2. 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

3. 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

4. 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”

5. 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.

6. 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.

7. 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

8. 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

9. 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

10. 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

11. 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!

12. 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

13. 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

14. 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

15. 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

16. 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

17. 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

18. 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

19. 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 / ( )) x 100 = 25%
If the government introduces a minimum wage of $4 an hour, how much unemployment is created?
2000 hours per day

20. 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

21. 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

22. 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

23. 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

24. FORMULAS
Nominal Wage Rate
Price Level
RWR =

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?
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

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?
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

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?
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

28. 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

29. 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.

30. 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.

31. 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.

32. 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.

33. 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?

34. 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).

35. 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.

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

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

38. 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.

39. 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.

40. 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.

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

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

43. 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.

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

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

46. 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.

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

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

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

50. 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.

51. 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.