CH. 8: THE ECONOMY AT FULL EMPLOYMENT: THE CLASSICAL MODEL

• Describe the relationship between the quantity of labor employed and real GDP

• Explain what determines •the demand for labor

• the supply of labor

• employment, the real wage rate,

• productivity

• potential GDP

•Saving, Investment, and Interest rates

Objectives

–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

The Classical Model: A Preview

– The classical dichotomy• At full employment, the forces that determine real

variables are independent of those that determine nominal variables.

– The classical model • A model of the economy that determines the real

variables at full employment.

– The PPF illustrates:• Increasing marginal

opportunity cost• Efficient versus

inefficient • Unattainable

– An outward shift is economic growth

• more resources• improved technology

Real GDP and Employment

Production Function

• The Production Function– the relationship between real GDP and the

quantity of labor employed, other things remaining the same.

• Marginal product of labor

• Average product of labor (productivity)

• Diminishing returns to labor

• Upward shift of production function

• human capital • capital• technology

Production Function

Production Function

• Holding production function constant, if employment increases, what is the effect on marginal product, average product?

• If there is a technological advance shifting production function upwards, what is the effect on marginal product, average product?

The Labor Market

• Potential GDP is the level of GDP produced if the economy is at full employment.

• Determinants of potential GDP:• The demand for labor• The supply of labor• The production function

– capital (human and physical)– technology

The Labor Market

• The Demand for Labor– marginal product of labor

• additional real GDP produced by an additional hour of labor, ceteris paribus.

– law of diminishing returns, • as the quantity of labor increases, the marginal

product of labor decreases, holding capital and technology constant.

The Labor Market

The Labor Market

– The marginal product of labor is the slope of the production function.

– What does LDMR imply about production function?

The Labor Market

Because of the law of diminishing marginal returns, the MP of labor curve is downward sloping.

The Labor Market• A profit maximizing firm

will hire additional labor until real wage = MP

• MP curve is labor demand curve

• Demand vs. Quantity demanded

The Labor Market

• Factors shifting labor demand– human capital– physical capital– payroll taxes on employers

The Labor Market

• The Supply of Labor– quantity of labor supplied

• the number of labor hours that all the households in the economy plan to work at a given real wage rate.

– supply of labor • relationship between the quantity of labor supplied

and the real wage rate, all other things remaining the same.

The Labor Market

– The higher the real wage rate, the greater is the quantity of labor supplied.

The Labor Market

• The quantity of labor supplied increases as the real wage rate increases for two reasons:– Hours per person increase

• While income and substitution effects work in opposite directions, net effect is generally positive in aggregate.

– Labor force participation increases

• Empirical evidence is that the labor supply curve is fairly steep.

The Labor Market

• Factors shifting labor supply– population – immigration– taxes on wages received by employees – generosity of income support programs– home technology

The Labor Market

Equilibrium

• If wage<equil– Shortage– Wage rises

• If wage>equil– Surplus– Wage falls

The Labor Market

When the labor market is in equilibrium, • the economy is at full employment• natural rate of unemployment. • frictional and structural, but no cyclical

unemployment• no upward or downward pressure on real

wages.• GDP = potential GDP

The Labor Market

If wage rate > equilibrium:• economy is below full employment • unemployment > natural rate

• downward pressure on real wages.If wage rate < equilibrium• Economy is beyond full employment (over-heated) • unemployment < natural rate• upward pressure on real wages

The determinants of potential GDP

• How do each of the following affect wages, employment, productivity, real GDP?– An increase in labor supply– An increase in labor demand– An upward shift in the production function

Increase in labor supply

Increase in labor demand

Upward shift in production function

Investment, Saving, and the Interest Rate

• Capital stock

total amount of plant, equipment, buildings, and inventories, physical capital.

• Gross investment

purchase of new capital.• Depreciation

wearing out of the capital stock.• Net investment

Gross Investment – depreciation.

Investment, Saving, and the Interest Rate

• Business investment decisions are influenced by

• The expected profit rate (internal rate of return)• The real interest rate = nominal interest rate –

inflation rate

Investment, Saving, and the Interest Rate

• The Expected Profit Rate– “internal rate of return” is relatively high during

business cycle expansions and relatively low during recessions.

– Advances in technology can increase the expected profit rate.

– Taxes affect the internal rate of return 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.

Investment, Saving, and the Interest Rate

• Investment Demand– the relationship

between the level of planned investment and the real interest rate.

Investment, Saving, and the Interest Rate

• Factors shifting Investment Demand– technological innovation– taxes on investment income– expected future profitability of

investments

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

– personal disposable income minus consumption expenditure.

• Business saving

– retained profits and additions to pension funds by businesses.

• Government saving

– government’s budget surplus.

• National saving

– sum of private saving and government saving.

• Any of these components can be negative.

Investment, Saving, and the Interest Rate

Why do people save?• Permanent income hypothesis.

– Permanent income = average income received per year over life-time

– If a person wants to consumption smooth, can spend permanent income each year for entire life.

• If current income > permanent income save• If current income < permanent income dissave• Young versus old?• Temporary decline in income?• Volatility of saving versus consumption?

Investment, Saving, and the Interest Rate

• Saving Supply– relationship between saving and the real

interest rate, other things remaining the same. – As the real interest rate rises, the level of

saving increases.• Substitution effect: save more• Wealth effect

– Borrowers save more – Savers save less– Cancels out across borrowers and lenders.

Investment, Saving, and the Interest Rate

Factors shifting savings curve:

• Disposable income• Wealth• Expected future income• Tax incentives• Social Security• Government budget deficit• Foreign savings

Investment, Saving, and the Interest Rate

Equilibrium Interest Rate

Investment, Saving, and the Interest Rate

• Effect of each of the following on saving, investment and interest rates:– News that income will fall next year.– Technological advance that creates new

profitable investment projects.– Tax cuts on corporate profits.– Personal income tax– permanent versus temporary tax cut.

-.3

-.2

-.1

.0

.1

.2

.3

.4

.5

1970 1975 1980 1985 1990 1995

% change in investment % change in consumption

Why is investment more volatile than consumption?

Why is durable spending more volatile than nondurable spending?