CH. 8: THE ECONOMY AT FULL
EMPLOYMENT: THE CLASSICAL MODEL
• Describe the relationship between the quantity
of labor employed and real GDP
• Explain what determines
•the demand for labor
• the supply of labor
• employment, the real wage rate,
• productivity
• potential GDP
•Saving, Investment, and Interest rates
Objectives
–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
The Classical Model: A Preview
– The classical dichotomy
• At full employment, the forces that determine real
variables are independent of those that determine
nominal variables.
– The classical model
• A model of the economy that determines the real
variables at full employment.
Real GDP and Employment
– The PPF illustrates:
• Increasing marginal
opportunity cost
• Efficient versus
inefficient
• Unattainable
– An outward shift is
economic growth
• more resources
• improved technology
Production Function
• The Production Function
– the relationship between real GDP and the
quantity of labor employed, other things
remaining the same.
Production Function
• Marginal product of
labor
• Average product of
labor (productivity)
• Diminishing returns
to labor
• Upward shift of
production function
• human capital
• capital
• technology
Production Function
• Holding production function constant, if
employment increases, what is the effect on
marginal product, average product?
• If there is a technological advance shifting
production function upwards, what is the effect
on marginal product, average product?
The Labor Market
• Potential GDP is the level of GDP
produced if the economy is at full
employment.
• Determinants of potential GDP:
• The demand for labor
• The supply of labor
• The production function
– capital (human and physical)
– technology
The Labor Market
• The Demand for Labor
– marginal product of labor
• additional real GDP produced by an additional
hour of labor, ceteris paribus.
– law of diminishing returns,
• as the quantity of labor increases, the marginal
product of labor decreases, holding capital and
technology constant.
The Labor Market
The Labor Market
– The marginal
product of labor
is the slope of
the production
function.
– What does
LDMR imply
about
production
function?
The Labor Market
Because of the law
of diminishing
marginal returns,
the MP of labor
curve is downward
sloping.
The Labor Market
• A profit maximizing firm
will hire additional labor
until real wage = MP
• MP curve is labor
demand curve
• Demand vs. Quantity
demanded
The Labor Market
• Factors shifting labor demand
– human capital
– physical capital
– payroll taxes on employers
The Labor Market
• The Supply of Labor
– quantity of labor supplied
• the number of labor hours that all the households
in the economy plan to work at a given real wage
rate.
– supply of labor
• relationship between the quantity of labor supplied
and the real wage rate, all other things remaining
the same.
The Labor Market
– The higher the
real wage rate,
the greater is
the quantity of
labor supplied.
The Labor Market
• The quantity of labor supplied increases as the
real wage rate increases for two reasons:
– Hours per person increase
• While income and substitution effects work in
opposite directions, net effect is generally positive
in aggregate.
– Labor force participation increases
• Empirical evidence is that the labor supply
curve is fairly steep.
The Labor Market
• Factors shifting labor supply
–
–
–
–
–
population
immigration
taxes on wages received by employees
generosity of income support programs
home technology
The Labor Market
• Equilibrium
• If wage<equil
– Shortage
– Wage rises
• If wage>equil
– Surplus
– Wage falls
The Labor Market
• When the labor market is in equilibrium,
• the economy is at full employment
• natural rate of unemployment.
• frictional and structural, but no cyclical
unemployment
• no upward or downward pressure on real
wages.
• GDP = potential GDP
The Labor Market
• If wage rate > equilibrium:
• economy is below full employment
• unemployment > natural rate
• downward pressure on real wages.
• If wage rate < equilibrium
• Economy is beyond full employment
(over-heated)
• unemployment < natural rate
• upward pressure on real wages
The determinants of potential GDP
• How do each of the following affect
wages, employment, productivity, real
GDP?
– An increase in labor supply
– An increase in labor demand
– An upward shift in the production function
Increase in labor supply
Increase in labor demand
Upward shift in production function
Investment, Saving, and the
Interest Rate
• Capital stock
– total amount of plant, equipment, buildings,
and inventories, physical capital.
• Gross investment
– purchase of new capital.
• Depreciation
– wearing out of the capital stock.
• Net investment
– Gross Investment – depreciation.
Investment, Saving, and the
Interest Rate
• Business investment decisions are
influenced by
• The expected profit rate (internal rate of return)
• The real interest rate = nominal interest rate –
inflation rate
Investment, Saving, and the
Interest Rate
• The Expected Profit Rate
– “internal rate of return” is relatively high during
business cycle expansions and relatively low
during recessions.
– Advances in technology can increase the
expected profit rate.
– Taxes affect the internal rate of return
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.
Investment, Saving, and the
Interest Rate
• Investment Demand
– the relationship
between the level of
planned investment
and the real interest
rate.
Investment, Saving, and the
Interest Rate
• Factors shifting Investment Demand
– technological innovation
– taxes on investment income
– expected future profitability of
investments
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
– personal disposable income minus consumption
expenditure.
• Business saving
– retained profits and additions to pension funds by
businesses.
• Government saving
– government’s budget surplus.
• National saving
– sum of private saving and government saving.
• Any of these components can be negative.
Investment, Saving, and the
Interest Rate
• Why do people save?
•
Permanent income hypothesis.
– Permanent income = average income received per year over
life-time
– If a person wants to consumption smooth, can spend permanent
income each year for entire life.
• If current income > permanent income 
save
• If current income < permanent income 
dissave
• Young versus old?
•
Temporary decline in income?
Investment, Saving, and the
Interest Rate
• Saving Supply
– relationship between saving and the real
interest rate, other things remaining the same.
– As the real interest rate rises, the level of
saving increases.
• Substitution effect: save more
• Wealth effect
– Borrowers save more
– Savers save less
– Cancels out across borrowers and lenders.
Investment, Saving, and the
Interest Rate
• Factors shifting
savings curve:
• Disposable income
• Wealth
• Expected future
income
• Tax incentives
• Social Security
• Government budget
Investment, Saving, and the
Interest Rate
Equilibrium
Interest Rate
Investment, Saving, and the
Interest Rate
• Effect of each of the following on saving,
investment and interest rates:
– News that income will fall next year.
– Technological advance that creates new
profitable investment projects.
– Tax cuts on corporate profits.
– Personal income tax
– permanent versus temporary tax cut.
.5
.4
.3
Why is
investment more
volatile than
consumption?
.2
.1
.0
-.1
-.2
-.3
1970
1975
1980
% change in investment
1985
1990
1995
% change in consumption
Why is durable spending more volatile than nondurable spending?