Ch. 7. At Full Employment: The Classical Model

The relationship between the quantity of labor employed and real GDP

Determinants of potential GDP, employment, and real wage rate

Determinants of the natural rate of unemployment

How borrowing and lending decisions determine the real interest rate, saving, and investment

Use classical model to explain changes and international differences in potential GDP and the standard of living

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The Classical Model: A Preview

Real versus Nominal VariablesReal variables

•measure quantities independent of prices; Reflect a “base year” set of prices.•e.g. Real GDP, employment and unemployment, real wage rate, consumption, saving, investment, and the real interest rate.

Nominal variables •Measures reflecting current prices•Nominal GDP, nominal wage rate, and the nominal interest rate.

The classical dichotomyAt 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.

Parts of the classical model

• Production Function

• Labor marketLabor demand

Labor supply

• Loan marketSupply of loanable fundsDemand for loanable funds

Production Function

•Shows relationship between labor and real GDP•Slope of line to origin = productivity (output per labor hour)•Slope of tangent = marginal product of labor•Law of diminishing marginal returns implies

MP decreases as L increasesPF flattens out as L increases

Production Function

• Shifts in the production function caused byMore capital

More productive workers

Better technology

• Movements along production function caused by changes in level of employment

The Labor Market and Potential GDP

Real wage rate

the quantity of good and services that an hour of labor earns.

Money (nominal) wage rate

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 when compared to MP of labor.

The Labor Market and Potential GDP

Labor Demand 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.

Marginal product of labor curve is same as labor demand curve

Firms will always hire workers if MP> real wage Profit maximizing firm hires until MP= real wage

The Labor Market and Potential GDP

Labor supply curve shows quantity of labor supplied for each real wage rate.

Quantity of labor supplied increases as the real wage rate increases for two reasons:

Hours per person increase (assuming IE<SE)Income effect (work less if real wage increases)Substitution effect (work more if real wage increases)

Labor force participation increases

If the U.S. allowed more immigration, the new equilibrium in the labor market would result in _____ wages and ____ employment

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25% 25%25%25%

30

1. Higher; higher.

2. Higher; lower

3. Lower; higher

4. Lower; lower

If there were technological innovations making labor more productive, this would lead to ____ wages and _____ employment

14

25% 25%25%25%

30

1. Higher; higher.

2. Higher; lower.

3. Lower; lower.

4. Lower; higher.

A less generous welfare program would likely lead to ____ wages and _____ employment.

15

25% 25%25%25%

30

1. Higher; higher.

2. Higher; lower.

3. Lower; lower.

4. Lower; higher.

Suppose that there more immigration is allowed into the U.S. This will cause potential GDP to _____ and productivity to ______.

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25% 25%25%25%

30

1. Rise; rise.

2. Rise; fall.

3. Fall; rise.

4. Fall; fall

Suppose that there is new capital added to the economy. This will cause potential GDP to _____ and real wages to ______.

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25% 25%25%25%

30

1. Rise; rise.

2. Rise; fall.

3. Fall; rise.

4. Fall; fall

Loanable Funds, Investment and the Real Interest Rate

Potential GDP depends on amounts of labor, capital, and other resources.

Capital stock • total quantity of plant, equipment, buildings, and business inventories.• determined by investment. • the funds that finance investment are obtained in the loanable funds market.

Demand for loanable funds

Demand for loan funds depends on The real interest rate = (nominal) interest rate - inflation Investment demand

expected profit rate (internal rate of return)

Supply of Loanable Funds

Supply of Loanable Funds Curve. Saving is the main item that makes up the supply of loanable funds.

The quantity of loanable funds supplied depends on The real interest rate (moves along the curve) Disposable income Wealth Expected future income Government budget

Surplus increases supply of loans

Foreign supply of loans to U.S. Trade surplus

Suppose that households decide to save more of their incomes. This should lead to

25

an incre

ase in

the su

pply...

An incre

ase in

the su

pply...

A decrease

in th

e deman...

An incre

ase in

the dema..

17%

30%33%

20%

1. an increase in the supply of loans and lower interest rates.

2. An increase in the supply of loans and higher interest rates.

3. A decrease in the demand for loans and lower interest rates.

4. An increase in the demand for loans and higher interest rates.

Suppose that households decide to save more of their incomes. This should lead to

26

Lower in

terest.

..

Lower in

terest.

..

High

er intere

s...

High

er intere

s...

33%

10%

33%

23%

1. Lower interest rates and more investment

2. Lower interest rates and less investment

3. Higher interest rates and more investment

4. Higher interest rates and less investment.

Suppose that the federal government increases its budget deficit. This should lead to

27

an incre

ase in

...

A decrease

in ...

A decrease

in ...

An incre

ase in

...

23%

30%30%

17%

1. an increase in the supply of loans and lower interest rates.

2. A decrease in the supply of loans and higher interest rates.

3. A decrease in the demand for loans and lower interest rates.

4. An increase in the demand for loans and higher interest rates.

Suppose that the federal government increases its budget deficit. This should lead to

28

Lower in

terest

rates a

nd ...

Lower in

terest

rates a

n...

High

er intere

st rate

s and...

High

er intere

st rate

s mo..

25% 25%25%25%

30

1. Lower interest rates and less investment

2. Lower interest rates and more investment

3. Higher interest rates and less investment

4. Higher interest rates more investment.