classical model.pdf

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8 THE ECONOMY ATFULL EMPLOYMENT:THE CLASSICAL

MODEL**

* * This is Chapter 24 in Economics .

C h a p t e r K e y I d e a s

Our Economys Anchor A. The economy is like a boat on a rolling sea. Potential GDP provides an anchor for the economB. The Classical Model explains how potential GDP is determined.C. Specifically, forces of demand and supply in labor and capital markets determine the real wag

rate, the real interest rate, and the level of potential GDP.

O u t l i n e

I. The Classical Model: A Preview

The Classical Model is introduced.

1. There are two distinct categories of variables that describe macroeconomic performance:a) Real variables: real GDP, employment and unemployment, the real wage rate,consumption, saving, investment, and the real interest rate.

b) Nominal variables: the price level (CPI or GDP deflator), the inflation rate, nominalGDP, the nominal wage rate, and the nominal interest rate.

2. The separation of macroeconomic performance into a real part and a nominal part is thebasis of the classical dichotomy.

3. The classical dichotomy states: At full employment, the forces that determine realvariables are independent of those that determine nominal variables.

4. The classical model is a model of an economy that determines the real variables at fullemployment.

5. Most economists believe that the economy fluctuates around full employment, but that thclassical model provides powerful insights into the level of full employment and potentiaGDP around which the economy fluctuates.

C h a p t e r


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II. Real GDP and Employment

A. Production Possibilities 1. The production possibilities frontier (PPF ) is the boundary between those combinations of

goods and services that can be produced and those that cannot.2. Figure 8.1(a) illustrates a

production possibilities frontierbetween leisure time and real GDP.3. The more leisure time forgone, the

greater is the quantity of laboremployed and the greater is the realGDP.

4. The PPF showing the relationshipbetween leisure time and real GDPis bowed-out, which indicates anincreasing opportunity cost: As realGDP increases, each additional unitof real GDP costs an increasingamount of forgone leisure.

5. Opportunity cost is increasingbecause the most productive laboris used first and as more labor isused, the labor used becomesincreasingly less productive.

B. The Production Function 1. The production function is the

relationship between real GDP andthe quantity of labor employed

when all other influences onproduction remain the same.

2. One more hour of labor employedmeans one less hour of leisure,therefore the production function isthe mirror image of the leisuretime-real GDP PPF .

3. Figure 8.1(b) illustrates theproduction function thatcorresponds to thePPF shown inFigure 8.1(a).

III. The Labor Market and Potential GDP

A. The Demand for Labor

1. The quantity of labor demanded is the labor hours hired by all the firms in theeconomy.


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T H E E C O N O M Y AT F U L L E M P L O Y M E N T : T H E C L A S S I C A L M O D E L 1 6 9

2. The demand for labor , Figure 8.2,is the relationship between thequantity of labor demanded and thereal wage rate when all otherinfluences on firms hiring plansremain the same.

3. The real wage rate is the quantityof good and services that an hour oflabor earns.a) The money wage rate is the

number of dollars an hour oflabor earns.

b) The average real wage rate is theaverage money wage rate dividedby the price level multiplied by100.

c) It is the real wage rate, not themoney wage rate, that determinesthe quantity of labor demanded.

4. The demand for labor depends on themarginal product of labor , whichis the additional real GDP producedby an additional hour of labor when all other influences on production remain the same.a) The marginal product of labor is calculated as the change in real GDP divided by the

change in the quantity of labor employed.b) The marginal product of labordiminishes as the quantity of labor employed increases,

other things remaining the same. Diminishing marginal product occurs because all thlabor employed works with the same fixed capital and technology, and is an examplethe law of diminishing returns .

c) The diminishing marginal product of labor limits the demand for labor.


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5. The demand for labor is themarginal product of labor. Figure8.3 shows the production function,PF , in part (a). The productionfunction determines the marginalproduct of labor. And the marginal

product of labor curve is thedemand for labor curve in part (b).a) Firms hire more labor as long

as the marginal product oflabor exceeds the real wagerate.

b) Eventually, with thediminishing marginal productof labor, the extra output froman extra hour of labor is exactly

what the extra hour of laborcosts, which is the real wage

rate. At this point, the profit-maximizing firm hires no morelabor.

c) When the marginal product oflabor changes, the demand forlabor changes. If the marginalproduct of labor increases, thedemand for labor shiftsrightward.

B. The Supply of Labor 1. The quantity of labor supplied

is the number of labor hours that all

the households in the economyplan to work at a given real wagerate.

2. The supply of labor is therelationship between the quantity oflabor supplied and the real wage rate when all other influences on work plans remain thesame.

3. The quantity of labor supplied increases as the real wage rate increases for two reasons:a) Hours per person increase because the higher the real wage rate, the higher the

opportunity cost of not working. There is an opposing income effect. The higher real wage rates increase household income, which increases the demand for leisure. Anincrease in the demand for leisure is the same thing as a decrease in the quantity of

labor supplied. The opportunity cost effect is usually greater than the income effectover the relevant range for most U.S. workers, so a rise in the real wage rate brings anincrease in the quantity of labor supplied.

b) 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.


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4. The labor supply response to anincrease in the real wage rate ispositive but small. A largepercentage increase in the real wagerate brings a small percentageincrease in the quantity of labor

supplied. Figure 8.4 illustrates alabor supply curve.


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C. Labor Market Equilibrium and Potential GDP 1. Labor market equilibrium occurs when

the real wage rate is such that the quantityof labor demanded is equal to the quantityof labor supplied. Figure 8.5(a) illustrateslabor market equilibrium.

2. Labor market equilibrium is full-employment equilibrium.

3. The level of real GDP at full employmentis potential GDP . Note that in Figure8.5(a), labor market equilibrium occurs at200 billion labor hours. Referring back tothe production function in Figure 8.1,repeated as Figure 8.5(b), 200 billionlabor hours means that potential GDP is$10 trillion.

IV. Unemployment at Full Employment

A. Unemployment always is present.1. The unemployment rate at full

employment is called thenatural rate ofunemployment.

2. The natural unemployment rate is alwayspositive; that is, there is always someunemployment because of job search and

job rationing.B. Job Search

1. Job search is the activity of workerslooking for an acceptable vacant job.

2. All unemployed workersfrictionally,structurally, and cyclically unemployed search for new jobs, and while they searchmany are unemployed. Job searchunemployment, and how it relates to


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the natural unemployment rate, isillustrated in Figure 8.6.

3. Job search can be affected by:a) Demographic change. As more

young workers entered the laborforce in the 1970s, the amountof frictional unemploymentincreased as they searched for

jobs. Frictional unemploymentmight have fallen in the 1980sas those workers aged. Two-earner households might increasesearch, because one membercan afford to search longer if theother still has income.

b) Unemployment compensation. The more generous unemployment compensation payments become, the lower theopportunity cost of unemployment, so the longer workers search for better

employment rather than any job. More workers are covered now by unemploymentinsurance than before, and the payments are relatively more generous.c) Structural change. An increase in the pace of technological change that reallocates job

between industries or regions increases the amount of search.C. Job Rationing

1. Job rationing is the practice of paying a real wage rate above the equilibrium level andthen rationing jobs by some method.

2. Job rationing can occur for two reasons:a) A firm pays anefficiency wage , which is a real wage rate set above the full-

employment equilibrium wage rate that balances the costs of benefits of this higher wage rate to maximize the firms profit. The higher wage rate attracts the mostproductive workers and then gives them the incentive to be productive so they do notlose their high-paying jobs.

b) A minimum wage is the lowest wage rate at which a firm may legally hire labor. Ifthe minimum wage is set above the equilibrium wage rate, job rationing occurs

D. Job Rationing and Unemployment 1. 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.2. Most economists agree that efficiency wages and minimum wages increase the natural

unemployment rate.a) Card and Krueger have challenged this view and argue that an increase in the

minimum wage works like an efficiency wage, making workers more productive andless likely to quit.

b) Hamermesh argues that firms anticipate increases in the minimum wage and cutemploymentbefore they occur. Therefore, looking at the effects of minimum wagechanges after the change occurs misses the effects.

c) Welch and Murphy say regional differences in economic growth, not changes in theminimum wage, explain the Card and Krueger theory.


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V. Investment, Saving, and the Interest Rate

A. Potential GDP depends on the quantity of productive resources, including capital.1. The capital stock is the total amount of plant, equipment, buildings, and inventories,

physical capital.2. Gross investment is the purchase of new capital.Depreciation is the wearing out and

scrapping of the capital stock.Net investment equals gross investment minus depreciation;net investment is the addition to the capital stock. Investment is financed bysaving , whichequals income minus consumption.

3. The return on capital is the real interest rate , which is equal to thenominal interestrate adjusted for inflation. The real interest rate is approximately equal to the nominalinterest rate minus the inflation rate.

B. Investment Decisions Business investment decisions are influenced by:1. The expected profit rate. The expected profit rate is relatively high during expansions and

relatively low during recessions. Increases in technology can increase the expected profitrate. Taxes affect the expected profit rate because firms are concerned about theafter-tax profit rate.

2. The real interest rate. The realinterest rate is the opportunity costof investment. An increase in thereal interest rate decreases thenumber of investment projects thatare profitable.

C. Investment Demand 1. Investment demand is the

relationship between investmentand the real interest rate, otherthings remaining the same.

2. The investment demand curve ,

illustrated in Figure 8.7, plots therelationship between investmentdemand and the real interest rate.a) The investment demand curve

slopes downward. A rise in thereal interest rate (say from 4percent to 6 percent) decreasesthe quantity of plannedinvestment demanded (from$1.2 trillion at A to $1.0trillion at B) along investmentdemand curveID in Figure 8.7.

b) If the expected profit rate increases, the investment demand curve shifts rightward.D. Saving Decisions 1. Households divide their disposable income between consumption expenditure and saving.2. Saving is affected by the real interest rate, disposable income, wealth, and expected future

income.


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3. The higher the real interest rate,the greater is a householdsopportunity cost of consumptionand so the larger is the amount ofsaving.

4. The larger disposable income, thegreater is a households saving.

5. The greater is a households wealth,the greater is its consumption andthe less is its saving.

6. The higher a households expectedfuture income, the greater is itscurrent consumption and the loweris its current saving.

E. Saving Supply 1. Saving supply is the relationship

between saving and the real interestrate, other things remaining thesame.

2. Figure 8.8 shows a saving supplycurve, which slopes upward becausea rise in the real interest rateincreases saving.

F. Equilibrium in the Capital Market 1. In the U.S. economy, there are many interrelated capital markets. Because funds can flow

from one market to another, we can think about the capital market as a whole.2. The real interest rate is determined by investment demand and saving supply.


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3. In Figure 8.9, ID is the investmentdemand curve, SS is the supply ofsaving curve, and the equilibriumreal interest rate is 6 percent. At theequilibrium real interest rate, thereis neither a shortage nor surplus of

saving.

VI. The Dynamic Classical Model

A. The Classical Model also hasimplications for how the economychanges over time.

B. Changes in Productivity 1. Labor productivity is real GDP

per hour of labor.2. Three factors influence labor

productivity.a) Physical capital : An increase in

capital increases laborproductivity.

b) Human capital : Humancapital is the knowledge andskill that people have obtainedfrom education and on-the-

job-training. An increase in human capital increases labor productivity.c) Technology : An increase in technology increases labor productivity.

3. When labor productivity increases, the production function shifts upward and potentialGDP increases.


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C. An Increase in Population1. Figure 8.11 (mislabeled as Figure

8.12) illustrates the effects from anincrease in population.

2. An increase in population increasesthe supply of labor and the supplyof labor curve shifts rightward. Theequilibrium real wage rate falls andthe equilibrium quantity ofemployment increases.

3. The increase in employment leadsto a movement up along theproduction function so thatpotential GDP increases. However,diminishing returns means thatpotential GDP per hour of workdecreases.


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D. An Increase in Labor Productivity1. Figure 8.12 (mislabeled as Figure

8.11) illustrates the effects from anincrease in labor productivity.

2. An increase in labor productivity canbe the result of an increase inphysical capital, an increase inhuman capital, or an advance intechnology. In all cases, theproduction function shifts upwardand the demand for labor increasesso that the demand for labor curveshifts rightward. The increase in thedemand for labor raises theequilibrium real wage rate andincreases the equilibrium quantity ofemployment.

3. The increase in employment leads to

a movement up along the productionfunction. In addition, the increase inlabor productivity shifted theproduction function upward. Botheffects increase potential GDP. Theupward shift of the productionfunction means that potential GDPper hour of work increases.


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E. Population and Productivity in the United States1. In the United States, over the past

two decades, both the populationand labor productivity haveincreased.

2. Figure 8.13 illustrates these effects.3. The increase in the demand for

labor exceeded the increase in thesupply of labor so that the real wagerate rose. Employment increased as aresult of both the increase in thedemand for labor and the increase inthe supply of labor.

4. The increase in productivity shiftedthe production function upward.That, combined with the increase inemployment, increased potentialGDP.

R e a d i n g B e t w e e n t h e L i n e s A news article discusses how productivity growth jumped in the third quarter of 2003. The analysis shothe effect of the increase in productivity on the production function and the demand for labor. It also

discusses how productivity feeds into long-term economic growth.


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N e w i n t h e S e v e n t h E d i t i o nThis chapter synthesizes the material on the labor market and the capital market presented in Chapters 7and 8 of the Sixth Edition. The material is presented in the context of the Classical Model of fullemployment and potential GDP.

Te a c h i n g S u g g e s t i o n sChapter 8 clearly explains to students how potential GDP is determined, what changes potentialGDP, why there is ever-persistent unemployment in our economy, and the functioning of the capitalmarket.One way to motivate students in the study of the labor underpinnings of the macroeconomy is toaddress the topic of wages. Students readily understand the difference in money wages versus real

wage rates. Ask them how much they think their money wages have increased during the past 12months. Their answers provide an opportunity to work out the percentage change in their wages andthen compare it to the percentage change in the CPI or GDP deflator. Use your own percentageincrease in wages as an opening example if thats not too depressing. If youre like most professors,your real wage rate is falling!This real wage rate discussion then allows you to ask the class: why has your real wage rate fallen and why have real wage rates for some of the students and in other occupations gone up? And, onaverage, do they think real wage rates are going up or down? These questions always generate someinterest, particularly if you pose another question about the future trend of real wage rates. They alsolet you introduce the idea that in macroeconomics, were concerned with the averages and aggregatesrather than the details of the distribution. You can move from these introductory ideas to set up theneed for the Classical Model presented in this chapter.

1. The Classical Model: A Preview This Classical Model makes extensive use of the demand and supply model of Chapter 3. It applies itto the labor market. It also applies it to the market for financial capital in which demand isinvestment demand, supply is saving supply, and price is the real interest rate, which is both thereturn to saving and the opportunity cost of investment. Once the student understands these parallelsof the Classical Model with the basic demand and supply analysis, the mechanics of this chapter willbe relatively straightforward.

2. Real GDP and Employment Building and using a toolkit. As you introduce the tradeoff between goods (real GDP) and leisuretime, use the opportunity to remind the students that learning economics is like building and using atoolkit. And here we use thePPF tool yet again. Keep reminding your students that economics is nota subject that you memorize (and forget after the exam). It is more like learning to drive a carsomething that eventually comes naturally and is never forgotten.

Making it personal. This topic is one that can benefit from drawing on the personal experiences ofstudents who have jobs and who make some choices with respect to hours per week to work, study,and take leisure. They get thePPF for leisure and GDP quickly.Simple examples. Changes in labor productivity are conveniently illustrated with simple concreteexamples. To see how physical capital increases productivity, contrast building a dam using shovelsand buckets, then shovels and wheelbarrows, then a front-end loader and a truck. To see how humancapital increases productivity, contrast the speed with which a student who has learned to type canproduce an essay with the speed at which a two-finger typist can accomplish the same task.


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3. The Labor Market and Potential GDP Marginal product of labor. Although you are teaching a macroeconomics course, you cant neglectsome crucial microeconomic underpinnings. And the marginal product of labor is one of theseunderpinnings. You can though avoid being too technical and can focus on the intuition. Some ofyour students might have completed the principles of microeconomics and seen the concept ofmarginal productivity before. This background enables you to encourage their participation in a

classroom discussion on this topic. Also, drawing on the life experience of students with jobs who work hours change from day to day or week to week can be useful. Get the students to see intuitivethat it is not worth while for a firm to hire an hour of labor unless the value of the production of thlabor at least covers the wage cost to the firm.Labor supply. Your main goal in teaching this topic is to explain why in total, hours increase as thereal wage rate increases. Again, drawing on the life experience of students with jobs whose workhours change from day to day or week to week can be useful. The two key points are: Even thoughsome workers might have a backward-bending labor supply curves (playing golf on weekdayafternoons when the wage rate rises enough), most have upward-sloping labor supply curves. Thelabor force participation rate increases as the real wage rate increases. These two features of indivibehavior imply that the supply curve to labor in aggregatethe supply of aggregate hoursincreaas the real wage rate rises, other things remaining the same.

Is immigration bad for us? Many people think that immigration is bad for existing citizens andlowers their living standard. Part of the popular political discussion, especially in Europe during2002, has a racist dimension, which you will want to avoid. But the raw economic dimension is

worth examining. When you discuss the effects of an increase in population, you will conclude thaan increase in population,ceteris paribus, increases real GDP but lowers real GDP per person andlowers the real wage rage. You might then ask: does this outcome mean that immigration is bad fous?The answer, of course, is absolutely not. Historically, immigrants have brought capital andentrepreneurship, and been some of the most creative sources of technological change. When youcombine the effects of capital accumulation and technological change with an increase in populatioyou see that real GDP increases but the change in the wage rate is ambiguous. Add the historical fathat capital accumulation and technological change have outstripped population growth, and youreach the conclusion that immigration has been (and probably continues to be) a positive economiforce.Why the Luddites were wrong. This chapter provides you with a wonderful opportunity to explain tyour students why the Luddites were wrongand why the modern neo-Luddite movement is wron(You can learn more than you need to know about Luddism and the Luddites, ancient and modern,at http://carbon.cudenver.edu/~mryder/itc_data/luddite.html)The Dynamic Classical Model. Explain that more capital and more productive capital that uses newtechnologies increases productivity, shifts the production function upward, and shifts the demand flabor curve rightward. Real GDP increases and on the average, the real wage rate rises.

You might then spend a few minutes agreeing that capital accumulation and technological changedecrease the demand for the labor that the new capital replaces. But it increases the demand for othtypes of laborcomplementary labor. People must acquire more skillsome people learn to work

with the new capital, some learn how to maintain it in good condition, some learn how to build it,

some learn how to market and sell it, some learn to design new ways of using it, some work onthinking up new goods and services to produce with it, and so on. All of these people are moreproductive that they were before.New technologies that create new products have even more obvious effects on productivity. Thedevelopment of the CD in the early 1980s is a good example. Suddenly thousands of people becam


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very productive converting the heritage of recorded music into digital format, cleaning up the sound,and making and selling millions of CDs. The same type of thing is now happening with the DVD.If you want to get side-tracked into philosophical disputes about man and machines, we cant helpyou in that area!

4. Unemployment at Full Employment Where is unemployment in the demand and supply diagram? Thoughtful students often ask aboutthe relationship between the (microeconomic-based) labor demand and labor supply model andunemployment. They cant see any unemployment in labor market equilibrium. Where is it, they

want to know.Explain that in the labor market, people use their time in two economically productive ways: they work and they job search. Working is supplying labor and this is the activity that the demand-supplymodel shows. It shows the quantity of labor demanded and supplied and the price (real wage rate)that equates the quantities demanded and supplied. The demand and supply model does notdetermine the quantity of job-search activity. People supply job-search activity because firms haveimperfect information about job seekers and workers have imperfect knowledge about available jobs.During the time spent on job search, people are unemployed. You can draw a diagram if you wishthat shows the quantity of job search on the x -axis and the real wage rate on the y -axis. The higherthe real wage rate, other things remaining the same, the greater is the amount of job search activity.

The equilibrium wage rate determined by demand and supply in the labor market determines thepoint on the job search curve at which the labor market operates and determines the quantity of job-search unemployment.Only if there were no uncertainty would the supply of job search (and unemployment) be zero. Insuch a case, a person out of work would not need to search for a new job. He or she would simplyreport to the new job on the day the worker knew that the job started! Thus, workers would never beunemployed because they would never search for jobs. Clearly, this happy state of affairs is not adescription of reality.One way to dramatize the fact that natural unemployment never hits zero is to bring in data onunemployment rates during World War II. Here are the numbers for the United States. Tell thestudents that more than 6 million people, mainly men, were recruited into the armed forces and thatmillions of others, mainly women, were mobilized to produce arms. Ask the students to guess theunemployment rate at the peak of war activity. Few will guess the unemployment rates correctly. (Itis pretty remarkable that the rate could have fallen to such a low level.)

Civilian population and labor force, 19411945

Civilian labor force

Year Civilianpopulation Total Employment

Unemploy-ment

Not in laborforce

Labor forceparticipation

rate

Employ-ment-to-

populationratio

Unemploy-ment rate

Thousands of persons 14 years of age and over Percent

1941 99,900 55,910 50,350 5,560 43,990 56.0 50.4 9.9

1942 98,640 56,410 53,750 2,660 42,230 57.2 54.5 4.71943 94,640 55,540 54,470 1,070 39,100 58.7 57.6 1.91944 93,220 54,630 53,960 670 38,590 58.6 57.9 1.21945 94,090 53,860 52,820 1,040 40,230 57.2 56.1 1.9

Source: Economic Report of the President , 2002

5. Investment, Saving, and the Interest Rate Definitions and the meaning of investment in economics. The student has met the key definitions ofthis section in Chapter 5, but to be absolutely sure that they are remembered, this chapter repeats


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them. It is worth emphasizing that in economics, capital and investment without anyqualification mean physical capital and purchase of newly produced physical capital goods. Everyusage of investment as the purchase of stocks or bonds can lead to confusion. So it is worth gettingthese matters clear right from the start.Real versus nominal interest rate. To drive home the distinction between the nominal interest rateand real interest rate, you might like to use the example of 30-year fixed rate mortgage. Get the

students to use the past 10-year average as a guide to the rate of increase in housing prices, andcalculate the real interest rate on a 30-year fixed rate mortgage. The student can get a quote for a 3year fixed rate mortgage athttp://www.bankrate.com/bhn/subhome/mtg_m1.asp and can find theprice increases in your own region athttp://www.homestore.com/Finance/HousePriceIndex/default.asp?gate=realtor Confusing saving and investment. Some of your students will confuse saving and investment. Andthis confusion will lead them to be puzzled by the slope of the investment demand curve. You canhelp all your students avoid this confusion by hitting it head on. Ask them the following question:the interest rate rises, Im going to put more money in my savings account, stock market, or

whatever. So why do we say that a higher interest rate decreases investment? In the ensuingdiscussion, get the students to see that placing funds in a savings account, stock market, or whatevis saving, which does increase if the interest rate rises (other things remaining the same). Remindthem that investment demand refers to the demand by firms (and households) for physical capitalgoods. By explicitly tackling this source of confusion, you can simultaneously explain whyinvestment and saving respond in opposite directions to a change in the interest rate.Why the interest rate is the opportunity cost of making an investment. An explicit numerical examplcan help to make this idea clear.Scenario 1 : The firm has no funds but can borrow any amount it chooses at an interest rate of 8percent a year. It can use the funds to invest in any or all of seven projects that have expected profirates shown in the table. (The interest component of cost has not been counted in calculating theexpected profit ratethat is, the expected profit rate is before paying interest.)Project Funds needed Expected profit rate

1 $200,000 252 $200,000 15

3 $200,000 104 $200,000 75 $200,000 56 $200,000 37 $200,000 1

Ask your class to say what the firm does.Get the students to Figure out and explain why the firm borrows $600,000 and invests in projects 12, and 3. It earns an expected profit of 17 percent on project 1, 7 percent on project 2, and 2 percenon project 3.Scenario 2 : Everything is the same as in Scenario 1 except that the firm has $1,400,000, which itcan use to invest in any or all of seven projects that have expected profit rates shown in the table.

Again, ask your class to say what the firm does.Get the students to Figure out and explain why the firm uses $600,000 of its funds to invest inprojects 1, 2, and 3.


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If necessary, modify the table as follows to get them to see that the firm can earn 8 percent by lendingthe remaining $800,000 to other firms.Project Funds needed Expected profit rate

1 $200,000 252 $200,000 153 $200,000 10

3A Any amount (+/) 84 $200,000 75 $200,000 56 $200,000 37 $200,000 1

Saving Decisions . The book is very clear on why the real interest rate, disposable income, wealth, andexpected future income should all influence saving and how. A potential problem is that brighterstudents who have fully understood substitution and income effects will see that an increase in thereal interest rate raises the opportunity cost of consumption now, but also raises current and expectedfuture disposable income for those with net financial assets, so the overall impact on saving istheoretically ambiguous. The best response is probably to simply assert that empirically we have

reason to believe that, in the United States at least, the substitution effect outweighs the incomeeffect and the saving supply schedule can be confidently presumed to be upward sloping, althoughperhaps fairly inelastic.

T h e B i g P i c t u r e

Where we have been

This chapter builds on the definitions and measurement of real GDP and the labor market, describedin Chapters 5 and 6. And it looks behind the aggregate supply curves described in Chapter 7. It alsouses the demand and supply model explained in Chapter 3. The chapter explains how fullemployment equilibrium real GDP, employment, real wage rate, the natural rate of unemployment,the capital stock, and the real interest rate are determined and looks at the forces that change them.

Where we are going:

Chapter 8 is the first of two chapters that explain aggregate supply and economic growth. Chapter 9explains the process of economic growth first encountered in Chapter 4 and then partially studied inthis chapter, Chapter 8. Chapters 8 is also useful as a foundation for the study of the business cycle.


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O v e r h e a d Tr a n s p a r e n c i e s

Transparency Text Figure Transparency title

45 Figure 8.1 Production Possibilities and the ProductionFunction

46 Figure 8.2 The Demand for Labor47 Figure 8.3 Marginal Product and the Demand for Labor48 Figure 8.4 The Supply of Labor49 Figure 8.5 The Labor Market and Potential GDP50 Figure 8.7 Investment Demand51 Figure 8.8 Saving Supply52 Figure 8.9 Equilibrium in the Capital Market

E l e c t r o n i c S u p p l e m e n t s

MyEconLab MyEconLabprovides pre- and post-tests for each chapter so that students can assess their ownprogress. Results on these tests feed an individualized study plan that helps students focus theirattention in the areas where they most need help.Instructors can create and assign tests, quizzes, or graded homework assignments thatincorporate graphing questions. Questions are automatically graded and results are tracked usingan online grade book.

PowerPoint Lecture Notes

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A d d i t i o n a l D i s c u s s i o n Q u e s t i o n s1. Does the marginal product of labor always show diminishing returns or is it possible that constant

even increasing returns might occur? Why or why not?

2. Unemployment is bad for the unemployed individual and bad for the nation. Hence the

government should force the unemployment rate to 0 percent. Comment on this assertion,discussing both its feasibility and its desirability.

3. How can the actual unemployment rate to be less than the natural unemployment rate?

4. If the demand for a firms product decreased, what would be the likely impact on the firms demanfor labor? Why?


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5. What is the difference between the real wage rate and the money wage rate?

6. Does an increase in the real wage rate shift the labor demand curve? Why or why not?

7. When labor becomes more productive, what happens to the equilibrium real wage rate and level ofemployment?

8. Why is the supply of labor curve so steep? What might explain the low responsiveness of the quantityof labor supplied to changes in the real wage rate?

9. Why does the arrival of more young workers into the labor force increase the natural unemploymentrate?

10. What is the argument that the minimum wage does not contribute to unemployment? What are therebuttals?

11. If it is made easier to immigrate to the United States, what should be expected to be the impact onpotential GDP and the real wage rate?

12. How would you expect an increase in the age at which workers qualify for full Social Securityretirement benefits to change the natural unemployment rate?

13. What is the opportunity cost of consumption and how does an increase in that opportunity costinfluence the allocation of income to consumption and saving?

14. Explain why and how investment depends on the real interest rate.

15. If the actual real interest rate differs from the equilibrium real interest rate, what forces drive the realinterest rate to the equilibrium real interest rate?

16. Suppose that capital equipment became more productive and hence more profitable. What happensto the real interest rate?

17. Suppose that people decide to increase their saving. What effect does this change have on theequilibrium quantity of investment? Why?

18. In a recession, the personal saving rate as a percentage of disposable income often goes up, but totalsaving goes down. Explain.

19. If you expected inflation to accelerate and were about to buy a house, would you want to take out afixed rate or a variable rate mortgage? Why?


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A n s w e r s t o t h e R e v i e w Q u i z z e s

Page 186 (page 558 in Economics )1. The leisure hoursreal GDPPPF shows the amount of possible real GDP that can be produced at

different amounts of leisure. The production function is the relationship between real GDP and theamount of labor employed. The amount leisure is related to the amount of labor. For each extra houof labor there is one less extra hour of leisure available. Therefore, the production function reversethe direction of the horizontal, x -axis in the diagram, and is like the mirror image of thePPF . RealGDP in the PPF decreases as more and more leisure leads to less and less real GDP and in theproduction function increases as more and more labor leads to more real GDP.

2. The bowed-out shape of the leisure hours-real GDPPPF shows that the opportunity cost of eachextra hour of leisure is increasing. This means that for each extra hour ever increasing amounts of GDP must be forgone. The reason for increasing opportunity cost is that the most productive laboris used first and as more labor is used it is increasingly less productive.

3. A rise in the real wage rate brings a decrease in the quantity demanded of labor because ofdiminishing returns in production. As more and more labor is employed, it is increasingly lessproductive. Firms seek to maximize profits, which means that they continue to employ labor as lonthe marginal product exceeds the real wage rate paid. The last hour of labor hired is that hour wher

the marginal product is equal to the real wage rate. If the real wage rate increases, the firm then finthat the marginal product of the last labor hour is less than the real wage rate. This decreases profitso the firm reduces the amount of labor it employs until once again the marginal product of the lashour of labor employed is equal to the real wage rate.

4. An increase in the real wage rate increases the quantity of labor supplied for two reasons: the averahours supplied per person increases; and the labor force participation rate increases.i. When the real wage rate increases, so does the opportunity cost of leisure, which means that

many households are willing to supply more labor. The households income increases, whichincreases the demand for normal goods, one of which is leisure time. This income effect issmaller for most households than the opportunity cost effect, so the average hours per personincreases.

ii. When the real wage rate increases, the relative value of other uses of time decreases. This mea

that more people who had previously chosen not to be part of the labor force because the real wage rate was less than the value of other uses of their time are now more likely to find the re wage rate higher than the value of their alternatives and chose to enter the labor force. The keyrelevant groups are most likely to be students, those keeping house full-time, and youngerretirees.

5. If the real wage rate is above or below the full-employment level there is a surplus or shortage of lthat then causes the real wage rate to adjust. For example, if the real wage rate is above the full-employment level, there is a surplus of labor. The real wage rate falls. If the real wage rate is belowthe full-employment level, there is a shortage of labor and the real wage rate rises. In either case, threal wage rate adjusts until the surplus or shortage is eliminated and the labor market is inequilibrium at full-employment.

6. Potential GDP is determined from the labor market equilibrium. When the labor market is inequilibrium, there is full employment. The amount of employment at full employment in turndetermines the amount of potential GDP via the production function.


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3. An increase in technology shifts the production function higher so that labor productivity increase As a result, the demand for labor increases, which leads to a higher real wage rate and an increase full employment. Potential GDP increases because the production function shifts upward andbecause full employment increases.


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1 9 0 C H A P T E R 8

A n s w e r s t o t h e P r o b l e m s1. a. The table shows Crusoes production function. It replaces leisure with labor and labor equals 12

hours a day minus leisure hours. The graph is similar to Fig. 8.1(b) on page 181 (Fig. 24.1(b) onpage 553 in Economics ). It plots labor on the x -axis and real GDP on the y -axis. As laborincreases from zero to 12 hours a day, real GDP increases from $0 to $30 a day.

Crusoes Production FunctionLabor Real GDP

(dollars per day) (dollars per day)

0 02 104 186 248 28

10 3012 30

b. When labor increases from 0 to 2 hours a day, the marginal product of labor is $5. When labor

increases from 2 to 4 hours a day, the marginal product of labor is $4. When labor increasesfrom 4 to 6 hours a day, the marginal product of labor is $3. When labor increases from 6 to 8hours a day, the marginal product of labor is $2. When labor increases from 8 to 10 hours a day,the marginal product of labor is $1. When labor increases from 10 to 12 hours a day, themarginal product of labor is $0. Marginal product is the change in real GDP divided by thechange in labor hours.

2. a. The table shows Nauticas production function. It replaces leisure with labor and labor equals100 hours a day minus leisure hours. The graph is similar to Fig. 8.1(b) on page 181 (Fig.24.1(b) on page 553 in Economics ). The graph plots labor on the x -axis and real GDP on the y -axis. As labor increases from zero to 100 hours a day, real GDP increases from $0 to $75 a day.

Nauticas Production FunctionLabor Real GDP

(hours per day) (dollars per day)

0 020 2540 4560 6080 70

100 75

b. When labor increases from 0 to 20 hours a day, the marginal product of labor is $25. Whenlabor increases from 20 to 40 hours a day, the marginal product of labor is $20. When laborincreases from 40 to 60 hours a day, the marginal product of labor is $15. When labor increasesfrom 60 to 80 hours a day, the marginal product of labor is $10. When labor increases from 80to 100 hours a day, the marginal product of labor is $5. Marginal product is the change in realGDP divided by the change in labor hours.

3. a. The demand for labor schedule is the same as the marginal product of labor schedule. Themarginal product of labor schedule is described in solution 1(b). The marginal product must bealigned with the midpoint of the change in labor. So, for example, the marginal product of $5


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an hour is aligned with 1 hour of work, the midpoint between 0 and 2 hours. The graph plots amarginal product of $5 at 1 hour and a marginal product of $1 at 9 hours of labor and is astraight line between these points. At 2 hours of labor, the marginal product is $4.50.

Crusoes Demand ScheduleReal wage rate Quantity of labor demanded

(dollars per hour) (hours per day)5.00 14.00 33.00 52.00 71.00 90.00 11

b. The table below lists hours of labor from zero to 12 a day. Against each hour, the wage rate at which Crusoe is willing to supply labor is $4.50 an hour. Crusoes supply curve is horizontal $4.50 an hour.

Crusoes Supply Schedule

Real wage rate Quantity of labor supplied(dollars per hour) (hours per day)

4.50 04.50 24.50 44.50 64.50 84.50 104.50 12

c. The full-employment equilibrium real wage rate is $4.50 an hour, and the quantity of laboremployed is 2 hours a day. The full-employment equilibrium real wage rate is $4.50 an hour

because Crusoe is willing to work any number of hours at this wage rate. The equilibrium leveof employment is 2 hours a day because this is the number of hours at which Crusoes marginproduct of labor is $4.50 an hour.

d. Potential GDP is $10 a day. Potential GDP is $10 a day because this quantity of real GDP isproduced when labor is 2 hours a day.


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1 9 2 C H A P T E R 8

4. a. The demand for labor is Nauticas marginal product. The marginal product of labor schedule isdescribed in solution 2(b). The marginal product must be aligned with the midpoint of thechange in labor. So, for example, the marginal product of $45 an hour is aligned with 10 hoursof work, the midpoint between 0 and 20 hours. The graph plots a marginal product of $45 at10 hours and a marginal product of $15 at 7 hours of labor and is a straight line between thesepoints. At 50 hours of labor, the marginal product is $25.

Nauticas Demand ScheduleReal wage rate Quantity of labor demanded(dollars per hour) (hours per day)

25 1020 3015 5010 705 90

b. The table below lists hours of labor from 10 to 70 a day. The wage rate at which people inNautica are willing to supply 10 hours of labor is $10 an hour. For each 50 cent increase in the

real wage rate, they are willing to supply an additional hour. So for each $5 increase in the real wage rate, the people of Nautica are willing to supply an additional 10 hours.

Nauticas Supply ScheduleReal wage rate Quantity of labor supplied

(dollars per hour) (hours per day)

10 1015 2020 3025 4030 5035 60

40 70c. The full-employment equilibrium real wage rate is $20 an hour, and the quantity of labor

employed is 30 hours a day. The full-employment equilibrium real wage rate is $20 an hourbecause at this wage rate 30 hours will be supplied; because when the marginal product of 30hours is $20, 30 hours will be demanded. Equilibrium is where the quantity demanded of laboris equal to the quantity supplied.

d. Nauticas potential GDP is a bit more than $700 a day. You know that at 20 hours of labor,Nautica produces $500 of real GDP and at 40 hours of labor, Nautica produces $900 of realGDP. At 30 hours of labor, Nautica can produce real GDP of a bit more than the midpoint of$500 and $900. (More because thePPF bows outward.)

5. a. Yes.b. Yes.

c. No.The firm receives a total revenue of $17 million. It spends $16 million ($10 million on theplant, $3 million on labor and $3 million on fuel). Before paying interest, the firm has a surplusof $1 million. If the interest rate is 5 percent a year, the interest cost is $0.5 million. If theinterest rate is 10 percent a year, the interest cost is $1 million. If the interest rate is 15 percent a


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year, the interest cost is $1.5 million. So the firm earns a profit at 5 percent, breaks even at 10percent, and incurs a loss at 15 percent. The firm will not invest to incur a loss.

6. a. Yes.b. Yes.c. No.

The firm receives a total revenue of $40 million. It spends $36 million. Before paying interestthe firm has a surplus of $4 million. If the interest rate is 5 percent a year, the interest cost onthe $36 million it invests in the project is $1.8 million. If the interest rate is 10 percent a year,the interest cost is $3.6 million. If the interest rate is 15 percent a year, the interest cost is $5.4million. So the firm earns a profit at 5 percent, earns a smaller profit at 10 percent, and incurs loss at 15 percent. The firm will not invest if it incurs a loss, which it will at an interest rate of15 percent.

7. a. The graph has saving on the x -axis and the interest rate on the y -axis. Three points are plotted at$10,000 and 4 percent; $12,500 and 6 percent; and $15,000 and 8 percent. The saving supplycurve passes through these points.

b. Saving decreases, and the saving supply curve shifts leftward.8. a. The graph has saving on the x -axis and the interest rate on the y -axis. Three points are plotted at

$10,000 and 4 percent; $15,000 and 6 percent; and $20,000 and 8 percent. The saving supplycurve passes through these points.

b. Saving decreases, and the saving supply curve shifts leftward.9. a. Potential GDP would decrease.

A crack down on illegal immigrants and millions of workers returned to their country of origin would decrease the supply of labor. The equilibrium quantity of labor would decrease. Fullemployment would decrease and potential GDP would decrease.

b. Employment would decrease. A crack down on illegal immigrants and millions of workers returned to their country of origin would decrease the supply of labor. The equilibrium quantity of labor would decrease.

c. The real wage rate would rise. When the supply of labor decreases, there is a movement up the demand for labor curve and threal wage rate rises.

10. a. Potential GDP would increase. A freeing up of immigration into the United States would increase the supply of labor. Theequilibrium quantity of labor would increase. Full employment would increase and potentialGDP would increase.

b. Employment would increase. A freeing up of immigration into the United States would increase the supply of labor. Theequilibrium quantity of labor would increase.

c. The real wage rate would fall. With no change in the demand for labor an increase in the supply of labor would create amovement up the demand for labor curve and the real wage rate would fall.

11. a. Potential GDP would increase. A increase in investment that increased productivity would increase the demand for labor. Theequilibrium quantity of labor would increase. Full employment would increase and potentialGDP would increase.

b. Employment would increase. A increase in investment that increased productivity would increase the demand for labor. Theequilibrium quantity of labor would increase.


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1 9 4 C H A P T E R 8

c. The real wage rate would rise. When the demand for labor increases, there is a movement up the supply of labor curve and thereal wage rate rises.

12. a. Potential GDP would decrease. A severe drought that brought a fall in productivity would decrease the demand for labor. Theequilibrium quantity of labor would decrease. Full employment would decrease and potentialGDP would decrease.

b. Employment would decrease. A severe drought that brought a fall in productivity would decrease the demand for labor. Theequilibrium quantity of labor would decrease.

c. The real wage rate would fall. When the demand for labor decreases, there is a movement down the supply of labor curve andthe real wage rate falls.

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