Ch. 7. At Full Employment: The Classical
Model
 The relationship between the quantity of labor employed
and real GDP
 Determinants of potential GDP, employment, and real
wage rate
 Determinants of the natural rate of unemployment
 How borrowing and lending decisions 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
Real versus Nominal Variables
Real variables
•measure quantities independent of prices; Reflect a “base year”
set of prices.
•e.g. Real GDP, employment and unemployment, real wage rate,
consumption, saving, investment, and the real interest rate.
Nominal variables
•Measures reflecting current prices
•Nominal GDP, nominal wage rate, and the nominal interest rate.
The classical dichotomy
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.
Parts of the classical model
• Production Function
• Labor market
Labor demand
Labor supply
• Loan market
 Supply of loanable funds
 Demand for loanable funds
Production Function
•Shows relationship between
labor and real GDP
•Slope of line to origin =
productivity (output per labor
hour)
•Slope of tangent = marginal
product of labor
•Law of diminishing marginal
returns implies
MP decreases as L increases
PF flattens out as L
increases
Production Function
• Shifts in the production function caused by
More capital
More productive workers
Better technology
• Movements along production function
caused by changes in level of employment
The Labor Market and Potential GDP
Real wage rate
the quantity of good and services that an hour of
labor earns.
Money (nominal) wage rate
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 when
compared to MP of labor.
The Labor Market and Potential GDP
Labor Demand 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.
Marginal product of labor curve is same as labor demand
curve
 Firms will always hire workers if MP> real wage
 Profit maximizing firm hires until MP= real wage
The Labor Market and Potential GDP
Labor supply curve
shows quantity of labor supplied for each real wage rate.
Quantity of labor supplied increases as the real
wage rate increases for two reasons:
 Hours per person increase (assuming IE<SE)
Income effect (work less if real wage increases)
Substitution effect (work more if real wage increases)
 Labor force participation increases
If the U.S. allowed more immigration, the new
equilibrium in the labor market would result in _____
wages and ____ employment
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Higher; lower
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2.
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4.
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If there were technological innovations making labor
more productive, this would lead to ____ wages and
_____ employment
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14
A less generous welfare program would likely lead to
____ wages and _____ employment.
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Higher; lower.
Lower; lower.
Lower; higher.
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2.
3.
4.
30
15
Suppose that there more immigration is allowed
into the U.S. This will cause potential GDP to
_____ and productivity to ______.
25%
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Rise; rise.
Rise; fall.
Fall; rise.
Fall; fall
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1.
2.
3.
4.
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17
Suppose that there is new capital added to the
economy. This will cause potential GDP to _____
and real wages to ______.
25%
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Rise; rise.
Rise; fall.
Fall; rise.
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1.
2.
3.
4.
30
18
Loanable Funds, Investment and the Real
Interest Rate
Potential GDP depends on amounts of labor,
capital, and other resources.
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.
Demand for loanable funds
Demand for loan funds depends on
 The real interest rate = (nominal) interest rate inflation
 Investment demand
expected profit rate (internal rate of return)
Supply of Loanable Funds
 Supply of Loanable Funds Curve.
 Saving is the main item that makes up the supply of
loanable funds.
The quantity of loanable funds supplied depends on
 The real interest rate (moves along the curve)
 Disposable income
 Wealth
 Expected future income
 Government budget

Surplus increases supply of loans
 Foreign supply of loans to U.S.

Trade surplus
Suppose that households decide to save more
of their incomes. This should lead to
1. an increase in the supply
of loans and lower interest
rates.
2. An increase in the supply
of loans and higher
interest rates.
3. A decrease in the demand
for loans and lower
interest rates.
4. An increase in the
demand for loans and
higher interest rates.
33%
17%
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Suppose that households decide to save more
of their incomes. This should lead to
1. Lower interest rates and
more investment
2. Lower interest rates and
less investment
3. Higher interest rates and
more investment
4. Higher interest rates and
less investment.
33%
33%
23%
10%
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26
Suppose that the federal government increases
its budget deficit. This should lead to
1. an increase in the supply
of loans and lower interest
rates.
2. A decrease in the supply
of loans and higher
interest rates.
3. A decrease in the demand
for loans and lower
interest rates.
4. An increase in the
demand for loans and
higher interest rates.
30%
30%
23%
17%
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27
Suppose that the federal government increases
its budget deficit. This should lead to
1.
2.
3.
4.
Lower interest rates and less
investment
Lower interest rates and more
investment
Higher interest rates and less
investment
Higher interest rates more
investment.
25% 25% 25% 25%
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30
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