Ch. 7. At Full Employment: The Classical Model
The relationship between the quantity of labor employed
and real GDP
What determines the full-employment level of
employment, real wage rate and potential GDP
What determines unemployment when the economy is at
full employment
How borrowing and lending decisions interact to
determine the real interest rate, saving, and investment
Use classical model to explain changes and international
differences in potential GDP and the standard of living
1
The Classical Model: A Preview
To understand macroeconomic performance, economists
distinguish between real variables and nominal variables.
Real variables measure quantities that tell us what is
happening to economic well-being—real GDP,
employment and unemployment, the real wage rate,
consumption, saving, investment, and the real interest
rate.
Nominal variables measure objects that tell us how dollar
values and the cost of living are changing—the price level,
the inflation rate, nominal GDP, nominal wage rate, and
the nominal interest rate.
The Classical Model: A Preview
The separation of macroeconomic performance into a real
part and a nominal part is the basis of the classical
dichotomy.
The classical dichotomy states:
At full employment, the forces that determine real variables
are independent of those that determine nominal variables.
The classical model is a model of an economy that
determines the real variables.
Real GDP and Employment
Production Possibilities
The production possibility frontier (PPF) is the boundary
between those combinations of goods and services that
can be produced and those that cannot.
To study the relationship between the quantity of labor
employed and real GDP, we begin with a special PPF: one
that shows the boundary between leisure and real GDP.
Real GDP and Employment
Time can be allocated to
leisure or to labor, which
produces real GDP.
The more leisure time
forgone, the greater is the
quantity of labor employed
and the greater is the real
GDP.
Real GDP and Employment
When 250 billion hours of
leisure are taken and 200
billion hours allocated to
labor, real GDP produced is
$12 trillion.
The opportunity cost of
each extra unit of real GDP
costs an increasing amount
of leisure forgone.
The PPF is bowed outward.
Real GDP and Employment
The production function
that corresponds to the
PPF above
Along the production
function, an increase in
labor hours brings an
increase in real GDP.
The Labor Market and Potential GDP
The labor market determines the labor hours employed.
The quantity of labor employed and the production
function determine the quantity of real GDP supplied.
The Demand for Labor
The quantity of labor demanded is the labor hours hired
by all firms in the economy.
The Labor Market and Potential GDP
The quantity of labor demanded depends on
1. The real wage rate
2. The marginal product of labor
Demand for Labor Curve
The demand for labor is the relationship between the
quantity of labor demanded and the real wage rate
when all other influences on hiring plans remain the
same.
The Labor Market and Potential GDP
The real wage rate is the quantity of good and services
that an hour of labor earns.
The money (nominal) wage rate is the number of
dollars an hour of labor earns.
Real wage = (Money wage rate ÷ GDP deflator) × 100.
The real wage rate, not the money wage rate,
determines the quantity of labor demanded.
The Labor Market and Potential GDP
Marginal Product of Labor
marginal product of labor is the additional real GDP
produced by an additional hour of labor when all other
influences on production remain the same.
law of diminishing returns
As the quantity of labor increases, and the quantity of
capital and technology remain the same, the marginal
product of labor decreases.
The Labor Market and Potential GDP
Marginal Product Calculation
Marginal product of labor is the change in real
GDP divided by the change in the quantity of
labor employed.
The marginal product of labor is the slope of
the production function.
The Labor Market and Potential GDP
Diminishing Marginal Product and the Demand for
Labor
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.
At this point, the profit-maximizing firm hires no more
labor.
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 quantity of labor supplied depends on
1. The real wage rate
2. The working-age population
3. The value of other activities
The Labor Market and Potential GDP
The Supply of Labor Curve
is the relationship between the quantity of labor supplied
and the real wage rate when all other influences on the
quantity of labor supplied remain the same.
The Labor Market and Potential GDP
The quantity of labor supplied increases as the real wage
rate increases for two reasons:
 Hours per person increase
 Labor force participation increases
The Labor Market and Potential GDP
Hours per Person
The real wage rate is the opportunity cost of not working,
so as the real wage rate rises, more people choose to
work.
But a higher real wage rate increases income, which
increases the demand for normal goods, including leisure.
An increase in the quantity of leisure demanded means a
decrease in the quantity of labor supplied.
The opportunity cost effect is usually greater than the
income effect, so a rise in the real wage rate brings an
increase in the quantity of labor supplied.
The Labor Market and Potential GDP
Labor Force Participation
Higher real wage rate induces some people who choose
not to work at lower real wage rates to enter the labor
force.
The response to a rise in the real wage rate is positive but
small.
As the real wage rate rises, a given percentage increase
in the real wage rate brings a small percentage increase in
the quantity of labor supplied.
The labor supply curve is relatively steep.
The Labor Market and Potential GDP
Labor Market Equilibrium
The labor market is in equilibrium at the real wage rate at
which the quantity of labor demanded equals the quantity
of labor supplied.
The Labor Market and Potential GDP
Potential GDP Not Physical Limit
Potential GDP is not the largest real GDP that the
economy cab produce.
Potential GDP is the real GDP produced when the
economy is at full employment.
Potential GDP is one point on the PPF.
Unemployment at Full Employment
When the economy is at full employment, unemployment
is always present for two broad reasons:
 Job search
 Job rationing
Job Search
Job search is the activity of looking for a suitable vacant
job.
The amount of job search depends on a number of factors,
one of which is the real wage rate.
Unemployment at Full Employment
The amount of job search unemployment changes over
time and the main sources are
 Demographic change
 baby boom
More women in labor force
 Structural change
New technologies eliminate some jobs, create others
 Unemployment compensation
Affects length of job search among unemployed
Job rationing
Minimum wage
Efficiency wage
Loanable Funds and the Real Interest Rate
Potential GDP depends on the quantities of factors of
production, one of which is capital.
The capital stock
• total quantity of plant, equipment, buildings, and
business inventories.
• determined by investment.
• the funds that finance investment are obtained in the
loanable funds market.
Loanable Funds and the Real Interest Rate
The Market for Loanable Funds
the market in which households, firms, governments, and
financial institutions borrow and lend.
The quantity of loanable funds demanded depends on
 The real interest rate
 Investment demand
expected profit rate (internal rate of return)
 Government deficit
Loanable Funds and the Real Interest Rate
The Real Interest rate and the Opportunity Cost of
Loanable Funds
The real interest rate is the quantity of goods and
services that a unit of capital earns.
The nominal interest rate is the number of dollars that a
unit of capital earns.
The real interest rate is approximately equal to the
nominal interest rate minus the inflation rate.
The real interest rate is the opportunity cost of loanable
funds.
Loanable Funds and the Real Interest Rate
The Demand for Loanable Funds Curve
Shows the relationship between the quantity of loanable
funds demanded and the real interest rate, ceteris
parabus.
•Changes in interest rate cause movements along curve
•Changes in other factors (e.g. investment demand,
government deficits) can shift the curve.
Loanable Funds and the Real Interest Rate
Supply of Loanable Funds
The quantity of loanable funds supplied depends on
 The real interest rate
 Disposable income
 Wealth
 Expected future income
 Government and international factors
Loanable Funds and the Real Interest Rate
The Supply of Loanable Funds Curve
is the relationship between the quantity of loanable funds
supplied and the real interest rate when all other
influences on lending plans remain the same.
Saving is the main item that makes up the supply of
loanable funds.
Using the Classical Model
The U.S. Economy Through the Eye of the Classical
Model
The U.S. economy was close to full employment in 2005.
It was also close to full employment in 1986.
The figures on the next slide illustrate the forces that
moved the economy from one full-employment equilibrium
to another.
Using the Classical Model
Advances in technology and
investment increased labor
productivity and increased
the demand for labor.
The population expanded
and increased the supply of
labor.
The real wage rate rose and
equilibrium employment
increased.
Using the Classical Model
The increase in labor
productivity shifted the
production function upwards
and …
the increase in equilibrium
employment increased
potential GDP.
Working with the classical model
Analyze effect of the following on real wages,
employment, real GDP and productivity.
• increase in immigration or population growth
•Technological improvements that enhance
productivity of labor
• Effect on real interest rates?
•Increased saving
•Effect on real interest rates?
•Larger government budget deficits
•Effect on real interest rates? (Ignore offsetting changes
in saving for now)