The economy at Full Employment Lecture notes 4 Instructor: MELTEM INCE

The Classical Model Economists have made progress in understanding how the economy works by dividing the variables that describe macroeconomic performance into two lists: Real variables Nominal variables Real variables like real GDP, employment, and the real wage rate describe what is happening to living standards Nominal variables like the price level and nominal wage rate tell us how dollar values and the value of money are changing.

The Classical Model The classical model is a model of the economy that determines the real variables—real GDP, employment and unemployment, the real wage rate, consumption, saving, investment, and the real interest rate—at full employment. Most economists believe that the economy is rarely at full employment but that the classical model provides a benchmark against which to measure the actual state of the economy.

The Labor Market and Potential GDP  The demand for labor  The supply of labor  Labor market equilibrium  Potential GDP

The Labor Market and Potential GDP The Demand for Labor  The quantity of labor demanded is the labor hours hired by all firms in the economy.  The demand for labor is the relationship between the quantity of labor demanded and the real wage rate, other things remaining the same.  The real wage rate is the quantity of good and services that an hour of labor earns.  The money wage rate is the number of dollars an hour of labor earns.

The Labor Market and Potential GDP  The demand for labor depends on the marginal product of labor, which is the additional real GDP produced by an additional hour of labor when all other influences on production remain the same.  The marginal product of labor is governed by the law of diminishing returns, which states that as the quantity of labor increases, but the quantity of capital and technology remain the same, the marginal product of labor decreases.

The Labor Market and Potential GDP The marginal product of labor curve is the demand for labor curve. Firms hire more labor as long as the marginal product of labor exceeds the real wage rate. With the diminishing marginal product of labor, the extra output from an extra hour of labor is exactly what the extra hour of labor costs, i.e. the real wage rate.

The Labor Market and Potential GDP The Supply of Labor  The quantity of labor supplied is the number of labor hours that all the households in the economy plan to work at a given real wage rate.  The supply of labor is the relationship between the quantity of labor supplied and the real wage rate, all other things remaining the same.

The Labor Market and Potential GDP The labor market is in equilibrium at the real wage rate at which the quantity of labor demanded equals the quantity of labor supplied. Labor market equilibrium is full-employment equilibrium. The level of real GDP at full employment is potential GDP.

Unemployment at Full Employment The unemployment rate at full employment is called the natural rate of unemployment. Unemployment always is present for two broad reasons  Job search  Job rationing

Unemployment at Full Employment Job search is the activity of workers looking for an acceptable vacant job. All unemployed workers search for new jobs, and while they search many are unemployed. The amount of job search unemployment changes over time and the main sources of these changes are  Demographic change  Unemployment compensation  Structural change

Unemployment at Full Employment Job rationing occurs when employed workers are paid a wage that creates an excess supply of labor. Job rationing can occur for two reasons  Efficiency wage  Minimum wage

Unemployment at Full Employment An efficiency wage is a real wage rate that is set above the full-employment equilibrium wage that balances the costs and benefits of this higher wage rate to maximize the firm’s profit. A minimum wage is the lowest wage rate at which a firm may legally hire labor.

Investment, Saving, and the Interest Rate Investment and Capital  The capital stock is the total amount of plant, equipment, buildings, and inventories, physical capital.  Gross investment is the purchase of new capital.  Depreciation is the wearing out of the capital stock.  Net investment equals gross investment minus depreciation, and net investment is the addition to the capital stock.

Investment, Saving, and the Interest Rate  The expected profit rate is relatively high during business cycle expansions and relatively low during recessions.Advances in technology can increase the expected profit rate.  The real interest rate is the opportunity cost of the funds used to finance investment.

Investment, Saving, and the Interest Rate Saving  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.

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

Investment, Saving, and the Interest Rate Saving is influenced by  The real interest rate  Disposable income  Wealth  Expected future income

Investment, Saving, and the Interest Rate Real Interest Rate The higher the real interest rate, the greater is a household’s opportunity cost of consumption and so the larger is the amount of saving. Disposable Income The higher the disposable income, the greater is a household’s saving. Wealth The greater is a household’s wealth, other things remaining the same, the greater is its consumption and the less is its saving. Expected Future Income The higher a household’s expected future income, the greater is its current consumption and the lower is its current saving.

Investment, Saving, and the Interest Rate

The Dynamic Classical Model Labor productivity is real GDP per hour of labor. Three factors influence labor productivity.  Physical capital  Human capital  Technology

The Dynamic Classical Model  Human capital is the knowledge and skill that has been acquired from education and on-the-job training.  Learning-by-doing is the activity of on-the-job education that can greatly increase labor productivity.

The Dynamic Classical Model Real GDP increases if  The economy recovers from a recession  Potential GDP increases Two factors that increase potential GDP are  An increase in population  An increase in labor productivity