2 8 PART 3 Potential GDP and the Natural Unemployment Rate THE REAL ECONOMY8Potential GDP and theNatural Unemployment RateCHAPTER
3 C H A P T E R C H E C K L I S TWhen you have completed your study of this chapter, you will be able toExplain the forces that determine potential GDP and the real wage rate and employment at full employment.1Explain the forces that determine the natural unemployment rate.2
4 MACROECONOMIC APPROACHES The Two Main Schools of ThoughtThe two main approaches to macroeconomics are based on two schools of thought:Classical macroeconomicsKeynesian macroeconomicsDon’t skip over the Lucas wedge and Okun gap material in the “Eye On the U.S. Economy.”
5 MACROECONOMIC APPROACHES Classical macroeconomicsA body of theory about how a market economy works and why it experiences economic growth and fluctuations.The classical view is that markets work well and deliver the best available macroeconomic performance.The economy will fluctuate, and growth will slow down from time to time.But no government remedy can improve the performance of the market.
6 MACROECONOMIC APPROACHES Classical macroeconomic fell into disrepute during the 1930s, which was a decade of high unemployment and stagnant production throughout the world.Great DepressionA decade (the 1930s) of high unemployment and stagnant production throughout the world economy.Classical macroeconomics predicted that the Great Depression would end but gave no method for ending it more quickly.
7 MACROECONOMIC APPROACHES Keynesian macroeconomicsA body of theory about how a market economy works that stresses it inherent instability and the need for active government intervention to achieve full employment and sustained economic growth.John Maynard Keynes, in his book “The General Theory of Employment, Interest, and Money,” began this school of thought.Keynes’ theory was that too little consumer spending and investment lead to the Great Depression.
8 MACROECONOMIC APPROACHES Keynes’ solution to depression and high unemployment was increased government spending.But Keynes predicted that his policy aimed at curing unemployment in the short term might increase it in the long term.This prediction became reality during the 1960s and 1970s, when inflation exploded, growth slowed, and unemployment increased.IT was time for another challenge to the mainstream: new macroeconomics
9 MACROECONOMIC APPROACHES The New MacroeconomicsNew macroeconomicsA body of theory about how a market economy works based on the view that macro outcomes depend on micro choices—the choices of rational individuals and firms interacting in markets.New classical macroeconomics incorporates the ideas of classical economists that markets work and new Keynesian macroeconomics incorporates the ideas of Keynesian economists that markets adjust slowly.
10 MACROECONOMIC APPROACHES The key difference between the two new schools is in their view of how quickly price and wages adjust in the face of excess demand or excess supply.But this difference is tiny, and a consensus is emerging.The Road AheadWe follow the new consensus and begin with an explanation of what determines real GDP and employment and the pace of economic growth.
11 8.1 POTENTIAL GDP Potential GDP The level of real GDP that the economy would produce if it were at full employment.We produce the goods and services that make up real GDP by using factors of production: labor and human capital, physical capital, land, and entrepreneurship.At any given time, the quantities of human capital, physical capital, land, entrepreneurship, and the state of technology are fixed.Students sometimes understand the definition of potential GDP but have a hard time seeing it in practice. You may want to spend some time comparing the United States to Europe using the Eye on the Global Economy box Potential GDP in the United States and Europe. If you talked about global differences in unemployment in chapter 21, discussing higher unemployment benefits and less flexible labor markets for France, Germany, and Italy, you can now use this information again to highlight how this determines differences in potential GDP. Use the Eye on the Global Economy box to describe the labor market differences. Mention that the higher unemployment benefits in Europe reduce the opportunity cost of job search. Together with differences in attitudes toward leisure, Europeans work an average of 28 hours per week compared to Americans’ 34 hours per week. Then link this discussion to the calculation of potential GDP. This will help to cement ideas that potential GDP is not some mythical number that is the same for each economy but that it depends on the underlying differences across countries, which include both labor market differences and productivity differences.
12 8.1 POTENTIAL GDPThe quantity of labor employed depends on the choices of people and businesses.So real GDP produced depend on the quantity of labor employed.To describe the relationship between real GDP and the quantity of labor employed, we use a relationship called the production function.
13 The Production Function 8.1 POTENTIAL GDPThe Production FunctionProduction functionA relationship that shows the maximum quantity of real GDP that can be produced as the quantity of labor employed changes and all other influences on production remain the same.
14 8.1 POTENTIAL GDP Figure 8.1 shows the production function. 100 billion hours of labor can produce $6 trillion of real GDP at point A.
15 8.1 POTENTIAL GDP200 billion hours of labor can produce $10 trillion of real GDP at point B.300 billion hours of labor can produce $12 trillion of real GDP at point C.The production function PF is a limit to what is attainable.
16 8.1 POTENTIAL GDPThe production function is a boundary between the attainable and the unattainable.The production function displays diminishing returns: The tendency for each additional hour of labor employed to produce successively smaller additional amounts of real GDP.
18 The Labor Market 8.1 POTENTIAL GDP Quantity of labor demanded The Demand for LaborQuantity of labor demandedThe total labor hours that all the firms in the economy plan to hire during a given time period at a given real wage rate.
19 8.1 POTENTIAL GDP Demand for labor The relationship between the quantity of labor demanded and real wage rate when all other influences on firms’ hiring plans remain the same.The lower the real wage rate, the greater is the quantity of labor demanded.
20 8.1 POTENTIAL GDPFigure 8.2 shows the demand for labor.
22 Quantity of labor supplied 8.1 POTENTIAL GDPThe Supply of LaborQuantity of labor suppliedThe number of labor hours that all the households in the economy plan to work during a given time period and at a given real wage rate.Supply of laborThe relationship between the quantity of labor supplied and the real wage rate when all other influences on work plans remain the same.
23 8.1 POTENTIAL GDPFigure 8.3 shows the supply of labor.
25 8.1 POTENTIAL GDPThe quantity of labor supplied increases as the real wage rate increases for two reasons:Hours per person increase as the real wage rate increases.The labor force participation rate increases as the real wage rate increases.
26 8.1 POTENTIAL GDP Labor Market Equilibrium A rise in the real wage rate eliminates a shortage of labor by decreasing the quantity demanded and increasing the quantity supplied.A fall in the real wage rate eliminates a surplus of labor by increasing the quantity demanded and decreasing the quantity supplied.If there is neither a shortage nor a surplus, the labor market is in equilibrium.
27 8.1 POTENTIAL GDP Figure 8.4(a) shows labor market equilibrium. 1. Full employment occurs when the quantity of labor demanded equals the quantity of labor supplied.2. Equilibrium real wage rate is $30 an hour.3. Full-employment quantity of labor is 200 billion hours a year.
29 8.1 POTENTIAL GDP Full Employment and Potential GDP When the labor market is in equilibrium, the economy is at full employment and real GDP equals potential GDP.
30 8.1 POTENTIAL GDP Figure 8.4(b) shows potential GDP. 1. When the full-employment quantity of labor is 200 billion hours a year,This is a good place to try to get students to start thinking about the current position of the economy and then tie back to this in future chapters. Ask students to think about what they know about the economy regarding GDP and unemployment. Ask them whether they think that the unemployment rate is above or below the natural rate of unemployment in the United States (in other words, is unemployment high or low right now relative to where it is usually at–have students think about discussions of unemployment they might have heard on the news or at home to make some conjectures here). Use this discussion to determine whether the United States is at potential GDP, or perhaps above it or below it.2. Potential GDP is $10 billion.
32 8.2 THE NATURAL UNEMPLOYMENT RATE So far, we’ve focused on the forces that determine the quantity of labor employed.Now we look at what determine the unemployment rate when the economy is at full employment?To understand the amount of frictional and structural unemployment that exists at the natural unemployment rate, economists focus on two fundamental causes of unemployment:Job searchJob rationingAsk your students how many of them would take a job 2,000 miles away if it paid 5 percent more (10 percent, 20 percent more). Explain that this is another kind of labor market rigidity. That is, as people marry and have children they begin to settle down in a community. They might have relatives close by and have developed long‐standing relationships. It is difficult to simply pull up stakes and move half way across the country to take a job offer. Another important point to get across is to convince students not to think about the unemployment rate as being a single number. Unemployment rates vary substantially across states and regions.You might get your students to use the BLS Web site to find the unemployment rate in selected major metropolitan areas and note the large variation.Pose the question: if job prospects are so good for some of the cities listed, then why aren’t workers migrating to them and away from the areas where labor market prospects are comparatively poorer like New York or Chicago?The answer: not everyone is willing to immediately pull up stakes and move.
33 8.2 THE NATURAL UNEMPLOYMENT RATE Job SearchJob searchThe activity of looking for an acceptable vacant job.The amount of job search depends onDemographic changeUnemployment benefitsStructural change
34 8.2 THE NATURAL UNEMPLOYMENT RATE Demographic ChangeAn increase in the proportion of the population that is of working age brings an increase in the entry rate into the labor force and an increase in the unemployment rate.This factor increased the unemployment rate during the 1970s and decreased it during the 1980s.
35 8.2 THE NATURAL UNEMPLOYMENT RATE Unemployment BenefitsAn unemployed person who receives no unemployment benefits faces a high opportunity cost of job search and has an incentive to keep job search brief.An unemployed person who receives generous unemployment benefits faces a lower opportunity cost of job search and has an incentive to search for longer.
36 8.2 THE NATURAL UNEMPLOYMENT RATE Structural ChangeLabor market flows and unemployment are influenced by the pace and direction of technological change.Technological change can bring a structural slump, as it did during the 1970s.Technological change can bring a structural boom, as it did during the 1990s.
37 8.2 THE NATURAL UNEMPLOYMENT RATE Job RationingJob rationingA situation that arises when the real wage rate is above the equilibrium level.The real wage rate might be set above the equilibrium level for three reasons:Efficiency wageMinimum wageUnion wage
38 8.2 THE NATURAL UNEMPLOYMENT RATE Efficiency WageIf a firm pays only the going market wage, employees have no incentive to work hard because they know that even if they are fired for shirking, they can find another job at a similar wage rate.So some firms pay an efficiency wage.Efficiency wageA real wage rate that is set above the full-employment equilibrium wage rate to induce greater work effort.
39 8.2 THE NATURAL UNEMPLOYMENT RATE The Minimum WageIf the government sets a minimum wage above the equilibrium wage rate, unemployment results.Union WageLabor unions operate in some labor markets and agree a wage with employers.Union wageA wage rate that results from collective bargaining between a labor union and a firm.
40 8.2 THE NATURAL UNEMPLOYMENT RATE Job Rationing and UnemploymentThe above-equilibrium real wage rate decreases the quantity of labor demanded and increases the quantity of labor supplied.If the real wage rate is above the full-employment equilibrium level, the natural unemployment rate increases.
41 8.2 THE NATURAL UNEMPLOYMENT RATE Figure 8.5 shows how job rationing increases the natural unemployment rate.An efficiency wage rate:1. Decreases the quantity demanded—job rationing.Where is unemployment in the demand-supply diagram? Thoughtful students often ask about the relationship between the (microeconomic-based) labor demand-labor supply model and unemployment. They can’t “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: work and job search.Working is supplying labor and this is the activity that the labor demand-supply model shows. The labor demand-supply model does not determine the quantity of job-search. People undertake job-search because workers have imperfect knowledge about available jobs and firms have imperfect information about job seekers.During the time spent on full-time job search, people are unemployed.Only if there were no uncertainty would the supply of job search (and unemployment) be zero. In such a case, a person out of work would not need to search for a new job. He or she would simply report to the new job on the day the worker knew that the job started! Thus, workers would never be unemployed because they would never search for jobs. Clearly, this happy state of affairs is not a description of reality.2. Increases the quantity of labor supplied.3. Increases the natural unemployment rate.
43 Natural Unemployment in YOUR Life You will encounter natural unemployment many times in your life.If you now have a job, you probably went through a spell of natural unemployment as you searched for that job.And when you graduate and look for a full-time job, you might spend some time searching for the best match for your skills and location preferences.You might know someone who has recently lost a job and is going through the agony of figuring out what to do next.Natural unemployment can be painful for unemployed people, but, from a social perspective, it enables scarce resources to be allocated to their most valuable uses.