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Why do Americans earn more and produce more than Europeans?

© 2013 Pearson 24 When you have completed your study of this chapter, you will be able to 1 Explain what determines potential GDP. 2 Explain what determines the natural unemployment rate. CHAPTER CHECKLIST Potential GDP and the Natural Unemployment Rate

© 2013 Pearson MACROECONOMIC APPROACHES AND PATHWAYS  The Three Main Schools of Thought The three main approaches to macroeconomics are based on three schools of thought : Classical macroeconomics Keynesian macroeconomics Monetarist macroeconomics

© 2013 Pearson Classical Macroeconomics According to classical macroeconomics, the market economy works well and delivers the best available macroeconomic performance. Aggregate fluctuations are a natural consequence of an expanding economy with rising living standards. Government intervention can only hinder the ability of the market to allocate resources efficiently. MACROECONOMIC APPROACHES AND PATHWAYS

© 2013 Pearson Classical macroeconomics fell into disrepute during the 1930s, which was a decade of high unemployment and stagnant production throughout the world. Great Depression is a 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. MACROECONOMIC APPROACHES AND PATHWAYS

© 2013 Pearson Keynesian Macroeconomics According to Keynesian macroeconomics, the market economy is inherently unstable and it requires 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 led to the Great Depression. MACROECONOMIC APPROACHES AND PATHWAYS

© 2013 Pearson 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. The global recession of 2008–2009 and fear of another great depression revived interest in Keynesian ideas. MACROECONOMIC APPROACHES AND PATHWAYS

© 2013 Pearson MACROECONOMIC APPROACHES AND PATHWAYS Monetarist Macroeconomics According to monetarist macroeconomics, the classical view of the world is broadly correct, but in addition to fluctuations that arise from the normal functioning of an expanding economy, fluctuations in the quantity of money also generate the business cycle. A slowdown in the growth rate of money brings recession and a large decrease in the quantity of money brought the Great Depression.

© 2013 Pearson Milton Friedman was the most prominent monetarist. The view that monetary contractions are the sole source of recessions is held by few economists today. But the view that the quantity of money plays a role in economic fluctuations is accepted by all economists and is part of today’s consensus. MACROECONOMIC APPROACHES AND PATHWAYS

© 2013 Pearson  Today’s Consensus Each of the earlier schools provides insights and ingredients that survive in today’s consensus. Classical macroeconomics provides the story of the economy at or close to full employment. But the classical approach doesn’t explain how the economy performs in the face of a major slump in spending. MACROECONOMIC APPROACHES AND PATHWAYS

© 2013 Pearson Keynesian macroeconomics takes up the story in a recession or depression. When spending is cut and the demand for most goods and services and the demand for 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. MACROECONOMIC APPROACHES AND PATHWAYS

© 2013 Pearson Monetarist macroeconomics elaborates the Keynesian story by 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. MACROECONOMIC APPROACHES AND PATHWAYS

© 2013 Pearson Another component of today’s consensus is the view that the long-term problem of economic growth is more important than the short-term problem of recessions. Even a small slowdown in economic growth brings a huge cost in terms of a permanently lower level of income per person.  The Road Ahead We follow the new consensus and begin with an explanation of what determines potential GDP and the pace at which it grows. MACROECONOMIC APPROACHES AND PATHWAYS

© 2013 Pearson 24.1 POTENTIAL GDP Potential GDP is the value of real GDP when all the economy’s factors of production are fully employed. 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. But the quantity of labor is not fixed.

© 2013 Pearson 24.1 POTENTIAL GDP The quantity of labor employed depends on the choices of people and businesses. So real GDP produced depends 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.

© 2013 Pearson 24.1 POTENTIAL GDP  The Production Function Production function is a 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.

© 2013 Pearson 24.1 POTENTIAL GDP Figure 24.1 shows the production function. 100 billion hours of labor can produce $9 trillion of real GDP at point A.

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24.1 POTENTIAL GDP 300 billion hours of labor can produce $16 trillion of real GDP at point C. 200 billion hours of labor can produce $13 trillion of real GDP at point B. The production function PF is a limit to what is attainable.

© 2013 Pearson 24.1 POTENTIAL GDP The production function displays diminishing returns: The tendency for each additional hour of labor employed to produce successively smaller additional amounts of real GDP. The production function is a boundary between the attainable and the unattainable.

© 2013 Pearson 24.1 POTENTIAL GDP  The Labor Market The Demand for Labor Quantity of labor demanded is the total labor hours that all the firms in the economy plan to hire during a given time period at a given real wage rate.

© 2013 Pearson 24.1 POTENTIAL GDP Demand for labor is 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.

© 2013 Pearson 24.1 POTENTIAL GDP Figure 24.2 shows the demand for labor.

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24.1 POTENTIAL GDP 1. If the real wage rate rises from $50 to $80 an hour, the quantity of labor demanded decreases.

© 2013 Pearson 24.1 POTENTIAL GDP 2. If the real wage rate falls from $50 to $25 an hour, the quantity of labor demanded increases.

© 2013 Pearson 24.1 POTENTIAL GDP The Supply of Labor Quantity of labor supplied is the 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 labor is the relationship between the quantity of labor supplied and the real wage rate when all other influences on work plans remain the same.

© 2013 Pearson 24.1 POTENTIAL GDP Figure 24.3 shows the supply of labor.

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24.1 POTENTIAL GDP 1. If the real wage rate falls from $50 to $25 an hour, the quantity of labor supplied decreases.

© 2013 Pearson 24.1 POTENTIAL GDP 2. If the real wage rate rises from $50 to $75 an hour, the quantity of labor supplied increases.

© 2013 Pearson 24.1 POTENTIAL GDP The 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.

© 2013 Pearson 24.1 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.

© 2013 Pearson 24.1 POTENTIAL GDP Figure 24.4(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 $50 an hour. 3. Full-employment quantity of labor is 200 billion hours a year.

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24.1 POTENTIAL GDP Full Employment and Potential GDP When the labor market is in equilibrium, the economy is at full employment. When the economy is at full employment, real GDP equals potential GDP.

© 2013 Pearson 24.1 POTENTIAL GDP Figure 24.4(b) shows potential GDP. 1. When the full- employment quantity of labor is 200 billion hours a year, 2. Potential GDP is $13 trillion.

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24.2 THE NATURAL UNEMPLOYMENT RATE So far, we’ve focused on the forces that determine the quantity of labor employed. Now we look at what determines 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 search Job rationing

© 2013 Pearson 24.2 THE NATURAL UNEMPLOYMENT RATE  Job Search Job search is the activity of looking for an acceptable vacant job. The amount of job search depends on Demographic change Unemployment benefits Structural change

© 2013 Pearson 24.2 THE NATURAL UNEMPLOYMENT RATE Demographic Change An 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.

© 2013 Pearson 24.2 THE NATURAL UNEMPLOYMENT RATE Unemployment Benefits An 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.

© 2013 Pearson 24.2 THE NATURAL UNEMPLOYMENT RATE Structural Change Labor 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. As some industries contracted in the 1970s, labor turnover increased, job search increased, and the natural unemployment rate increased. Technological change can bring a structural boom, as it did during the 1990s.

© 2013 Pearson 24.2 THE NATURAL UNEMPLOYMENT RATE  Job Rationing Job rationing occurs when the real wage rate is above the full-employment equilibrium level. The real wage rate might be set above the full- employment equilibrium level for three reasons: Efficiency wage Minimum wage Union wage

© 2013 Pearson 24.2 THE NATURAL UNEMPLOYMENT RATE Efficiency Wage If 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 wage is a real wage rate that is set above the full-employment equilibrium wage rate to induce greater work effort.

© 2013 Pearson 24.2 THE NATURAL UNEMPLOYMENT RATE The Minimum Wage If the government sets a minimum wage above the equilibrium wage rate, unemployment results. Union Wage Labor unions operate in some labor markets and they agree a money wage rate with employers. Union wage is a wage rate that results from collective bargaining between a labor union and a firm.

© 2013 Pearson 24.2 THE NATURAL UNEMPLOYMENT RATE Job Rationing and Unemployment The 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.

© 2013 Pearson 24.2 THE NATURAL UNEMPLOYMENT RATE Figure 24.5 shows how job rationing increases the natural unemployment rate. 3. Increases the natural unemployment rate. 1. Decreases the quantity demanded—job rationing. 2. Increases the quantity of labor supplied. An efficiency wage rate

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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. Why Do Americans Earn More and Produce More than Europeans?

© 2013 Pearson 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 curve lies to the right of the European demand for labor curve. Why Do Americans Earn More and Produce More than Europeans?

© 2013 Pearson 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. Why Do Americans Earn More and Produce More than Europeans?

© 2013 Pearson 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. Why Do Americans Earn More and Produce More than Europeans?