© 2015 pearson - ap economics con muÑiz · keynesian macroeconomics according to keynesian...

© 2015 Pearson

Why do Americans earn more and

produce more than Europeans?

© 2015 Pearson

24

When you have completed your

study of this chapter, you will be able to

1 Explain what determines potential GDP.

2 Explain what determines the natural unemployment rate.

CHAPTER CHECKLIST

Potential GDP and the

Natural Unemployment Rate

© 2015 Pearson

MACROECONOMIC APPROACHES AND PATHWAYS

The Three Main Schools of Thought

The three main approaches to macroeconomics are based

on three schools of thought:

• Classical macroeconomics

• Keynesian macroeconomics

• Monetarist macroeconomics

© 2015 Pearson

Classical Macroeconomics

According to classical macroeconomics, the market

economy works well and delivers the best available

macroeconomic performance.

Aggregate fluctuations are a natural consequence of an

expanding economy with rising living standards.

Government intervention can only hinder the ability of

the market to allocate resources efficiently.



© 2015 Pearson

Classical macroeconomics fell into disrepute during the

1930s, which was a decade of high unemployment and

stagnant production throughout the world.

Great Depression is a decade (the 1930s) of high

unemployment and stagnant production throughout the

world economy.

Classical macroeconomics predicted that the Great

Depression would end but gave no method for ending it

more quickly.



© 2015 Pearson

Keynesian Macroeconomics

According to Keynesian macroeconomics, the

market economy is inherently unstable and it requires

active government intervention to achieve full

employment and sustained economic growth.

John Maynard Keynes, in his book “The General Theory

of Employment, Interest, and Money,” began this school

of thought.

Keynes’ theory was that too little consumer spending

and investment led to the Great Depression.


© 2015 Pearson

Keynes’ solution to depression and high unemployment

was increased government spending.

But Keynes predicted that his policy aimed at curing

unemployment in the short term might increase it in the

long term.

This prediction became reality during the 1960s and

1970s, when inflation exploded, growth slowed, and

unemployment increased.

The global recession of 2008–2009 and fear of another

great depression revived interest in Keynesian ideas.


© 2015 Pearson


Monetarist Macroeconomics

According to monetarist macroeconomics, the

classical view of the world is broadly correct, but in

addition to fluctuations that arise from the normal

functioning of an expanding economy, fluctuations in

the quantity of money also generate the business cycle.

A slowdown in the growth rate of money brings

recession and a large decrease in the quantity of money

brought the Great Depression.

© 2015 Pearson

Milton Friedman was the most prominent monetarist.

The view that monetary contractions are the sole source

of recessions is held by few economists today.

But the view that the quantity of money plays a role in

economic fluctuations is accepted by all economists and

is part of today’s consensus.


© 2015 Pearson

Today’s Consensus

Each of the earlier schools provides insights and

ingredients that survive in today’s consensus.

Classical macroeconomics provides the story of the

economy at or close to full employment.

But the classical approach doesn’t explain how the

economy performs in the face of a major slump in

spending.


© 2015 Pearson

Keynesian macroeconomics takes up the story in a

recession or depression.

When spending is cut and the demand for most goods

and services and the demand for labor all decrease,

prices and wage rates don’t fall but the quantity of goods

and services sold and the quantity of labor employed do

fall and the economy goes into recession.

In a recession, an increase in spending by governments,

or a tax cut that leaves people with more of their earnings

to spend, can help to restore full employment.


© 2015 Pearson

Monetarist macroeconomics elaborates the Keynesian story by emphasizing that a contraction in the quantity of money brings higher interest rates and borrowing costs, which are a major source of cuts in spending that bring recession.

Increasing the quantity of money and lowering the interest rate in a recession can help to restore full employment.

And keeping the quantity of money growing steadily in line with the expansion of the economy’s production possibilities can help to keep inflation in check and can also help to moderate the severity of a recession.


© 2015 Pearson

Another component of today’s consensus is the view that

the long-term problem of economic growth is more

important than the short-term problem of recessions.

Even a small slowdown in economic growth brings a

huge cost in terms of a permanently lower level of income

per person.

The Road Ahead

We follow the new consensus and begin with an

explanation of what determines potential GDP and the

pace at which it grows.


© 2015 Pearson

24.1 POTENTIAL GDP

Potential GDP is the value of real GDP when all the

economy’s factors of production are fully employed.

We produce the goods and services that make up real

GDP by using factors of production: labor and human

capital, physical capital, land, and entrepreneurship.

At any given time, the quantities of human capital,

physical capital, land, entrepreneurship, and the state of

technology are fixed.

But the quantity of labor is not fixed.

© 2015 Pearson

24.1 POTENTIAL GDP

The quantity of labor employed depends on the choices

of people and businesses.

So real GDP produced depends on the quantity of labor

employed.

To describe the relationship between real GDP and the

quantity of labor employed, we use a relationship called

the production function.

© 2015 Pearson

24.1 POTENTIAL GDP

The Production Function

Production function is a relationship that shows the

maximum quantity of real GDP that can be produced as

the quantity of labor employed changes and all other

influences on production remain the same.

© 2015 Pearson

24.1 POTENTIAL GDP

Figure 24.1 shows

the production

function.

100 billion hours of

labor can produce

$11 trillion of real

GDP at point A.

© 2015 Pearson

24.1 POTENTIAL GDP

300 billion hours of

labor can produce

$20 trillion of real

GDP at point C.

200 billion hours of labor can produce $16 trillion of real GDP at point B.

The production function

PF is a limit to what is

attainable.

© 2015 Pearson

24.1 POTENTIAL GDP

The production function

displays diminishing

returns: The tendency

for each additional hour

of labor employed to

produce successively

smaller additional

amounts of real GDP.

The production function is a boundary between the attainable and the unattainable.

© 2015 Pearson

24.1 POTENTIAL GDP

The Labor Market

The Demand for Labor

Quantity of labor demanded is the total labor hours

that all the firms in the economy plan to hire during a

given time period at a given real wage rate.

© 2015 Pearson

24.1 POTENTIAL GDP

Demand for labor is the relationship between the

quantity of labor demanded and real wage rate when all

other influences on firms’ hiring plans remain the same.

The lower the real wage rate, the greater is the quantity

of labor demanded.

© 2015 Pearson

24.1 POTENTIAL GDP

Figure 24.2

shows the

demand for

labor.

© 2015 Pearson

24.1 POTENTIAL GDP

1. If the real wage

rate rises from

$50 to $80 an

hour, the

quantity of labor

demanded

decreases.

© 2015 Pearson

24.1 POTENTIAL GDP

2. If the real wage

rate falls from

$50 to $25 an

hour, the

quantity of labor

demanded

increases.

© 2015 Pearson

24.1 POTENTIAL GDP

The Supply of Labor

Quantity of labor supplied is the number of labor

hours that all the households in the economy plan to

work during a given time period and at a given real

wage rate.

Supply of labor is the relationship between the

quantity of labor supplied and the real wage rate when

all other influences on work plans remain the same.

© 2015 Pearson

24.1 POTENTIAL GDP

Figure 24.3 shows the supply of labor.

© 2015 Pearson

24.1 POTENTIAL GDP

1. If the real

wage rate falls

from $50 to

$25 an hour,

the quantity of

labor supplied

decreases.

© 2015 Pearson

24.1 POTENTIAL GDP

2. If the real

wage rate

rises from $50

to $75 an

hour, the

quantity of

labor supplied

increases.

© 2015 Pearson

24.1 POTENTIAL GDP

The quantity of labor supplied increases as the real

wage rate increases for two reasons:

• Hours per person increase as the real wage rate

increases.

• The labor force participation rate increases as

the real wage rate increases.

© 2015 Pearson

24.1 POTENTIAL GDP

Labor Market Equilibrium

A rise in the real wage rate eliminates a shortage of

labor by decreasing the quantity demanded and

increasing the quantity supplied.

A fall in the real wage rate eliminates a surplus of labor

by increasing the quantity demanded and decreasing

the quantity supplied.

If there is neither a shortage nor a surplus, the labor

market is in equilibrium.

© 2015 Pearson

24.1 POTENTIAL GDP

Figure 24.4(a) shows

labor market equilibrium.

1. Full employment occurs

when the quantity of labor

demanded equals the

quantity of labor supplied.

2. Equilibrium real wage rate

is $50 an hour.

3. Full-employment quantity

of labor is 200 billion hours

a year.

© 2015 Pearson

24.1 POTENTIAL GDP

Full Employment and Potential GDP

When the labor market is in equilibrium, the economy is

at full employment.

When the economy is at full employment, real GDP

equals potential GDP.

© 2015 Pearson

24.1 POTENTIAL GDP

Figure 24.4(b) shows

potential GDP.

1. When the full-employment

quantity of labor is 200

billion hours a year,

2. Potential GDP is $16

trillion.

© 2015 Pearson

24.2 THE NATURAL UNEMPLOYMENT RATE

So far, we’ve focused on the forces that determine the

quantity of labor employed.

Now we look at what determines the unemployment rate

when the economy is at full employment.

To understand the amount of frictional and structural

unemployment that exists at the natural unemployment

rate, economists focus on two fundamental causes of

unemployment:

• Job search

• Job rationing

© 2015 Pearson


Job Search

Job search is the activity of looking for an acceptable

vacant job.

The amount of job search depends on

• Demographic change

• Unemployment benefits

• Structural change

© 2015 Pearson


Demographic Change

An increase in the proportion of the population that is of

working age brings an increase in the entry rate into the

labor force and an increase in the unemployment rate.

This factor increased the unemployment rate during the

1970s and decreased it during the 1980s.

© 2015 Pearson


Unemployment Benefits

An unemployed person who receives no unemployment

benefits faces a high opportunity cost of job search and

has an incentive to keep job search brief.

An unemployed person who receives generous

unemployment benefits faces a lower opportunity cost

of job search and has an incentive to search for longer.

© 2015 Pearson


Structural Change

Labor market flows and unemployment are influenced by the pace and direction of technological change.

Technological change can bring a structural slump, as it did during the 1970s.

As some industries contracted in the 1970s, labor turnover increased, job search increased, and the natural unemployment rate increased.

Technological change can bring a structural boom, as it did during the 1990s.

© 2015 Pearson


Job Rationing

Job rationing occurs when the real wage rate is

above the full-employment equilibrium level.

The real wage rate might be set above the full-

employment equilibrium level for three reasons:

• Efficiency wage

• Minimum wage

• Union wage

© 2015 Pearson


Efficiency Wage

If a firm pays only the going market wage, employees

have no incentive to work hard because they know that

even if they are fired for shirking, they can find another

job at a similar wage rate.

So some firms pay an efficiency wage.

Efficiency wage is a real wage rate that is set above

the full-employment equilibrium wage rate to induce

greater work effort.

© 2015 Pearson


The Minimum Wage

If the government sets a minimum wage above the

equilibrium wage rate, unemployment results.

Union Wage

Labor unions operate in some labor markets and they

agree a money wage rate with employers.

Union wage is a wage rate that results from collective

bargaining between a labor union and a firm.

© 2015 Pearson


Job Rationing and Unemployment

The above-equilibrium real wage rate decreases the

quantity of labor demanded and increases the quantity

of labor supplied.

If the real wage rate is above the full-employment

equilibrium level, the natural unemployment rate

increases.

© 2015 Pearson


Figure 24.5 shows how job rationing increases the natural unemployment rate.

3. Increases the natural

unemployment rate.

1. Decreases the quantity

demanded—job rationing.

2. Increases the quantity

of labor supplied.

An efficiency wage rate

© 2015 Pearson

The quantity of capital per worker is greater in the United

States than in Europe.

U.S. technology, on average, is more productive than

European technology.

These differences between the United States and Europe

mean that U.S. labor is more productive than European

labor.

© 2015 Pearson

Because U.S. labor is

more productive than

European labor, U.S.

employers will pay more

for a given quantity of labor

than European employers

will pay.

1. The U.S. demand for

labor in lies to the right

of the European

demand for labor.

© 2015 Pearson

2. Higher European income

taxes and unemployment

benefits mean that the

U.S. supply of labor lies

to the right of the

European supply.

3. Americans work longer

hours than Europeans.

4. The equilibrium real wage

rate in the United States

is higher than in Europe.

© 2015 Pearson

Because U.S. labor is

more productive than

European labor, the U.S.

production function, lies

above the European

production function.

3. Americans work longer

hours than Europeans.

5. Potential GDP is higher

in the United States

than in Europe.

© 2015 pearson - ap economics con muÑiz · keynesian macroeconomics according to keynesian...

Documents