Chapter 6

Principles of

Macroeconomics, Fourth Edition

Instructor’s Manual

The Full-Employment Model

•  In the long run, the U.S. economy creates jobs for all qualified workers. •  Full employment is possible if price, real wages and interest rates adjust to bring

about an equilibrium in the labor, capital, and product markets.

Nominal Wages, Price and Real Wages

The Labor Market in the Full-Employment Model

•  There are two distinct ways to think about this adjustment process. •  First, real wages, interest rates, and prices adjust quickly so that the labor,

capital, and goods markets are always in equilibrium. •  Second, in the long run, real wages, interest rates, and prices adjust eventually.

The Labor Demand Curve (a)

•  The labor demand curve is downward sloping.

The Labor Demand Curve (b)

•  The labor demand curve is downward sloping for two reasons. •  First, labor is less expensive compared to other inputs. •  Second, labor is less expensive relative to the price of the output, so the value of

labor's marginal product exceeds the wage.

The Labor Supply

•  The labor supply curve is vertical, or perfectly inelastic. •  An increase in the real wage has two effects—an income and a substitution effect—

that work in opposite directions. •  The income effect: a higher real wage makes workers better off, so workers want

to buy more goods and leisure; this means they supply less labor •  The substitution effect: a higher real wage makes leisure more expensive

•  In the U.S. labor market, the income and substitution effects almost exactly offset one another, so labor supply is constant when the real wage rises.

Real Wage Matters to Workers

•  Workers care about their real wage, not the nominal wage. •  w = nominal wage = amount of money workers get for working •  P = aggregate price level (such as the CPI) •  The real wage is w/P = the purchasing power workers get for working

Wages and Price Levels

•  If a worker's nominal wage doubles and all prices double, then w/P is constant and workers are no better or worse off.

•  In the United States, aggregate real wages have been roughly constant since 1980, with a gradual decline in the early 1990s offset by a rise at the end of the 1990s.

•  However, the average real wage in 2003 is only slightly above the average real wage in 1965.

Shifts in the Labor Demand Curve

•  The labor demand curve shifts to the right with: •  An increase in the number or quality of machines workers use which increases

workers' marginal productivity •  An improvement in technology which increases workers' productivity •  An increase in the price of machinery and equipment which makes labor relatively

cheaper •  An overall expansion of the economy

Effects of Changes in Investment and Technology

Examples of Labor Supply Curve Shifts

•  The labor supply curve shifts to the right with: •  Increased immigration •  Increased labor force participation; I.e. women since the 1970s

The Labor Market Equilibrium in the 1990s

•  The labor demand curve for skilled workers shifts to the right and the real wage paid to skilled workers increases.

•  The labor demand curve for unskilled workers shifts to the left and the real wage paid to unskilled workers decreases.

•  Technological change in the 1990s benefited skilled workers but hurt unskilled workers.

The Circular Flow of Income

Product Market Equilibrium

•  The equilibrium in the product, or goods, market depends on the adjustment of interest rates and equilibrium in the capital market.

•  The full employment level of output, Yf, (or potential output) can be derived from the aggregate production function which gives the relationship between output and employment, holding technology and the capital stock fixed.

The Short-Run Aggregate Production Function

•  When employment increases; output increases at a diminishing rate due to diminishing returns. Additional workers are less productive because they use less-productive machinery and equipment.

•  In a full-employment economy, where all workers get jobs, they produce the full-employment level of output Yf.

•  Yf is also potential GDP.

Short-run Aggregate Production and Labor Market

Equilibrium

•  The entire output is eventually paid out to households as income. •  These income payments are just enough to buy all of the output.

Investment

•  Firms often spend more than they earn in order to purchase investment goods. •  To do this, they borrow funds.

•  Investment is an injection into the spending stream. •  Equilibrium in the product market means leakages = injections. •  Or savings = investment •  How does savings come to equal investment?

•  The real interest rate adjusts in the capital market so that the supply of savings equals the demand for savings, which is investment.

Household Saving

•  The capital market is the market for loanable funds. •  The supply of loanable funds is savings by households. •  Househols save:

•  For retirement •  For future consumption •  For emergencies •  For education for children •  To buy a new home or car

•  Saving is a “leakage” from the expenditure stream.

The Supply of Loanable Funds

•  The savings, or supply of loanable funds, curve is vertical. •  An increase in r has no effect on savings because the substitution and income effects

move in opposite directions and roughly offset one another. •  The income effect: An increase in r means savers can achieve their savings goals

by saving less which means they consume more. •  The substitution effect: An increase in r rewards saving with greater returns, so

households save more.

Short-Run Loanable Funds Market

Shifts in the Supply of Loanable Funds

•  Household saving increases and the supply of loanable funds shifts right when: •  After-tax income, or disposable income, Y – T, rises

•  That is, when Y, income, rises •  Or when taxes, T, fall

The Demand for Loanable Funds

•  Loanable funds are used to purchase new homes, new plants, machinery, and equipment.

•  Investment, or the demand for loanable funds, is a downward sloping function of the interest rate. •  Firms invest if they expect the returns on adding extra capacity (i.e. profits) > the

costs of borrowing funds. •  The higher the real interest rate, the higher is the cost of funds and the lower is

investment.

Equilibrium in the Capital Market

•  The interest rate adjusts so that S = I, or leakages = injections. •  This implies that the goods market is also in equilibrium.

Demand = Supply

•  Demand = consumption and investment (remember we are ignoring government and the foreign sector) •  Demand = C + I

•  Supply is Yf, full-employment output •  Household income is divided between consumption and saving.

•  C + Sf which must equal output and income •  So Yf = C + Sf •  Or Sf = Yf - C

•  If in equilibrium leakages equal injections, Sf = I. •  So I = Yf - C •  Or C + I = Yf, which means Demand = Supply

The Introduction of PCs

•  The real wage increases. •  The productivity of workers increases. •  Full-employment output increases, so aggregate income increases. •  Savings and investment increase.

Women Enter the Work Force

•  The participation of women in the labor force has increased since 1970. •  The real wage falls. •  Employment expands. •  Full-employment output income increases. •  Savings and investment increase while the real interest rate falls.

This concludes the Instructor’s Manual Slide Set for Chapter 6

Principles of

Macroeconomics, Fourth Edition

by Joseph E. Stiglitz

Carl E. Walsh

W. W. Norton & Company Independent and Employee-Owned