8 Potential GDP and the Natural Unemployment Rate CHAPTER EYE ONS Classical macroeconomics Great Depression Keynesian macroeconomics Union wage New macroeconomics Efficiency wage Demand of labor Union wage Supply of labor Production function Quantity of labor demanded Diminishing returns Quantity of labor supplied Job rationing Potential GDP Job search 2

CLASSICAL vs KEYNESIAN CLASSICAL KEYNESIAN MONETARISTS Agree with Classical View but add idea that fluctuations in the quantity of money influence the business cycle Slow in growth rate of money = recession Cause: large decrease in the quantity of money Fix: none Milton Friedman MARKETS ECONOMY GOVERNMENT DEPRESSION &HIGH UNEMPLOYMENT DISPUTED Great Depression Foundation Works Well Will Fluctuate and Growth will Slow Cannot Improve Market Performance Occur & Will Fix Itself Natural consequence In the 30’s, The Great Depression 25% unemployment 30% Decrease Prdxn Cause: natural Fix: none Popular until 1930’s Works but is Unstable Must Spend to Counteract Decreased Private Spending Occur when households and businesses do not spend enough on consumption and investment TWO Possible Problems: 1. Slow rate of RGDP Increase 2. Persistent Inflation Cause: too little consumer spending and investment Fix: Increase Govt Spending  that could cause worse problems in the future John Keynes, around 1930’s

But “In the long run we are all dead” KEYNESIAN ISSUES Slow rate of RGDP Growth Job creation is SLOW Short Term = Decrease in Unemployment Long Term = Increase in Unemployment Inflation 60’s saw increased inflation 70’s saw explosion of inflation 60’s & 70’s saw increased unemployment 60’s & 70’s saw Slow RGDP growth But “In the long run we are all dead”

NEW ECONOMIC THEORY- Today’s Consensus Each School of Thought Provides Insight Classical – during expansion (at/near full employment) Keynesian – during recessions When spending is cut and the demand for most goods, services, and labor all decrease, prices and wage rates don’t fall but the quantity of goods and services sold and the quantity of labor employed do fall and the economy goes into recession. In a recession, an increase in spending by governments, or a tax cut that leaves people with more of their earnings to spend, can help to restore full employment. Monetarists – Emphasizing that a contraction in the quantity of money brings higher interest rates and borrowing costs, which are a major source of cuts in spending that bring recession. Increasing the quantity of money and lowering the interest rate in a recession can help to restore full employment. And keeping the quantity of money growing steadily in line with the expansion of the economy’s production possibilities can help to keep inflation in check and can also help to moderate the severity of a recession. LT is more important than ST MACRO outcomes depend on MICRO choices Markets work well and adjust slowly to shocks Even a small slowdown in economic growth brings a huge cost in terms of a permanently lower level of income per person.

EYE ON US ECONOMY The Lucas wedge is equivalent to 6 years’ real GDP. During the 1960s, U.S. real GDP per person expanded at 2.9 percent a year. The red line shows the actual path of real GDP. The black line shows the path of real GDP if that growth rate has been maintained. The shaded wedge shows the lost output— equivalent to $284,500 per person. The Okun gap is equivalent to about 3 months’ real GDP. The red line shows the output gap—the percentage deviation of real GDP from potential GDP. When real GDP is below potential GDP, output is lost and the gap is negative. A negative gap is called an Okun gap. The Okun gap since the end of 1960 is equivalent to $12,850 per person. So smoothing the business cycle has a smaller payoff compared to the potentially huge payoff from restoring real GDP growth to its 1960s rate.

POTENTIAL GDP When is the economy at full employment? RGDP = Potential GDP What is potential GDP? The amount of GDP that would be produced if the economy were at full employment Can RGDP exceed PGDP? Yes, temporarily at the business cycle peak Why does RGDP = PGDP? Because they fluctuate around each other – mathematically they are equal. RGDP  is made by using ALL factors of production. Land, Capital, Entrepreneurship are constant Labor IS NOT constant  it depends on peoples choices THUS, RGDP depends on the quantity of labor employed

FUNDAMENTAL CAUSES OF UNEMPLOYMENT Job Search  Looking for a job The amount of Job Search depends on Demographic Change Unemployment Benefits Structural Change Job Rationing  RWR > equilibrium RWR may be above equilibrium because Efficiency Wage Minimum Wage Union Wage RWR > Equilibrium Rate  $QLD and #QLS  #Natural Unemployment Rate

POTENTIAL GDP Factors of Production Labor & Human Capital Physical Capital Land Entrepreneurship All Factors of Production are FIXED at any given point in time EXCEPT LABOR Labor employed depends on choices of people RGDP produced depends on quantity of labor employed Diminishing Returns Extra workers have less capital with which to work

FIRMS LABOR DEMAND $RWR = #QLD Quantity of Labor Demanded Demand for Labor $RWR = #QLD Movement along the curve Shift in the curve Change in Productivity

HOUSEHOLDS LABOR SUPPLY #RWR = #QLS Quantity of Labor Supplied Supply of Labor #RWR = #QLS Hrs/person # Labor Force Participation Rate # What matters to people is not the dollars they earn BUT What those dollars will buy!

GRAPH SHELLS RWR RWR LS1 LS LS2 LD2 LD1 LD LABOR LABOR CURVE SHIFTS: DEMAND SUPPLY RWR RWR LS1 LS LS2 LD2 LD1 LD LABOR LABOR CURVE SHIFTS: $ qty LS = $Wages (on y axis) $ LS = #income taxes $ LS = #unemployment benefits $ LS = $population CURVE SHIFTS: $ qty LD = #Wages (on y axis) $ LD = $Productivity

GRAPH RELATIONSHIP Notice Full Employment is achieved at EQUILIBRIUM Notice the two graphs LINE UP at Qty of Labor Employed When the economy is at Full Employment  RGDP = PGDP

LABOR MARKET – Natural Unemployment Rate Full Employment = Natural Unemployment Rate IF RWR > Equilibrium Rate  $QLD and #QLS  #Natural Unemployment Rate Main causes of unemployment at full Employment Job Search Demographic Change Unemployment Benefits Structural Change Job Rationing Efficiency Wage Minimum Wage Union Wage

EXERCISES Draw Labor Market graph Draw Production Function Table Quantity of labor demanded (billions of hours per year) 1 2 3 4 5 Real GDP (billions of 2000 dollars) 9 12 14 15 Real wage rate (2000 dollars per hour) Table Quantity of labor supplied (billions of hours per year) 1 2 3 4 5 Real wage rate (2000 dollars per hour) 1.50 2.00 2.50 3.00 3.50 4.00 Draw Labor Market graph Draw Production Function Show relationship between graphs What is the equilibrium real wage rate What is the equilibrium employment What is potential GDP Show the effect of a significant decrease in labor productivity on both graphs

EXERCISES Draw Labor Market graph Draw Production Function Table Quantity of labor demanded (billions of hours per year) 1 2 3 4 5 Real GDP (billions of 2000 dollars) 9 12 14 15 Real wage rate (2000 dollars per hour) Table Quantity of labor supplied (billions of hours per year) 1 2 3 4 5 Real wage rate (2000 dollars per hour) 1.50 2.00 2.50 3.00 3.50 4.00 Draw Labor Market graph Draw Production Function Show relationship between graphs What is the equilibrium real wage rate What is the equilibrium employment What is potential GDP Show the effect of a significant decrease in labor productivity on both graphs

EXERCISES $3 3 billion $12 billion Labor Demand Curve Shifts Left Table Quantity of labor demanded (billions of hours per year) 1 2 3 4 5 Real GDP (billions of 2000 dollars) 9 12 14 15 Real wage rate (2000 dollars per hour) Table Quantity of labor supplied (billions of hours per year) 1 2 3 4 5 Real wage rate (2000 dollars per hour) 1.50 2.00 2.50 3.00 3.50 4.00 $3 3 billion $12 billion Labor Demand Curve Shifts Left Production Function Curve Shifts down

EXERCISES The economy of Sweden has seen changes during the past 50 years, but the change has been steady and population growth has been modest. Sweden has high unemployment benefits, a high minimum wage, and strong labor unions. Use this information to answer 1 and 2. Does the unemployment that Sweden experiences arise primarily from job search or job rationing? Which of the factors listed suggest that Sweden has a higher natural unemployment rate than the United States and which suggest that Sweden has a lower natural unemployment rate than the United States? Does the unemployment that Sweden experiences arise primarily from job search or job rationing? High Unemployment benefits = increased job search High minimum wage & strong labor unions = job rationing Thus, not possible to determine Which of the factors listed suggest that Sweden has a higher natural unemployment rate than the United States and which suggest that Sweden has a lower natural unemployment rate than the United States? Lower  modest population growth Higher  All others

EXERCISES The figure illustrates the labor market on Sandy Island. In addition (not shown in the figure), a survey tells us that when Sandy Island is at full employment, people spend 1,000 hours a day in job search. Use this information to answer Exercises 3 and 4. Find the full-employment equilibrium real wage rate and quantity of labor employed and calculate the natural unemployment rate. If the government introduces a minimum wage of $4 an hour, how much unemployment is created? Find the full-employment equilibrium real wage rate and quantity of labor employed and calculate the natural unemployment rate. Equilibrium RWR = $3 Equilibrium employment = 3,000 hours per day (1000 / (1000+3000)) x 100 = 25% If the government introduces a minimum wage of $4 an hour, how much unemployment is created? 2000 hours per day

EXERCISES The following events occur in the United States one at a time: An oil embargo in the Middle East cuts supplies of oil to the United States. The Anaheim Angels win the World Series. U.S. labor unions negotiate wage hikes that affect all workers. A huge scientific breakthrough doubles U.S. labor productivity. Migration to the United States increases the working-age population. 1.Sort the items into four groups that Change: Production Function Supply of Labor Demand for Labor Do not Change any Shifts down  Oil embargo Shifts up  Scientific breakthrough Increases  increased migration Increases scientific breakthrough Inc. prdctvty world series, union negotiation Union negotion does increase QLS and decrease QLD

EXERCISES The following events occur in the United States one at a time: An oil embargo in the Middle East cuts supplies of oil to the United States. The Anaheim Angels win the World Series. U.S. labor unions negotiate wage hikes that affect all workers. A huge scientific breakthrough doubles U.S. labor productivity. Migration to the United States increases the working-age population. Which of the events increase the equilibrium quantity of labor and which decrease the equilibrium quantity of labor? Which of the events raise the real wage rate and which of the events lower the real wage rate? Which of the events increase potential GDP and which decrease potential GDP? Increase Eq. Qty Labor scientific breakthrough and increased migration Decrease Eq. Qty Labor  union negotiation higher wages Raise Eq. RWR  scientific breakthrough and union negotiation Lower Eq. RWR increased migration Increase PGDP  scientific breakthrough and increased migration Decrease PGDP  oil embargo and union negotiated wage increase

EXERCISES . What is the quantity of labor employed, potential GDP, the real wage rate, and total labor income? Suppose that the government introduces a minimum wage of $0.80 an hour. What is the real wage rate, the quantity of labor employed, potential GDP, and unemployment? Does the unemployment arise from job search or job rationing? Is the unemployment cyclical? Explain Labor hours (per day) Real GDP (dollars per year) 10 100 20 180 30 240 40 280 Real wage rate (dollars per hour) Quantity of labor demanded Quantity of labor supplied (hours per day) 1.00 10 50 0.80 20 40 0.60 30 0.40 RWR = $0.60/hr Eq. Qty Labor = 30 hrs/day PGDP = 240/yr RWR = $0.80/hr Qty Labor employed = 20 hrs/day PGDP = 180/yr Unemployment = 20 hrs per day due to job rationing from minimum wage

EXERCISES Tsunami Social Cost Yet to Come Relief experts estimate it could take up to a decade for some places to fully recover, and reconstruction will cost about $9 billion. ... An assessment by the Indonesian government estimated total damage from the tsunami at $4.5 billion to $5 billion. ... Housing, commerce, agriculture, fisheries, and transport vehicles and services suffered losses of $2.8 billion, or 63 percent of the total. CNN, 19 December 2005 Explain the effect of the tsunami on employment in Indonesia. Did Indonesia move along its production function or did its production function shift? How did Indonesia’s potential GDP change? Demand for Labor Decreased  decreased productivity Supply of Labor Decreased  Due to deaths Production function shifted down  due to destruction Production function moved downward  due to fall in employment PGDP decreases

FORMULAS Nominal Wage Rate Price Level RWR =

Why Do Americans Earn More and Produce More than Europeans? EYE on U.S. POTENTIAL GDP Why Do Americans Earn More and Produce More than Europeans? The quantity of capital per worker is greater in the United States than in Europe. U.S. technology, on the average, is more productive than European technology. These differences between the United States and Europe mean that U.S. labor is more productive than European labor. 25

Why Do Americans Earn More and Produce More than Europeans? EYE on U.S. POTENTIAL GDP Why Do Americans Earn More and Produce More than Europeans? Because U.S. labor is more productive than European labor, U.S. employers will pay more for a given quantity of labor than European employers will pay. 1. The U.S. demand for labor in lies to the right of the European demand for labor. 26

Why Do Americans Earn More and Produce More than Europeans? EYE on U.S. POTENTIAL GDP Why Do Americans Earn More and Produce More than Europeans? 2. Higher European income taxes and unemployment benefits mean that the European supply of labor lies to the left of the U.S. supply. 3. Americans work longer hours than Europeans. 4. The equilibrium real wage rate in the United States is higher than in Europe. 27

Why Do Americans Earn More and Produce More than Europeans? EYE on U.S. POTENTIAL GDP Why Do Americans Earn More and Produce More than Europeans? Because U.S. labor is more productive than European labor, the U.S. production function, lies above the European production function. 3. Americans work longer hours than Europeans. 5. Potential GDP is higher in the United States than in Europe. 28

The Lucas Wedge and the Okun Gap During the 1960s, U.S. real GDP per person expanded at 2.9 percent a year. The red line shows the actual path of real GDP. The black line shows the path of real GDP if that growth rate has been maintained. The shaded wedge shows the lost output— equivalent to $284,500 per person.

The Lucas Wedge and the Okun Gap The red line shows the output gap—the percentage deviation of real GDP from potential GDP. When real GDP is below potential GDP, output is lost and the gap is negative. A negative gap is called an Okun gap. The Okun gap since the end of 1960 is equivalent to $12,850 per person.

The Lucas Wedge and the Okun Gap Since the end of the 1960s when the growth rate of real GDP slowed: The Lucas wedge is equivalent to more than 6 years’ income. The Okun gap is equivalent to about 3 months’ income. So smoothing the business cycle has a smaller payoff compared to the potentially huge payoff from restoring real GDP growth to its 1960s rate.

Potential GDP in the United States and European Union In 2008, potential GDP per person in the United States was $44,000 (in 2005 dollars). In 11 major European economies, potential GDP per person was $32,000—a gap of 38 percent. Part (a) of the figure shows this large difference.

Potential GDP in the United States and European Union In the United States in 2008, the real wage rate was $34 an hour and in Europe, it was $29 an hour—a 17 percent gap. Part (b) of the figure shows this large difference. How can the average American produce 38 percent more than the average European but earn in wages only 17 percent more?

Potential GDP in the United States and European Union The answer is that Americans work more than Europeans. 1. 48 out of every 100 Americans have jobs compared with 46 out of every 100 Europeans. 2. Europeans work shorter hours than Americans—30.5 hours a week compared to the 34 hours that Americans work—a 12 percent difference shown in part (c).

Average Unemployment Rates over Six Decades If we look back at the U.S. economy decade by decade, we can see through the ups and downs of the business cycle and focus on the broad trends. By looking at the average unemployment rates across the decades, we get an estimate of the movements in the natural unemployment rate.

Average Unemployment Rates over Six Decades During the 1950s and 1960s, the unemployment rate averaged less than 5 percent.

Average Unemployment Rates over Six Decades During the 1970s and 1980s, the average unemployment rate climbed to more than 7 percent.

Average Unemployment Rates over Six Decades The 1990s and 2000s saw the average unemployment rate fall but not quite back to the rate of the 1950s and 1960s.

Average Unemployment Rates over Six Decades You will be a member of the labor force in the 2010s. The average unemployment rate of the second decade of the 2000s will have a big effect on your job market success.

Unemployment Benefits and the Natural Unemployment Rate Europe has much higher unemployment benefits than the United States. Are the higher unemployment benefits the source of Europe’s higher natural unemployment rate? To isolate the effects of unemployment benefits, we need to keep other things the same. Canada provides an experiment in which things are similar.

Unemployment Benefits and the Natural Unemployment Rate Before 1980, unemployment rates in the United States and Canada were similar.

Unemployment Benefits and the Natural Unemployment Rate The key change in the 1980s was an increase in Canadian unemployment benefits.

Unemployment Benefits and the Natural Unemployment Rate Almost 100 percent of Canada’s unemployed people receive benefits compared to 38 percent in the United States.

Unemployment Benefits and the Natural Unemployment Rate Unemployed benefits appears to have a large effect on the natural unemployment rate.

Unemployment Benefits and the Natural Unemployment Rate The gap narrowed after 2000 as cyclical unemployment rose less in Canada in the last two recessions.

The Federal Minimum Wage The Fair Labor Standards Act of 1938 set the federal minimum wage in the United States at 25¢ an hour. Over the years, the minimum wage has increased and in 2009 it was $7.25 an hour. Although the minimum wage has increased, it has not kept up with the rising cost of living.

The Federal Minimum Wage The figure shows the real minimum wage rate in 2005 dollars from 1959 to 2009.

The Federal Minimum Wage During the late 1960s, the minimum wage in 2005 dollars was $7.50 an hour.

The Federal Minimum Wage The minimum wage decreased during the 1970s and 1980s and has fluctuated around $6 an hour since the mid-1980s.

Natural Unemployment You will encounter natural unemployment at many points in your life. If you now have a job, you probably went through a spell of natural unemployment as you searched for it. When you graduate and look for a full-time job, you most likely will spend some more time searching for the best match for your skills and location preferences. In today’s world of rapid technological change, most of us must retool and change our jobs at least once and for many of us, more than once.

Natural Unemployment You might know an older worker who has recently lost a job and is going through the agony of figuring out what to do next. Although natural unemployment can be painful for people who experience it, from a social perspective, it is productive. It enables scarce labor resources to be re-allocated to their most valuable uses.