CH. 8: THE ECONOMY AT FULL EMPLOYMENT: THE CLASSICAL MODEL Describe the relationship between the quantity of labor employed and real GDP Explain what determines the demand for labor the supply of labor employment, the real wage rate, productivity potential GDP Saving, Investment, and Interest rates This chapter provides the best coverage of the labor market’s link to the aggregate supply side of the economy of any introductory text on the market. It clearly explains to students how potential GDP is determined, what changes potential GDP and why there is ever-persistent unemployment in our economy. One way to motivate students in the study of the labor underpinnings of the macroeconomy is to address 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 12 months. Their answers provide an opportunity to work out the percentage change in their wages and then compare it to the percentage change in the CPI or GDP deflator. Use your own percentage increase in wages as an opening example if that’s not too depressing. If you’re 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, on average, do they think real wage rates are going up or down? These questions always generate some interest, particularly if you pose another question about the future trend of real wage rates. They also let you introduce the idea that in macroeconomics, we’re concerned with the averages and aggregates rather than the details of the distribution. You can move from these introductory ideas to set up the need for the model in this chapter.

Objectives Explain how business investment decisions and household saving decisions are made Explain how investment and saving interact to determine the real interest rate Use the classical model to explain the forces that change potential GDP

The Classical Model: A Preview The classical dichotomy At full employment, the forces that determine real variables are independent of those that determine nominal variables. The classical model A model of the economy that determines the real variables at full employment.

Real GDP and Employment The PPF illustrates: Increasing marginal opportunity cost Efficient versus inefficient Unattainable An outward shift is economic growth more resources improved technology

Production Function The Production Function the relationship between real GDP and the quantity of labor employed, other things remaining the same.

Production Function Marginal product of labor Average product of labor (productivity) Diminishing returns to labor Upward shift of production function human capital capital technology

Production Function Holding production function constant, if employment increases, what is the effect on marginal product, average product? If there is a technological advance shifting production function upwards, what is the effect on marginal product, average product?

The Labor Market Potential GDP is the level of GDP produced if the economy is at full employment. Determinants of potential GDP: The demand for labor The supply of labor The production function capital (human and physical) technology

The Labor Market The Demand for Labor marginal product of labor additional real GDP produced by an additional hour of labor, ceteris paribus. law of diminishing returns, as the quantity of labor increases, the marginal product of labor decreases, holding capital and technology constant.

The Labor Market

The Labor Market The marginal product of labor is the slope of the production function. What does LDMR imply about production function?

The Labor Market Because of the law of diminishing marginal returns, the MP of labor curve is downward sloping.

The Labor Market A profit maximizing firm will hire additional labor until real wage = MP MP curve is labor demand curve Demand vs. Quantity demanded

The Labor Market Factors shifting labor demand human capital physical capital payroll taxes on employers

The Labor Market The Supply of Labor quantity of labor supplied the number of labor hours that all the households in the economy plan to work at a given real wage rate. supply of labor relationship between the quantity of labor supplied and the real wage rate, all other things remaining the same. Labor supply. Your main goal in teaching this topic is to explain why in total, hours increase as the real wage rate increases. Again, drawing on the life experience of students with jobs whose work hours change from day to day or week to week can be useful. The two key points are: Even though some workers might have a backward-bending labor supply curves (playing golf on weekday afternoons when the wage rate rises enough), most have upward-sloping labor supply curves. The labor force participation rate increases as the real wage rate increases. These two features of individual behavior imply that the supply curve to labor in aggregate—the supply of aggregate hours—increases as the real wage rate rises, other things remaining the same.

The Labor Market The higher the real wage rate, the greater is the quantity of labor supplied.

The Labor Market The quantity of labor supplied increases as the real wage rate increases for two reasons: Hours per person increase While income and substitution effects work in opposite directions, net effect is generally positive in aggregate. Labor force participation increases Empirical evidence is that the labor supply curve is fairly steep.

The Labor Market Factors shifting labor supply population immigration taxes on wages received by employees generosity of income support programs home technology

The Labor Market Equilibrium If wage<equil If wage>equil Shortage Wage rises If wage>equil Surplus Wage falls

The Labor Market When the labor market is in equilibrium, the economy is at full employment natural rate of unemployment. frictional and structural, but no cyclical unemployment no upward or downward pressure on real wages. GDP = potential GDP

The Labor Market economy is below full employment If wage rate > equilibrium: economy is below full employment unemployment > natural rate downward pressure on real wages. If wage rate < equilibrium Economy is beyond full employment (over-heated) unemployment < natural rate upward pressure on real wages

The combination of the labor market equilibrium and the production function determine the potential level of GDP.

The determinants of potential GDP How do each of the following affect wages, employment, productivity, real GDP? An increase in labor supply An increase in labor demand An upward shift in the production function

Increase in labor supply

Increase in labor demand

Upward shift in production function

Investment, Saving, and the Interest Rate Capital stock total amount of plant, equipment, buildings, and inventories, physical capital. Gross investment purchase of new capital. Depreciation wearing out of the capital stock. Net investment Gross Investment – depreciation. Definitions and the meaning of investment in economics. The student has met the key definitions of this section in Chapter 19, but to be absolutely sure that they are remembered, this chapter repeats them. It is worth emphasizing that in economics, “capital” and “investment” without any qualification mean physical capital and purchase of newly produced physical capital goods. Everyday usage of investment as the purchase of stocks or bonds can lead to confusion. So it is worth getting these matters clear right from the start.

Investment, Saving, and the Interest Rate Business investment decisions are influenced by The expected profit rate (internal rate of return) The real interest rate = nominal interest rate – inflation rate Confusing saving and investment. Some of your students will confuse saving and investment. And this confusion will lead them to be puzzled by the slope of the investment demand curve. You can help all your students avoid this confusion by hitting it head on. Ask them the following question: “If the interest rate rises, I’m 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 ensuing discussion, get the students to see that placing funds in a savings account, stock market, or whatever, is saving, which does increase if the interest rate rises (other things remaining the same). Remind them that investment demand refers to the demand by firms (and households) for physical capital goods. By explicitly tackling this source of confusion, you can simultaneously explain why investment and saving respond in opposite directions to a change in the interest rate.

Investment, Saving, and the Interest Rate The Expected Profit Rate “internal rate of return” is relatively high during business cycle expansions and relatively low during recessions. Advances in technology can increase the expected profit rate. Taxes affect the internal rate of return because firms are concerned about after-tax profits.

Investment, Saving, and the Interest Rate The Real Interest Rate The real interest rate is the opportunity cost of the funds used to finance investment. Regardless of whether a firm borrows or uses its own financial resources, it faces this opportunity cost.

Investment, Saving, and the Interest Rate Investment Demand the relationship between the level of planned investment and the real interest rate.

Investment, Saving, and the Interest Rate Factors shifting Investment Demand technological innovation taxes on investment income expected future profitability of investments

Investment, Saving, and the Interest Rate Investment is financed by national saving and borrowing from the rest of the world. Saving is current income minus current expenditure, and in part finances investment. The U.S. saving rate. The low U.S. saving rate, described in this chapter, is very interesting to stuents. They are also intrigued by the low level of personal saving and the high level of business saving. It is worth emphasizing that part of the reason for the low personal saving rate is that payroll deductions for employment pension plans are business savings.

Investment, Saving, and the Interest Rate Personal saving personal disposable income minus consumption expenditure. Business saving retained profits and additions to pension funds by businesses. Government saving government’s budget surplus. National saving sum of private saving and government saving. Any of these components can be negative.

Investment, Saving, and the Interest Rate Why do people save? Permanent income hypothesis. Permanent income = average income received per year over life-time If a person wants to consumption smooth, can spend permanent income each year for entire life. If current income > permanent income  save If current income < permanent income  dissave Young versus old? Temporary decline in income? Volatility of saving versus consumption?

Investment, Saving, and the Interest Rate Saving Supply relationship between saving and the real interest rate, other things remaining the same. As the real interest rate rises, the level of saving increases. Substitution effect: save more Wealth effect Borrowers save more Savers save less Cancels out across borrowers and lenders.

Investment, Saving, and the Interest Rate Factors shifting savings curve: Disposable income Wealth Expected future income Tax incentives Social Security Government budget deficit Foreign savings

Investment, Saving, and the Interest Rate Equilibrium Interest Rate

Investment, Saving, and the Interest Rate Effect of each of the following on saving, investment and interest rates: News that income will fall next year. Technological advance that creates new profitable investment projects. Tax cuts on corporate profits. Personal income tax permanent versus temporary tax cut.

Why is investment more volatile than consumption?

Why is durable spending more volatile than nondurable spending?