CHAPTER 6
Building Blocks of the Flexible-Price
Model
6-1
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Questions
• What is a full-employment analysis?
• What keeps the economy at full
employment when wages and prices
are flexible?
• What determines the level of
consumption spending?
• What determines the level of
investment spending?
6-2
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Questions
• What determines the level of net
exports?
• What determines the level of the
exchange rate?
6-3
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Full-Employment Analysis
• We will now look at the economy over
the short-run
– a period in which its productive
resources are fixed
• We will assume that wages and prices
are flexible so that all markets clear
– supply equals demand in the labor
market
– full-employment analysis
6-4
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Flexible-Price Model
• Two sets of factors determine the
levels of potential output and real
wages
– the production function
– the balance of supply and demand in the
labor market
6-5
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The Production Function
• Potential output (Y*) is determined by
– the size of the labor force (L)
– the economy’s capital stock (K)
– the efficiency of labor (E)
– a parameter indicating how quickly
returns to investment diminish ()

1 
Y*  (K) (LE)
6-6
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 6.1 - The Production Function
6-7
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Flexible-Price Model
• The assumption that wages and prices
are flexible was commonly made by
“classical” economists
• Thus, this assumption is often called
the classical assumption
– guarantees that markets work
– guarantees full employment
– guarantees that actual output is equal to
potential output
6-8
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Flexible-Price Model
• The flexible-price assumption is not
always a good one
– a market economy does not always
produce full employment
• The “Keynesian” model assumes that
wages and prices are sticky
– this will be covered in Section III of text
• The Classical assumption simplifies
the analysis of the economy
6-9
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Table 6.1 - Classical Flexible-Price versus
Keynesian Sticky-Price Analyses
6-10
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The Labor Market
• Assume there are K identical firms
– each firm owns one unit of the economy’s
capital stock
– each firm hires L workers and pays them
the same wage W
– each firm sells Y units of output at a perunit price of P
– no firm has control over the price it
receives or the wage it pays
• these are determined by the market
6-11
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The Labor Market
• To determine how many workers to
hire, the firm follows two rules
– hire workers to boost output
– stop hiring when the extra revenue from
the output hired by the last worker just
equals his or her wage
6-12
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The Labor Market
• The value of the output produced by
the last worker hired is the product
price (P) multiplied by the marginal
product of labor (MPL)
• The cost of hiring the last worker is
his or her wage (W)
• The firm will keep hiring until
P  MPL - W  0
6-13
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Labor Market
• The marginal product of labor is the
difference between what the firm can
produce with its current labor force
(Lfirm) and what it could produce if it
hired one more worker
• At its current labor force, the output
of the firm will be
Yfirm  F(1, L firm)
6-14
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Labor Market
• Therefore, the marginal product of
labor (MPL) must be equal to
MPL  F(1, L firm  1)  F(1, L firm)
6-15
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Figure 6.2 - The Firm’s Output as a Function
of the Firm’s Employment
6-16
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Labor Market
• Using the Cobb-Douglas form of the
production function
MPL  (K firm )  E1  (L firm  1)1   (K firm )  E1  (L firm )1 
• Since Kfirm=1
MPL  (1)  E1  (L firm  1)1   (1)  E1  (L firm )1 
MPL  E1  [(L firm  1)1   (L firm )1  ]
6-17
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The Labor Market
MPL  E1  [(L firm  1)1   (L firm )1  ]
• The term in the brackets is a growth
rate of a variable raised to a power
1 
[(L firm  1)
1 
 (L firm )
]  (1  ) 
1
(L firm )
(1  )E1 
MPL 

(L firm )
6-18
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The Labor Market
• The firm hires workers up to the point
where the product price multiplied by
the marginal product of labor equals
the wage
P  MPL - W  0
• Substituting for MPL
1- 
(1 - )E
P
(L firm )
6-19
W
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Figure 6.3 - The Typical Firm’s Hiring Policy
6-20
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The Labor Market
• The typical firm’s demand for labor is
L firm
 (1 - )E
 
 (W/P)
1- 
1 /



• Because there are K firms in the
economy, total economy-wide
employment will be
 (1 - )E
L  K
 (W/P)
d
6-21
1- 
1 /



Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Labor Market
• If there are more workers than firms
want to hire at the current wage
– some of the unemployed will underbid
their fellow employed workers
– those who are employed will respond by
accepting a lower wage to keep their jobs
– real wages will fall and firms will hire
more workers
6-22
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Labor Market
• If there are fewer workers than firms
want to hire at the current wage
– some firms will try to bid workers away
by offering higher wages
– the real wage will rise and firms will
reduce the quantity of labor demanded
• Equilibrium occurs in the labor market
when labor demand is equal to the
labor force
6-23
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 6.4 - Equilibrium in the Labor Market
6-24
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The Labor Market
• Equilibrium in the labor market means
that
 (1 - )E
L  L  K
 (W/P)
1- 
d
1 /



• This means that the equilibrium real
wage is equal to

W
Y
1-   K 
 [(1 - )E ]   (1 - ) 
P
L 
L 
6-25
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Labor Market
• When the labor market is in
equilibrium, the typical firm produces
an output level equal to
Yfirm  (1) (E)1- (L/K)1-
• Total output will be K multiplied by the
typical firm’s output
Y  K  Yfirm  (K) (E)1- (L)1-
6-26
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The Labor Market
Y  K  Yfirm  (K) (E)1- (L)1-
• Simplifying, we get the Cobb-Douglas
production function
Y  (K) (LE)1-  Y *
• If markets work well, the actual level
of output in the economy (Y) will be
equal to the economy’s potential
output (Y*)
6-27
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 6.5 - In a Full-Employment Economy,
Real GDP Equals Potential Output
6-28
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Domestic Spending
• National income can be divided into
four components
– consumption spending (C)
– investment spending (I)
– government purchases (G)
– net exports (NX)
C  I  G  NX  Y
6-29
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Figure 6.6 - The Four Components of
Spending Add Up to Real GDP
6-30
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Consumption Spending
• Households use income (Y) in three
ways
– pay net taxes (T)
• assume that T = t  Y, where t is an average
tax rate
• disposable income is equal to income minus
taxes [YD = Y-T = (1-t)Y]
– save (SH)
– consume (C)
D
H
H
C  Y -S  Y-T-S
6-31
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Figure 6.7 - From National Income to
Consumption Spending
6-32
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Consumption Spending
• Consumption spending can be broken
down into two components
– a baseline level of consumption (C0)
• the amount that households would spend on
consumption goods if they had no income
– a fraction of disposable income (Cy  YD)
• Cy is the marginal propensity to consume,
amount by which consumption spending rises
in response to a $1 increase in disposable
income
6-33
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Consumption Spending
D
C  C0  Cy  Y  C0  Cy  (1 - t)Y
• Consumption is assumed to be a
linear function of real GDP (Y)
• There are other factors that affect
consumption besides disposable
income
– assumed to affect baseline consumption
(C0) only
6-34
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 6.8 - Other Determinants of
Consumption Spending
6-35
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Consumption Spending
• Cy is the marginal propensity to
consume
• 0<Cy<1
– if incomes rise, households will use some
of their extra income to increase their
consumption spending
– as incomes rise, households will also
increase their saving
6-36
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 6.9 - The Consumption Function
6-37
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Consumption Spending
• Example
– the tax rate (t) = 25%, national income
(Y) = $10 trillion, the baseline level of
consumption (C0) = $2 trillion, and the
marginal propensity to consume (Cy) =
0.6
YD  (1 - 0.25)  $10 trillion  $7.5 trillion
C  $2 trillion  (0.6  $7.5 trillion)  $6.5 trillion
6-38
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Investment Spending
• Fluctuations in investment spending
have two sources
– the interest rate
• a higher real interest rate makes investment
projects more expensive and lowers
investment
– business managers’ and investors’
confidence
• the higher their confidence, the higher is
investment spending
6-39
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Investment Spending
• Firms invest because their managers
believe that the investment projects
will be profitable
– this means that the discounted returns
on the investments must be greater than
the investments’ costs
– the most relevant interest rate for
determining the profitability of an
investment is the long-term, real, risky
interest rate
6-40
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Investment Spending
• Investment spending has two
components
– the baseline level of investment (I0)
– the responsiveness of investment to
changes in the interest rate (Ir)
I  I0 - (Ir  r)
6-41
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 6.10 - The Investment Function
6-42
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Investment Spending
• Example
– the baseline level of investment (I0) = $2
trillion, the interest-sensitivity of
investment (Ir) = $10 trillion, and the
real interest rate = 5%
I  $2 trillion- ($10 trillion 0.05)  $1.5 trillion
6-43
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Investment Spending
• An alternative way of looking at
investment is to see the level of
investment as a function of the level
of the stock market
• The same things that determine the
value of the stock market also
determine the level of investment
– expected future profits (confidence)
– the real interest rate
6-44
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Government Purchases
• Government purchases (G) include
purchases of labor and other goods
and services by federal, state, and
local governments
• Government purchases do not include
transfer payments
– transfer payments are negative taxes
• Economists do not inquire into what
determines G (or the tax rate t)
6-45
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Figure 6.11 - Government Purchases,
Transfer Payments, and Taxes
6-46
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International Trade
• Net exports (NX) is the difference
between gross exports (GX) and
imports (IM)
NX  GX - IM
6-47
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 6.12 - Gross Exports, Imports, and
Net Exports
6-48
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Gross Exports
• The volume of gross exports (GX)
depends on two variables
– the real GDP of the country’s trading
partners (Yf )
– the real exchange rate ()
GX  (Xyf  Y f )  (X  )
– Xyf is the increase in exports generated
by an increase in foreign GDP
– X is the increase in exports from an
increase in the real exchange rate
6-49
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 6.13 - Gross U.S. Exports and the
Real Exchange Rate, 1980-1990
6-50
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Gross Exports
• In the real world, there are
substantial lags that occur between
changes in the real exchange rate and
changes in the level of gross exports
– a change in the real exchange rate this
year will have little or no effect on gross
exports this year, but will have effects on
gross exports one, two, and three years
into the future
6-51
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 6.14 - The J-Curve in the 1980s
6-52
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Gross Imports
• The value of demand for imports
depends on domestic real GDP (Y)
• The quantity of imports demanded
depends also on the real exchange
rate ()
– however, the value of imports is largely
independent of the real exchange rate
– gross imports will be a constant share of
real GDP
IM  IMy  Y
6-53
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Net Exports
• Net exports (NX) are the difference
between gross exports (GX) and
imports (IM)
NX  GX - IM  (Xyf  Y f )  (X  ) - (IMy  Y)
• Net exports depend on three things
– the real exchange rate ()
– the level of real GDP abroad (Yf )
– the level of real GDP at home (Y)
6-54
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Exchange Rate
• The lives of foreign exchange
speculators are ruled by fear and greed
– a higher U.S. interest rate means that an
individual can profit from buying U.S. bonds
• the greater this interest differential, the higher
the greed factor
– if the U.S. real exchange rate rises, profits
from holding U.S. bonds will be lower
• the higher the greed factor, the lower must be
the exchange rate in order for fear to offset the
greed
6-55
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Figure 6.15 - Greed and Fear in Foreign
Exchange Markets
6-56
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The Exchange Rate
• The real exchange rate is determined
by two components
– the average foreign exchange trader’s
opinion of what the exchange rate should
be if there was no interest differential (0)
– the sensitivity of the exchange rate (r) to
the interest rate differential between
domestic real interest rates (r) and
foreign real interest rates (rf )
  0 - [r  (r - r f )]
6-57
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Net Exports
NX  GX - IM  (Xyf  Y f )  (X  ) - (IMy  Y)
• Substituting in for the real exchange
rate, we get
NX  (Xyf  Y f )  (X  0 ) - (X  r  r)  (X  r  r f ) - (IMy  Y)
• Having the definition of net exports in
this form tells us directly how
domestic and foreign interest rates
affect net exports
6-58
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Summary
• When the economy is at full
employment, the level of real GDP is
equal to potential output--the level of
output generated by the aggregate
production function, given the current
stocks of labor and capital and the
current level of the efficiency of labor
6-59
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Summary
• When wages and prices are flexible,
the working of the labor market keeps
the economy at full employment
– if labor demand is less than the labor
force, falling wages raise employment
– if labor demand is greater than the labor
force, rising wages soon curb labor
demand
6-60
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Summary
• The level of consumption spending is
determined by many things, but the
most important of them is the level of
disposable income
• The level of investment spending is
primarily determined by business
managers’ degree of optimism and by
the real interest rate
6-61
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Summary
• The stock market is a useful indicator
of the likely future level of investment
spending because its value depends
on the same factors that determine
investment spending
– the general degree of optimism about
future profits
– the real interest rate
6-62
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Summary
• The exchange rate is determined by
two factors
– foreign exchange traders’ view of the
long-run equilibrium level of the
exchange rate
– the interest rate differential between
investments at home and abroad
6-63
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Summary
• The level of net exports has three
determinants
– the level of the exchange rate
– the level of real GDP at home
• determines the level of imports
– the level of real GDP abroad
• affects the level of exports
6-64
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.