THE ECONOMY AT FULL
EMPLOYMENT: THE
CLASSICAL MODEL
24
CHAPTER
Objectives
After studying this chapter, you will able to
 Describe the relationship between the quantity of labor
employed and real GDP
 Explain what determines the demand for labor and the
supply of labor and how labor market equilibrium
determines employment, the real wage rate, and
potential GDP
Objectives
After studying this chapter, you will able to
 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
Our Economy’s Compass
Our economy follows a path like that of an explorer
probing new terrain.
Sometimes the explorer strays of course.
But the explorer has a compass that helps keep getting
back on the main track.
Our economy wanders around its main course—its full
employment trend—but like the explorer, has a compass
that keeps bringing it back.
The classical model is the compass and you’ll learn about
it in this chapter.
The Classical Model: A Preview
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: A Preview
The two lists of variables form the basis of a huge
discovery called the classical dichotomy, which states:
At full employment, the forces that determine real
variables are independent of those that determine
nominal variables.
For example, we can explain why real GDP in the United
States is 20 times that of Nigeria by looking only at real
variables. We don’t need to look at the price levels in the
two countries.
The Classical Model: A Preview
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.
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.
Real GDP and Employment
Figure 24.1(a) illustrates a
production possibility
frontier between leisure
time and 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
The PPF showing the
relationship between leisure
time and real GDP is bowedout, which indicates an
increasing opportunity cost.
Opportunity cost is
increasing because the most
productive labor is used first
and as more labor is used it
is increasingly less
productive.
Real GDP and Employment
The Production Function
The production function is the relationship between real
GDP and the quantity of labor employed, other things
remaining the same.
One more hour of labor employed means one less hour of
leisure, therefore the production function is the mirror
image of the leisure time-real GDP PPF.
Real GDP and Employment
Figure 24.1(b) illustrates
the production function
that corresponds to the
PPF shown in Figure
24.1(a).
Along the production
function, an increase in
labor hours brings an
increase in real GDP.
The Labor Market and Potential GDP
To understand how potential GDP is determined, we study:
 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
To calculate the real wage
rate, we divide the money
wage rate by the GDP
deflator and multiply by
100.
It is the real wage rate, not
the money wage rate, that
determines the quantity of
labor demanded.
Figure 24.2 shows a
demand for labor curve.
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
We calculate the marginal
product of labor as the
change in real GDP
divided by the change in
the quantity of labor
employed.
The Labor Market and Potential GDP
Figure 24.3 shows the
calculation of the marginal
product of labor and
illustrates the relationship
between the marginal
product curve and the
production function.
The Labor Market and Potential GDP
A 100 billion hour increase
in labor from 100 to 200
billion hours brings a $4
trillion increase in real
GDP—the marginal
product of labor is $40 an
hour.
The Labor Market and Potential GDP
A 100 billion hour increase
in labor from 200 to 300
billion hours brings a $3
trillion increase in real
GDP—the marginal
product of labor is $30 an
hour.
The marginal product of
labor is the slope of the
production function.
The Labor Market and Potential GDP
Figure 24.3(b) shows the
same information on the
marginal product curve,
MP.
At 150 (midway between
100 and 200), marginal
product is $40.
At 250 (midway between
200 and 300), marginal
product is $30.
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.
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 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
Figure 24.4 illustrates a
labor supply curve.
The higher the real wage
rate, the greater is the
quantity of labor supplied.
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 increase because the real wage rate is
the opportunity cost of not working.
But a higher real wage rates increase 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 increases because higher real
wage rates induce some people who choose not to work
at lower real wage rates to enter the labor force.
The labor supply response to an increase in the real wage
rate is positive but small.
A large 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
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.
The Labor Market and Potential GDP
Figure 24.5(a) illustrates
labor market equilibrium.
Labor market equilibrium
occurs at a real wage rate
of $35 and an employment
of 200 billion labor hours.
The Labor Market and Potential GDP
Potential GDP
At a full employment level
of 200 billion hours,
potential GDP is 10 trillion
dollars.
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
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.
Unemployment at Full Employment
Figure 24.6 illustrates the
relationship between the
amount of job search
unemployment and the
real wage rate.
Unemployment at Full Employment
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
Demographic change
As more young workers entered the labor force in the
1970s, the amount of frictional unemployment increased
as they searched for jobs.
Frictional unemployment may have fallen in the 1980s as
those workers aged.
Two-earner households may increase search, because
one member can afford to search longer if the other has
an income.
Unemployment at Full Employment
Unemployment compensation
The more generous unemployment benefit payments
become, the lower the opportunity cost of unemployment,
so the longer workers search for better employment rather
than any job.
More workers are covered now by unemployment
insurance than before, and the payments are relatively
more generous.
Unemployment at Full Employment
Structural change
An increase in the pace of technological change that
reallocates jobs between industries or regions increases
the amount of search.
Unemployment at Full Employment
Job Rationing
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.
The cost of a higher wage is direct.
The benefit of a higher wage is indirect: it enables a firm to
attract high-productivity workers, stimulates greater work
effort, lowers the quit rate, and lowers recruiting costs.
Unemployment at Full Employment
A minimum wage is the lowest wage rate at which a firm
may legally hire labor.
If the minimum wage is set below the equilibrium wage
rate, it has no effect.
If the minimum wage is set above the equilibrium wage
rate, it does affect the labor market.
Unemployment at Full Employment
Job Rationing and Unemployment
If the real wage rate is above the equilibrium wage,
regardless of the reason, there is a surplus of labor that
adds to unemployment and increases the natural
unemployment rate.
Most economists agree that efficiency wages and
minimum wages increase the natural unemployment rate.
David Card and Alan Krueger have challenged this view
and argue that an increase in the minimum wage works
like an efficiency wage, making workers more productive
and less likely to quit.
Unemployment at Full Employment
Dan Hamermesh argues that firms anticipated increases
in the minimum wage and cut employment before the
minimum wage increased.
Therefore, looking at the effects of minimum wage
changes after the change occurs misses the effects—an
example of the post hoc fallacy.
Finis Welch and Kevin Murphy say Card and Krueger
failed to take into account some regional differences in
economic growth that hide the effects of the change in the
minimum wage—an example of ceteris paribus not
holding.
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
Investment Decisions
Business investment decisions are influenced by
 The expected profit rate
 The real interest rate
Investment, Saving, and the Interest Rate
The Expected Profit 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.
Taxes affect the expected profit rate 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.
Either it pays the interest or it forgoes interest on its own
funds.
Investment, Saving, and the Interest Rate
Investment Demand
Investment demand is
the relationship between
the level of planned
investment and the real
interest rate.
Figure 24.7 illustrates an
investment demand curve.
Investment, Saving, and the Interest Rate
The investment demand
curve slopes downward.
A fall in the real interest
rate increases planned
investment along
investment demand curve.
A rise in the real interest
rate decreases planned
investment along
investment demand curve.
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.
Any of these components can be negative.
National saving is the sum of private saving and
government saving.
Households divide their disposable income between
consumption expenditure and 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.
Investment, Saving, and the Interest Rate
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
Saving Supply
Saving supply is the
relationship between
saving and the real interest
rate, other things
remaining the same.
Figure 24.8 shows a
saving supply curve, which
slopes upward.
Investment, Saving, and the Interest Rate
A fall in the real interest
rate decreases saving.
A rise in the real interest
rate increases saving.
Investment, Saving, and the Interest Rate
Determining the Real
Interest Rate
The real interest rate is
determined by investment
demand and supply of
savings.
In Figure 24.9, ID is the
investment demand curve.
SS is the supply of saving
curve.
Investment, Saving, and the Interest Rate
If the interest rate is above
its equilibrium level, SS
exceeds ID.
There is a surplus of funds
and the interest rate falls.
If the interest rate is below
its equilibrium level, ID
exceeds SS.
There is a shortage of
funds and the interest rate
rises.
Investment, Saving, and the Interest Rate
The equilibrium real
interest rate is 6 percent.
At the equilibrium real
interest rate, there is
neither a shortage nor
surplus of saving.
The Dynamic Classical Model
Changes in Productivity
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
Shifts in the Production Function
Any influence that increases labor productivity increases
real GDP at each level of labor hours and shifts the
production function upward.
An increase in physical capital, human capital, or a
technological advance all increase labor productivity.
The Dynamic Classical Model
Figure 24.10 illustrates in
increase in labor
productivity. The
production function shifts
upward from PF0 to PF1.
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
The Dynamic Classical Model
An Increase in Population
An increase in population increases the supply of labor.
The equilibrium real wage rate falls and the equilibrium
quantity of labor increases.
The increase in the equilibrium quantity of labor increases
potential GDP.
The potential GDP per hour of work decreases.
The Dynamic Classical Model
Figure 24.11(a) illustrates
these effects in the labor
market.
The Dynamic Classical Model
Potential GDP increases.
Potential GDP per hour of
work decreases.
Initially, potential GDP per
hour of work was $50--$10
trillion divided by 200
billion.
In the new equilibrium,
potential GDP per hour of
work is $43.33--$13 trillion
divided by 300 billion.
The Dynamic Classical Model
An Increase in Labor Productivity
Three factors increase labor productivity
 An increase in physical capital
 An increase in human capital
 An advance in technology
An increase in labor productivity shifts the production
function upward and increases the demand for labor.
The equilibrium real wage rate, quantity of labor, and
potential GDP all increase.
The Dynamic Classical Model
Figure 24.12(a) illustrates
these effects.
The labor demand curve
shifts rightward.
The real wage rate rises.
The equilibrium quantity of
labor increases.
The Dynamic Classical Model
Figure 24.12(b) shows the
change in the production
function.
The production function
shifts upward and the
quantity of labor employed
increases.
Both changes increase
potential GDP.
The Dynamic Classical Model
Population and Productivity in the United States
Population and productivity in the United States have
increased over time.
Between 1981 and 2001, both years close to full
employment:
 The working age population increased from 170 million
to 212 million–a 25 percent increase.
 Labor hours increased from 159 billion to 231 billion—a
45 percent increase.
The Dynamic Classical Model
Population and productivity in the United States have
increased over time.
Between 1981 and 2001, both years close to full
employment:
 The capital stock increased from $15 trillion (1996
dollars) to $25 trillion—a 67 percent increase.
 Technology advanced—most notably the information
revolution and the widespread computerization of
production processes.
The Dynamic Classical Model
The percentage increase in labor hours exceeded the
percentage increase in the population because the
increase in capital and technological advances increased
labor productivity, which increased the real wage rate,
which in turn increased the labor force participation rate.
THE END