THE ECONOMY AT 8 FULL EMPLOYMENT: CHAPTER THE CLASSICAL MODEL 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 1
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 Our Economy s 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 course its full employment trend but like the explorer, has a compass that keeps bringing it back. The classical model is the compass and you ll learn about it in this chapter. 2
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. 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 don t need to look at the price levels in the two countries. 3
The Classical Model: A Preview The classical model is a model of the economy that determines the real variables real GDP, employment and unemployment, the real wage rate, consumption, saving, investment, and the real interest rate at 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. 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. 4
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. Real GDP and Employment The PPF showing the relationship between leisure time and real GDP is bowedout, 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. 5
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. 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. 6
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 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. 7
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. 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. 8
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. 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. 9
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 GDP the marginal product of labor is $40 an hour. 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 GDP the marginal product of labor is $30 an hour. The marginal product of labor is the slope of the production function. 10
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. 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. 11
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. 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. 12
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 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. 13
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. 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. 14
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. The Labor Market and Potential GDP Potential GDP At a full employment level of 200 billion hours, potential GDP is 10 trillion dollars. 15
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 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. 16
Unemployment at Full Employment Figure 24.6 illustrates the relationship between the amount of job search unemployment and the real wage rate. 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 17
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. 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. 18
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. 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 19
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 firm s 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. 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. 20
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. 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 effects an 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 wage an example of ceteris paribus not holding. 21
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. Investment, Saving, and the Interest Rate Investment Decisions Business investment decisions are influenced by The expected profit rate The real interest rate 22
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. 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. 23
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. 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. 24
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. 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 government s 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. 25
Investment, Saving, and the Interest Rate Saving is influenced by The real interest rate Disposable income Wealth Expected future income Investment, Saving, and the Interest Rate Real Interest Rate The higher the real interest rate, the greater is a household s opportunity cost of consumption and so the larger is the amount of saving. Disposable Income The higher the disposable income, the greater is a household s saving. 26
Investment, Saving, and the Interest Rate Wealth The greater is a household s wealth, other things remaining the same, the greater is its consumption and the less is its saving. Expected Future Income The higher a household s expected future income, the greater is its current consumption and the lower is its current saving. 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. 27
Investment, Saving, and the Interest Rate A fall in the real interest rate decreases saving. A rise in the real interest rate increases saving. 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. 28
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. 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. 29
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 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. 30
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. The Dynamic Classical Model Figure 24.10 illustrates in increase in labor productivity. The production function shifts upward from PF 0 to PF 1. 31
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 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. 32
The Dynamic Classical Model Figure 24.11(a) illustrates these effects in the labor market. 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. 33
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. 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. 34
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. 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 million a 25 percent increase. Labor hours increased from 159 billion to 231 billion a 45 percent increase. 35
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 trillion a 67 percent increase. Technology advanced most notably the information revolution and the widespread computerization of production processes. 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. 36
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