neoclassical macroeconomics Full employment and the self- adjusting macroeconomy

neoclassical macro Assume to begin with, a pure market economy with no government and no foreign trade. We will also assume that labor demand is wage-elastic, but we can worry about that later. assume markets are perfectly competitive

unemployment Assume there is some unemployment due to an exogenous shock to the economy In neoclassical economics, if there is unemployment: labor supply (Ls) > labor demand (Ld) More workers are ready and willing to provide their labor services at the going wage rate than firms are ready and willing to hire.

the neoclassical labor market In neoclassical economics, when there is unemployment, we start with the labor market, which works similarly to the product markets in neoclassical theory, except that there is a special kind of good, called labor (L) or labor services, and a special kind of price, called the wage.

Labor Market w (real wage) L (Labor) Labor Supply (L s ) Labor Demand (L d ) w* L* (Ls = Ld) 0

neoclassical labor market When there is unemployment, labor supply is greater than labor demand, so the wage must be above the equilibrium level. Just as in neoclassical price theory, competition between and among the buyers and sellers will tend to push and pull the market toward the equilibrium.

Labor Market When Going Wage is Above Equilibrium Wage w (real wage) L (Labor) Labor Supply (L S ) Labor Demand (L D ) w* LD1LD1 LS1LS1 w1w1 0

Labor Market When Going Wage is Above Equilibrium Wage w (real wage) L (Labor) Labor Supply (L S ) Labor Demand (L D ) w* LD1LD1 LS1LS1 Excess Supply of Labor = L S 1 – L D 1 w1w1 0

equilibrating labor market There are unemployment people who want to work. Some offer to work for a little less than the wage, w 1, and when they do, firms increase their demand to hire by a little, and the supply contracts by a little. If there is still an excess supply of labor (unemployment) other unemployed workers will offer to work for a little less, and firms will increase their demand again.

neoclassical self-adjusting labor market This process continues until the wage reaches w*, and labor supply and labor demand are equal. Firms are able to buy exactly the amount of labor services they want at that wage rate, and everyone who is willing and able to work at that wage rate is working (full employment) The labor market returns to equilibrium

Labor Market w (real wage) L (Labor) Labor Supply (L s ) Labor Demand (L d ) w* L* (L s = L d ) 0

full employment More people are working, so more production is occurring, and more people are working so more people are earning income. Output and income increase by the same amount (national income accounting identity): Y (national output) = Y (national income)

Spending and sales Who is going to purchase the additional output produced by the newly employed workers, hired as a result of the fall in the wage?

Spending and sales Who is going to purchase the additional output produced by the newly employed workers, hired as a result of the fall in the wage? Some will be purchased by the newly employed workers, who will spend their new income on goods and services.

Spending and sales Who is going to purchase the additional output produced by the newly employed workers, hired as a result of the fall in the wage? Some will be purchased by the newly employed workers, who will spend their new income on goods and services. Will they buy all of it?

Income, spending, and sales Only if the newly employed all of their income will they purchase the new output in its entire. Some people, especially with lower incomes, spend all their income to live, but as a society, we normally (but not always) have some positive amount of savings (= income not spend).

Savings, (not) spending, and sales Savings is income not spent.

Savings, (not) spending, and sales Savings is income not spent. Savings is output not sold.

Savings, (not) spending, and sales Savings is income not spent. Savings is output not sold. Whatever the amount of savings is will correspond exactly to the same amount of output not sold. Firms will have excess inventories, and they will cut back output. When they cut back output, they lay off workers, and income and spending fall again.

full employment and business sales Businesses must have their level of output validated or justified by sales. They cannot continue to produce at a higher level of production unless they can sell that output. Otherwise, they will cut back output, and when they do, they no longer need as many workers.

savings and spending Even in an economy with no government and no foreign trade, there is another kind of spending besides consumption spending.

savings and spending Even in an economy with no government and no foreign trade, there is another kind of spending besides consumption spending. Investment

savings and spending Even in an economy with no government and no foreign trade, there is another kind of spending besides consumption spending. Investment Must look to the neoclassical analysis of savings and investment, or the loanable funds market.

Loanable Funds Market: savings function (supply of loanable funds) Interest Rate S, I S (Savings) i1i1 S 1 0

investment function: demand for loanable funds Interest Rate S, I I (Investment) i1i1 I1I1 0

Loanable Funds Market Interest Rate S, I S (Savings) I (Investment) i* S = I 0

Analyzing the loanable funds market An increase in savings resulting from an increase in income (rather than from a fall in the interest rate) means that the savings function (or supply of loanable funds curve) shifts out. Now, at the same old equilibrium rate of interest that used to equate savings and investment, savings is now higher.

Loanable Funds Market Shift in Savings Interest Rate S, I S1S1 I i1i1 I 1 S2S2 0 S2S2

Banks with excess currency to lend start lowering their interest rates to try to undersell their competition. As interest rates fall, investment demand increases, and savings contracts by a little bit. If there are still excess loanable funds, banks will cut interest rates again, and so on.

Loanable Funds Market Shift in Savings Interest Rate S, I S1S1 I i1i1 S 1 = I S2S2 S 2 = I i2i2 0

Neoclassical self-adjusting mechanism: necessary and sufficient conditions When S rises, interest rates fall, Investment increases, until: S = Yf Perfectly flexible wages, prices, and interest rates constitute the self-adjusting mechanism that ensures a tendency to full utilization of resources, including labor.

Necessary and sufficient conditions Perfectly flexible wage is a necessary but NOT sufficient condition for full employment. Must also have perfectly flexible interest rates. Another way of stating it: all markets, including factor markets, must be perfectly competitive.

Minimum Wage Above Equilibrium Wage Wage Quantity of Labor LSLS LDLD w* L D Min L S Min Unemployment = L S Min – L D Min Min. Wage 0

Minimum Wage Below Equilibrium Wage Wage Quantity of Labor LSLS LDLD w* L S Min L D Min Excess Demand = L D Min – L S Min Min. Wage 0