Measurement Y is GDP (it is measured in real dollars). As noted above, we want to measure Y in real dollars.<<you should know what this means from lecture 1>>. For our Cobb-Douglas production function (previous slide), K is measured in real dollars and N in terms of hours worked. K often is measured as the replacement cost of capital N often is measured in number of workers*hours per worker However, in practice, N can be measured in different ways (number of workers, number of effective workers, production workers). Hours worked takes into account part-time and full-time. # effective workers adjustment are made by BLS. Unskilled vs.skilled workers: skill differentials. Note: When we talk about standard of livings: income per capita is Y/Pop where Y is income and Pop is a population measure sometimes we assume Pop = N, labor force). 4 Macroeconomics 309 - Lecture 2

The Aggregate Production Function To build intuition let s represent the production function graphically. Hold A and N constant. Graph Y and K: level of output that can be produced at each level of K. Y AF(K,N) Increasing capital (K) increases output (Y). However increasing K of the same quantity produces smaller and smaller increases in output. Marginal product of capital (MPK) is decreasing (curve flattens). K 5 Macroeconomics 309 - Lecture 2

Example:Why are Marginal Products of Factors Decreasing? Consider a Iron Ore Mine where the only inputs are Excavators (K) and Miners (N). Suppose 10 miners work at the mine. Start with no excavators, output is 0. They cannot dig. When we add 1 excavator output is going to be low (miners can only use 1 machine to excavate) but positive. That single excavator is likely to be used fully (everybody has to wait in line to use it and it never sits idle). Suppose now the mine acquires other 10 excavators. Output is going to be higher and now the time waiting to use the excavator is going to be zero. However 1 excavator is going sit idle (and maybe used as replacement when another one breaks down). Adding additional excavators increases output but at slower and slower rate. Fixing A and N, MPK falls when K increases 6 Macroeconomics 309 - Lecture 2

The Aggregate Production Function (cont.) Now hold A and K fixed. Graph Y and N A different slope than the previous graph (steeper because 1-α > α). Y AF(K,N) Increasing labor (N) increases output (Y). Increasing N of the same quantity produces smaller and smaller increases in output. Marginal product of labor (MPN) is decreasing (curve flattens). N 7 Macroeconomics 309 - Lecture 2

Features of the Aggregate Production Function Define MPN = Marginal Product of Labor = how much output increases when N increases = dy/dn Define MPK = Marginal Product of Capital = how much output increases when K increases = dy/dk MPN =.7 A (K/N).3 =.7 (Y/N) Fixing A and K, MPN falls when N increases (smaller and smaller increments) MPK =.3 A (N/K).7 =.3 (Y/K) Fixing A and N, MPK falls when K increases (smaller and smaller increments) Define potential output Y* as F(N*,K*) = A (N*).7 (K*).3 8 Macroeconomics 309 - Lecture 2

Marginal Product of Labor Production Function Read the values of the slopes here Y Slope at N 2 AF(K,N) MPN Slope at N 1 Slope at N 1 MPN = A*dF(K,N)/dN Slope at N 2 N 1 N 2 N N 1 N 2 N 9 Macroeconomics 309 - Lecture 2

Marginal Product of Labor: Drop in TFP (A) Production Function Read the values of the slopes here Y Slope at N 2 AF(K,N) A F(K,N) MPN New Slope at N 2 Note: Slope at N 2 New Slope at N N 2 N 2 N 2 Decreasing A or K, decreases MPN (Decreasing A or N, decreases MPK) N 10 Macroeconomics 309 - Lecture 2

Two Measures of Productivity Labor Productivity = Y/N = A (K/N).3 Driven by A and K/N Total Factor Productivity (TFP) = A = Y/F(K,N) Basically TFP is a catch-all for anything that effects output other than K and N. Workweek of labor and capital Quality of labor and capital Regulation Infrastructure Competition Specialization Innovation Strategy (Entrepreneurial methods/new management techniques) Some components of TFP tend to be pro-cyclical (Definition of Pro-cyclical: Variable increases when Y is high, decreases when Y is low) 11 Macroeconomics 309 - Lecture 2

Economic Growth Part 1 12 Macroeconomics 309 - Lecture 2

Why Economic Growth? China s economy is growing at 10% a year. Where s that coming from? What about India? Why is the US economy growing so faster than Europe (about 1.5-2%)? What does explain such differential in performance? What may help Japan regain momentum in economic growth after 20 years of stagnation? What about Africa and its dismal economic performance over the last three decades? What about disparity of performance within Latin America (Chile vs. Argentina)? 13 Macroeconomics 309 - Lecture 2

Sources of Economic Growth We want to study what s behind ΔY/Y. Start from a stylized aggregate Cobb-Douglas production function for F(K,N): Y = A K α N 1-α Suppose the only factor increasing is K. Jumps to K + ΔK. Capital growth rate is ΔK/K. How much does Y grows? Rule of thumb for the proportional growth rate of a quantity raised to a power: ΔY/Y = αδk/k (1) If all economic growth ΔY/Y was due to the capital stock growth we would have (1). 14 Macroeconomics 309 - Lecture 2

Sources of Economic Growth (cont.) Similarly consider all growth is due to an increase in labor N + ΔN Same rule would deliver: ΔY/Y = (1-α)ΔN/N (2) Now consider an increase in TFP A + ΔA Same rule would deliver: ΔY/Y = ΔA/A (3) So how much does Y grows when everything can change? Simple: add (1), (2), (3) together! ΔY/Y = αδk/k + (1-α)ΔN/N + ΔA/A Identifies the three main components that account for output growth. Growth accounting. 15 Macroeconomics 309 - Lecture 2

Growth Accounting Y = A K.3 N.7 (US production function) implies: ΔY/Y = ΔA/A +.3*ΔK/K +.7*ΔN/N Output in a country can be decomposed in: 1. Growth in TFP (entrepreneurial ability, education, roads, technology, etc.) 2. Growth in Capital (machines, equipment, plants, etc.) 3. Growth in Labor (workforce, population, labor participation, etc.). Note: For a general production function (i.e. not Cobb-Douglas) ΔY/Y = ΔA/A + a k ΔK/K + a n ΔN/N where a k = elasticity of output with respect to capital (same def. for labor). 16 Macroeconomics 309 - Lecture 2

Growth Accounting (cont.) We care about growth in Y/pop (output per capita = Y/pop = A (K/pop) α (N/pop) 1-α ) => %Δ(Y/pop) = %ΔA +.3*%Δ(K/pop) +.7*%Δ(N/pop) We care about growth in Y/N (output per worker = labor productivity). => %Δ(Y/N) = %ΔA +.3*%Δ(K/N) We can decompose labor productivity growth in TFP growth and capital deepening (change in capital per worker): %ΔY = ΔY/Y = αδk/k + (1-α)ΔN/N + ΔA/A Gives ΔY/Y- ΔN/N = ΔA/A + α(δk/k -ΔN/N) Labor productivity growth= TFP growth + α(capital per worker growth) 17 Macroeconomics 309 - Lecture 2

Example: US Growth Accounting Annual Growth Rate of Y Annual Growth Rate of Y/N Annual Growth Rate of K/N Contribution of K/N (with α = 0.3) Annual Growth Rate of A 1948-1975 4.0% 3.0% 3.0% 0.9% (=.3*3%) 1975-1995 2.7% 1.7% 2.0% 0.6% (=.3*2%) 1995-2000 4.2% 3.0% 2.7% 0.81% (=.3*2.7%) 2000-2007 Exercise: complete. 2.1% (= 3%-.9%) 1.1% (= 1.7%-.6%) 2.19% (= 3%-.81%) 18 Macroeconomics 309 - Lecture 2

Limits Growth Accounting: Just Diagnostics these accounting exercises say nothing about causality, and so are very hard to interpret. Say you found it's 50% efficiency and 50% factor endowments. What conclusion do you draw from it? You could imagine a story where the underlying cause of growth is factor accumulation, with technological upgrading or enhanced allocative efficiency as the by-product. Or you could imagine a story whereby technological change is the driver behind increased accumulation. Both are compatible with the result from accounting decomposition. Indeed, I have yet to see a sources-of-growth decomposition which answers a useful and relevant economic or policy question. Dani Rodrik (KSG, Harvard) http://rodrik.typepad.com/dani_rodriks_weblog/2008/02/what-use-is-sou.html 19 Macroeconomics 309 - Lecture 2

Was the New Economy Really New??? U.S. Labor Productivity Growth (Y/N where N is the number of workers) 1959-1972: 3.1% 1972-1985: 1.7% 1985-1995: 1.7% 1996-2000: 2.9% 2001: 1.1% (going into a recession) 2002: 4.9% (coming out of recession) Y increase! 2003: 3.6% (pretty strong rate) N constant! 2004: 3.1% 2005: 2.0% 2006: 1.9% Source: http://www.bls.gov/lpc/ 20 Macroeconomics 309 - Lecture 2

Output Per Worker: 1950-1969 Red Line: Growth in Output per Worker. Recession years are highlighted. 21 Macroeconomics 309 - Lecture 2

Output Per Worker: 1970 2008 Red Line: Growth in Output per Worker. Recession years are highlighted. 22 Macroeconomics 309 - Lecture 2

Technology Adoption 23 Macroeconomics 309 - Lecture 2

Thoughts on the New Economy Thoughts on the U.S. in the mid-late 1990s Economic growth in the late 1990s did not look that different than past decades (first industrial revolution i.e. steam engine, electricity, assembly line, telecommunications (phone lines, television), computer, personal computers, then internet INNOVATION LEADS TO GROWTH!!!!) (see readings on Robert Gordon) The Growth is Not Sustainable Forever! All cycles are just that (i.e. cyclical). What about the stock market run up in late 1990s? - good question Overly optimistic (Greenspan and others thought so.) Evidence of over-optimism? decline in stock prices in 2001-2002 (perhaps?) Upside? (People start paying attention to economic fundamentals as opposed to believing in potentially unrealistic expectations). 24 Macroeconomics 309 - Lecture 2

What Does Cause Sustained Growth? Sustained Increases in the growth of A can cause a sustained growth in Y/N. Empirically, when a country exhibits faster Y/N growth.. 33% typically comes from growth in K/N 67% typically comes from growth in A (where N = employment (not hours) - limited data). Notable exception the 4-Tiger economies (South Korea, Taiwan, Hong Kong, Singapore) all factor accumulation (capital, physical and human), no role for TFP (work by economist Alwyn Young). 25 Macroeconomics 309 - Lecture 2

The Solow Model of Growth The basics: Simplified economy N(t) = employment = population. n = population growth rate Output: Y(t) = output (at time t) Production function Y = F(K, N) I(t) = Investment C(t) = Y(t) I(t) what s not consumed is invested. Per capita variables are lower case. Y/N = y; C/N = c Define y=y/n = f(k) 26 Macroeconomics 309 - Lecture 2

The Solow Model of Growth (cont.) The Steady State in this economy is when Consumption per worker, Output per worker and the capital-labor ratio are constant. The Solow model has 1 steady state Dynamics of capital in the economy: K(t+1) = I(t) + (1 - d)k(t) d = depreciation rate In a steady state the capital-labor ratio (K/N = k) is constant if I(t) = (n + d)k(t) NOTE; The amount invested has exactly to make up for the effective depreciation rate of capital per worker. The capital-labor ratio goes down because of the depreciation of the capital stock and because population is growing, therefore reducing K/N. 27 Macroeconomics 309 - Lecture 2

The Solow Model: A Steady State Let s graph per worker variables y = f(k) and I/N = (n + d)k. y, i f(k*) (n+d)k f(k) c* k* i* 28 Macroeconomics 309 - Lecture 2 k

How do we get the Steady State? Intuition Fundamental concept: saving is S = sy and we need to match the effective depreciation of capital. Suppose that sf(k) > (n + d)k then you are accumulating K. The resources saved and invested in the economy per worker are above the effective depreciation of capital per worker and k = K/N goes up. Suppose that sf(k) < (n + d)k then you are de-cumulating K. The resources saved and invested in the economy per worker are below the effective depreciation of capital per worker and k = K/N goes down. The Steady State is when sf(k) = (n + d)k then you are keeping k = K/N constant (the resources saved and invested in the economy per worker are equal to the effective depreciation of capital per worker). 29 Macroeconomics 309 - Lecture 2

How do we get the Steady State? Saving is S = sy, s < 1. In per capita terms saving = investment = depreciation sf(k) = (n + d)k. y, i (n+d)k f(k*) f(k) c* sf(k) i* k* k 30 Macroeconomics 309 - Lecture 2

Pinning down the Steady State The solution to equation sf(k) = (n + d)k pins down the steady state capital-labor ratio k*. The per capita output is then y = f(k*). Notice that in Steady State per capita output, consumption, capital are CONSTANT. Growth rates of per capita variables are 0. Notice that in Steady State total output, consumption, capital stock are GROWING. Growth rates are n (population growth). Steady State Levels depend on: n = pop growth d = depreciation f(.) = production function s = saving rate 31 Macroeconomics 309 - Lecture 2

What Happens in this model if 1. Saving rate goes up (s > s)? 2. Population growth rate goes up (n > n)? 3. Depreciation rate goes up (d > d)? 4. We have an increase in productivity (f (k) > f(k) for every k)? 5. Increase in the propensity to consume out of income? 32 Macroeconomics 309 - Lecture 2

The Labor Market Part 2 33 Macroeconomics 309 - Lecture 2

Labor Market Roadmap: Demand and Supply 3 main concepts. 1. Firms decide the optimal amount of labor to hire: Firm Labor Demand. If you aggregate (i.e. add up) those decisions you obtain the Aggregate Labor Demand. 2. Individual decision on optimal amount of leisure ( = 1-N) to consume (and hence how much to work): Individual Labor Supply. If you aggregate those decisions you obtain the Aggregate Labor Supply. 3. Classical representation of the Labor Market Equilibrium: Aggregate Labor Demand = Aggregate Labor Supply Note: no unemployment (real wages can adjust). 34 Macroeconomics 309 - Lecture 2

Labor Demand: Firm s Profit Maximizing Decision In a competitive market, a firm can sell as much Y as it wants at the going price p, and can hire as much N as it wants at the going nominal wage w. Facing w and p, a profit maximizing firm will hire N to the point were MPN = w/p (the benefit from an additional worker (in terms of additional output) must equal the cost which they are paid). <<This is straight from Microeconomics>> Why is this optimal? The MPN is decreasing in N, so: If MPN > w/p then the firm can increase profits by increasing N. (Intuition: the new worker adds more value than he costs, so profits increase). If MPN < w/p then the firm can increase profits by decreasing N. (Intuition: letting go a worker reduces the wage bill more than it cuts production, so profits increase). Example: With Cobb-Douglas production function: MPN =.7 Y/N =.7 A (K/N).3 If firms maximize profits, then: w/p =.7 Y/N =.7 A (K/N).3 35 Macroeconomics 309 - Lecture 2

The Labor Demand Curve Graphical representation of aggregate labor demand N d w/p * real wage N* MPN = N d N 36 Macroeconomics 309 - Lecture 2

Notes on the Labor Demand Curve Let us consider the level of K fixed for now. N d slopes downward (N d = MPN = (1-α) *A(K/N) α =.7 A * (K/N).3 ) N d rises with A and K. When A increases, all my inputs are more productive, so the marginal product of one extra unit of labor input is higher. When K is higher, I have more capital to use with my labor (one extra unit of labor can work with more capital), hence the marginal product of labor is higher. Note: Labor demand shifts when the aggregate production changes (we will see that the aggregate supply shifts). Caveat: Who says that there is a demand for more Y? Need to look at the demand side of economy (introduced in Topic 1 -discussed in depth throughout the course). 37 Macroeconomics 309 - Lecture 2

Labor Supply: Individual Utility Max. Labor Supply (N s ) Results from Individual Optimization Decisions. Households compare benefits of working (additional lifetime resources) with cost of working (forgone leisure). Question: how does the supply of labor moves with a change in real wages (w/p)? 1. Income effect says that as people become richer they want to consume more of all goods, that includes leisure, so they work less. 2. Substitution effect says that as the price of a good goes up today relative to another one you want to consume less of that good. The price of leisure is the wage you forego not to work. 38 Macroeconomics 309 - Lecture 2

Review of Individual Labor Supply Labor Supply (N s ) Results from Individual Optimization Decision <<This is straight from Microeconomics>> Call C individual consumption, p price level, L leisure. 1 unit of time to allocate between work N and leisure L. N = 1- L. The wage is the price of leisure! Individual Maximizes with respect to C and L her utility U(C, L) Subject to: N = 1- L (i.e. the time you do not work is what you consume as leisure) w(1-l) = pc (i.e. labor income = consumption; simple static budget constraint) Her optimal choice gives: w/p = U L (C, L)/ U C (C, L) Marginal rate of substitution (= ratio of marginal utilities) = relative prices. 39 Macroeconomics 309 - Lecture 2

Review of a simple Individual Labor Supply (cont.) Her optimal choice is: w/p = U L (C, L)/ U C (C, L) Marginal rate of substitution (= ratio of marginal utilities) = relative prices. If w/p goes up, then U L (C, L)/ U C (C, L) has to go up. QUESTION: Is N (= 1 L) going to increase or decrease? Recall first that marginal utility of a good goes down with the amount consumed (the 10 th hamburger is not as satisfying as the 1 st ). Substitution effect: if real wage goes up you work more. (U L (C, L) increases consume less leisure- and U C (C, L) decreases consume more goods). Income effect: if real wage goes up you work less. (U L (C, L) decreases consume more leisure- and U C (C, L) decreases even more consume more goods). 40 Macroeconomics 309 - Lecture 2

Factors Affecting Labor Supply Income effect and substitution effect are ambiguous if changes in w/p are permanent. Simplify: assign all the income effect to changes in Present Value of Lifetime Resources (PVLR) and we focus on a positively sloped N s (only subst. effect). Factors Affecting Labor Supply: The Current Real Wage (w/p). But also Future Real Wages through the Household s Present Value of Lifetime Resources (PVLR). The Marginal Tax Rate on Labor Income (t n ) leisure is more/less costly. The Marginal Tax Rate on Consumption (t c ) consumption is more/less costly. Value of Leisure (reservation wage) - non- work status (VL). The Working Age Population (pop). 41 Macroeconomics 309 - Lecture 2

The Labor Supply Curve Graphical representation of aggregate labor supply N s w/p N s (PVLR, t c, t n,vl, pop) N 42 Macroeconomics 309 - Lecture 2

The Labor Supply Curve Graphical representation of aggregate labor supply N s w/p Ns shifts left because of income effect N s (PVLR, t c, t n,vl, pop) Ns slopes up because of substitution effect of before-tax wages N 43 Macroeconomics 309 - Lecture 2

Labor Supply Curve Notes In terms of wages and earnings, there is both an income and substitution effect - we will look at them separately in the real world, they often occur jointly!!!! The Real Wage - HOLDING PVLR fixed: A higher w/p encourages individuals to substitute away from leisure and toward work (leisure becomes more expensive). This is a substitution effect. <<This is why the labor supply curve slopes upwards!!>> Estimating this substitution effect is difficult since PVLR is not easily held constant. Estimates range from 0-2% (For a 1% increase in after-tax w/p holding PVLR fixed, labor supply either increases by 0% or 2%). Very Wide Range little consensus. PVLR = initial wealth + present discounted value of earnings A higher PVLR induces individuals to work less (lower N s ) for a given after-tax wage, allowing them to enjoy more leisure (If leisure is preferred to work as I get richer, I can afford to work less). PVLR is net of taxes and non-work governmental transfers and inclusive of all other transfers. 44 Macroeconomics 309 - Lecture 2

Labor Supply Curve Notes (cont.) Marginal tax rate on labor income - Should have same substitution effect as the before tax real wage. Studies of the 1986 U.S. Tax Reform found that only high-earning married women worked more in response to lower marginal income tax rates. Marginal tax rate on consumption - see above Her optimal choice with taxes: w(1-t n )/p(1+t c ) = U L (C, L)/ U C (C, L) Value of Leisure (VL) - If leisure/no-work becomes more/less attractive, households will work less/more (reservation wage). (Welfare programs, child care, etc.). Working Age Population (pop): Usually defined as 16-64. (Includes changes in Labor Force Participation Rates) 45 Macroeconomics 309 - Lecture 2

Labor Market Equilibrium w/p N s (PVLR, t c, t n, pop, VL) w/p * N* N d (A,K) N 46 Macroeconomics 309 - Lecture 2

Ex 1: Temporary Increase in A w/p N s (PVLR, t c, t n, pop, VL) w/p w/p * 0 2 1 N d N* N N d (A,K) N 47 Macroeconomics 309 - Lecture 2

Ex 2: Permanent Increase in A w/p w/p w/p 3 N s 4 2 N s (PVLR, t c, t n, pop, VL) w/p * 0 1 N d N* N N N d (A,K) N 48 Macroeconomics 309 - Lecture 2

Interpretation If firm become more productive demand more labor. The N d moves to the right. Real wages at the initial level, since workers become scarce, go up. However PVLR stays the same so no movement of N s. Then if the productivity shock is temporary, everything reverts back. If the shift is permanent people are also permanently richer, so a jump of PVLR will produce a consequent shift left of the N s curve (income effect). This leaves the final result ambiguous. 49 Macroeconomics 309 - Lecture 2

Can Technological Progress destroy jobs? Facts: A, N, w/p are trending up over time. N/pop is trending down (except in U.S. since 1980). Higher A countries have higher w/p and lower N/pop. Implications: Adjusting for pop, higher A goes with lower N. Higher A reduces N d and destroys jobs? - NO! Labor Demand Increases. Labor Supply may decrease because of income effect. Higher A increases PVLR and reduces N s. Possibly N < N* if income effect is very strong. However no jobs are destroyed, workers choose to consume more leisure, work less. 50 Macroeconomics 309 - Lecture 2

Ex 3: Permanent Increase in Population w/p N s (PVLR, t c, t n, pop, VL) N s w/p * 0 2 1 N* N d (A,K) N 51 Macroeconomics 309 - Lecture 2

Consumption and Labor Taxes Marginal tax rate on labor income - people care about after-tax wage w(1-t n ) Consumption taxes - people care about after-tax price p(1+t c ) While the substitution effect of changing before-tax wage causes a movement along the supply curve, the substitution effect of changing taxes causes the labor supply curve to shift. If leisure becomes relatively more inexpensive than consumption (labor taxes or consumption taxes increase), the N s moves to the left. If the shift is permanent people are also permanently poorer, so a drop of PVLR will go down with consequent shift right of the N s curve (income effect). This leaves the final result ambiguous. 52 Macroeconomics 309 - Lecture 2

Ex 4: Temporary Increase in Taxes (t c or t n ) w/p N s N s (PVLR, t c, t n, pop, VL) 2 1 w/p * 0 N* N d (A,K) N 53 Macroeconomics 309 - Lecture 2

Ex 5: Permanent Increase in Taxes (t c or t n ). Try it. w/p N s (PVLR, t c, t n, pop, VL) w/p * N* N d (A,K) N 54 Macroeconomics 309 - Lecture 2

Recap on Labor Supply Substitution Effect: For a given PVLR, a higher after-tax wage increases N S. - This is why Labor Supply Curve Slopes Upward Income Effect: For a given after-tax wage, higher PVLR decreases N s. Evidence: Weak Consensus is that, with equal (%) increase in PVLR and the after-tax wage, N s falls (income effect dominates). A must read: Chapter 3 (on labor markets) in the text book. 55 Macroeconomics 309 - Lecture 2

Labor Market Equilibrium (in the long run!) We define Long-run Equilibrium in macroeconomics as occurring when the labor market clears. By definition, long-run macro equilibrium exists when N = N*. At N*, labor demand = labor supply. So, by definition, all workers who want a job (the suppliers) are able to find a firm looking for a worker (the demanders). Implies that cyclical unemployment = zero at N*. Long-run equilibrium is characterized by zero cyclical unemployment! It is an equilibrium in that there is no incentive for real wages to change at N* Real wages (w/p) has two components: nominal wages (w) and the price level (p). Note: Y* (by definition) = A K.3 (N*).7 Y* = long-run equilibrium level of output (where labor market is in equilibrium) 56 Macroeconomics 309 - Lecture 2

Our first aggregate supply curve Suppose prices (p) increase. What happens in the labor market? In terms of equilibrium, nothing happens! Increasing prices have no effect on labor demand (A and K do not change). Increasing prices have no effect on labor supply (VL, taxes, population, etc. do not change). You may ask Doesn t PVLR change when prices increase? No! As long as nominal wages adjust, real wages will be unchanged when p increases. The % change in prices will be match exactly by the % change in nominal wages real wages will not change (so PVLR will not change). No effect on labor supply. Key: Because real wages will not change, changes in prices will have NO effect on the labor market (i.e., it will have no effect on N*). Conclusion: Changing prices will have NO effect on Y* (since N* is constant). 57 Macroeconomics 309 - Lecture 2

Our first aggregate supply curve p LRAS Long Run Aggregate Supply Curve Y* If labor market clears, changes in prices will lead to equal changes in nominal wages. As a result, there will be no change in N* and hence, no change in Y*. Leads to a vertical LRAS curve. Prices do not affect production in the long run! Y 58 Macroeconomics 309 - Lecture 2

What shifts Y*? (the LRAS) Anything that affects the labor market will affect Y*! If N* increases, Y* will shift to the right. If N* decreases, Y* will shift to the left. Summary: Y* will shift right if: A, K increase (and income effect on N s is small relative to shift in N d ) population increases labor income taxes fall (and income effect is small relative to substitution effect) labor income taxes rise (and income effect is large relative to substitution effect) 59 Macroeconomics 309 - Lecture 2

Things to remember! The demand side of the economy is NOT important for determining Y*! All we need to know is A, K and N and we know Y*! The demand side of the economy is not important for economic growth! Key: If I ever ask you about what determines Y* (i.e., output/income/expenditure in the long-run), you should think about A, K and the labor market. - As a rule, K will be fixed unless I tell you otherwise (for simplicity, you will see why soon). Why do we care about the demand side of the economy? In the long run, prices will be determined by demand. Also, LRAS is dependent on labor market being in equilibrium. In the short run, labor market need not be in equilibrium. Demand will determine output in the SHORT RUN! 60 Macroeconomics 309 - Lecture 2

Summary. In the long run when labor markets clear. Supply side of economy (labor market, K, A, other inputs like oil) determines output. Demand side of economy (C+I+G+NX) will determine prices. In the short run when labor markets do not clear: Demand and Supply jointly determine prices and output (think of the simple examples I gave graphically in the lecture for topic 1). Three outstanding issues (we will get to them soon): - When is the labor market NOT in equilibrium? - What does the supply curve look like when labor market doesn t clear? - What determines demand? 61 Macroeconomics 309 - Lecture 2

When are labor markets in disequilibrium? Labor market is in disequilibrium when labor demand is not equal to labor supply. Nominal wages do not adjust to clear the labor market We refer to this as sticky wages. Because of wage contracts (and uncertainty), nominal wages no not always adjust immediately. Need a model for short-run disequilibrium --- we will do that in topic 6. 62 Macroeconomics 309 - Lecture 2

Cyclical Unemployment in Labor Markets When do we get cyclical unemployment in our models? Cyclical unemployment occurs when there are no jobs available (labor demand) for those with the skills and the desire to work (labor supply) at current wages. Cyclical unemployment occurs only in disequilibrium! (when desired labor demand < desired labor supply - at given wages) N s w /p b a Unemployment N d N(1) N(0) 63 Macroeconomics 309 - Lecture 2

Trends in Actual (Standardized) Unemployment Rates 1994 1996 1998 2000 2001 2002 2004 2005:Q3 Britain 9.6 8.2 6.3 5.5 5.0 5.1 4.7 4.6 Japan 2.9 3.4 4.1 4.7 5.0 5.4 4.7 4.3 United States 6.1 5.4 4.5 4.0 4.8 6.0 5.5 5.0 France 12.3 12.4 11.7 9.5 8.5 8.9 9.6 9.4 Germany 8.4 8.9 9.4 7.9 7.7 8.7 9.5 9.2 Spain 24.1 22.1 18.3 14.1 10.6 11.3 10.9 8.7 Poland 18.5 19.8 18.8 17.7 www.oecd.org 64 Macroeconomics 309 - Lecture 2

Why is Unemployment So High In Europe? 1. High labor income tax rates (t n ) 2. Firing restrictions 3. Centralized wage setting 4. Powerful unions and insiders 5. High minimum wages 6. Generous unemployment benefits 65 Macroeconomics 309 - Lecture 2

Explanation of High European Unemployment Centralized wage setting keeps wages from adjusting to each skill level, creating higher unemployment for the lower skilled. Examples: Southern Italy, Eastern Germany. Unions ask for high wages to benefit current members (insiders) at the expense of the unemployed (outsiders). The minimum wage and youth U are particularly high in France. Items 1 and 2 (and France s recent adoption of a maximum workweek) result in higher U rather than just lower w/p because of Items 3, 4, and 5. A lifting of labor market regulations has succeeded in bringing U down substantially in the U.K., New Zealand, and the Netherlands in the past decade. 66 Macroeconomics 309 - Lecture 2

What Have We Learned So Far? There are microeconomic fundamentals to the supply side of the economy Capital accumulation, Labor and TFP are important for production AND Growth!!! Some countries grow faster than others because they have rapid growth in TFP or K/N. Only growth in TFP can lead to sustained growth in Y/N How Labor Markets Work - The Role of Taxes, Technological Progress, Capital Accumulation, And Demographics on Wages and Employment. Demand is not important for determining long-run output (i.e., income, standard of livings, etc.). Supply (production) is the only thing that determines output in the long run! 67 Macroeconomics 309 - Lecture 2