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    * * 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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    1 6 8 C H A P T E R 8

    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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    1 7 0 C H A P T E R 8

    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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    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 7 1

    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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    1 7 2 C H A P T E R 8

    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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    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 7 3

    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 balance