The Economy at Full Employment: The Classical Model

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The Economy at Full Employment The Classical
Model

• Chapter 3

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Teaching Assistant

• Mashiur Rahman
• Office Hours T Th 100 pm to 130 pm
• Office 555 Fletcher Argue Building

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Macroeconomic Model

• A description of how households, firms,
  governments and foreigners take decisions and how
  these decisions are coordinated in markets.

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• Endogenous Variables
• Variables whose values are determined by the
  model.
• Exogenous Variables
• Variables whose values are determined outside
  the model.

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Classical Model

• A classical model is a macroeconomic model that
  explains how Real GDP and other variables are
  determined at full employment.

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• A classical model have a long list of endogenous
  variables. They are of two types. Real and
  nominal.
• Real Variables real GDP, savings, investment and
  the real interest rate.
• Nominal Variables price level and money wage
  rate.
• Exogenous Variables state of technology, govt.
  expenditure, taxes and quantity of money.

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The Canadian Economy at Full Employment
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• It was very close at full employment in 1980,
  1981, 1987, 1990 and 1999
• Rows 2-4 show the real GDP, employment and the
  real wage rate at a full employment and all three
  increase over time.
• Investments increased over time.
• Real interest rate does not.
• Last three rows show the price level, inflation
  rate and the interest rate.
• Price level increases over time but opposite is
  true for inflation and rate of interest

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A Question to ask

• What determines the level of Real GDP,
  employment, and the real wage rate, investments,
  savings and the real interest rate, the price
  level, inflation and nominal interest rate?
• Objective is to determine the level of full
  employment, the real wage rate and real GDP at
  full employment (i.e. potential GDP)

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Approach objectives in four steps

• The short run production function
• The demand for labor
• The supply of labor
• Labor market equilibrium.

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The short run production function

• The relationship between the maximum attainable
  real GDP and the quantity of labor.
• Only labor is the variable input.
• Slope is the marginal product of labor.

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The Short Run Production function and the demand
for labor

• Slopes upward. Increase in labor increases the
  Real GDP.
• Slope when employment is at 25 bn hrs is the
  slope of the tangent (black line) at this
  employment level. It is equal to the hypotenuse
  of the triangle, 20 bn hrs.

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The Demand for Labor

• Demand for labor can be derived from the short
  run production function.
• Relationship between the quantity of labor
  employed and the real wage rate.

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• A profit maximizing firm at which the cost of
  last hour of labor employed brings in an equal
  amount of revenue.
• Employ labor till
• W(MP)P
• or, W/PMP i.e. marginal product is equal to the
  real wage rate
• The lower the real wage, greater the quantity of
  labor employed.

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Shifts in the Production Function and Demand for
Labor

• Capital accumulation and technological change
  shift the production function upward.
• At any level of output the MP of labor is now
  higher.
• Demand for labor increases.

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Supply of Labor

• Work versus other activities The real wage rate
  has two effects on the quantity of labor
  supplied- income effect and a substitution
  effect.
• Substitution effect encourages to work more.
• Income effect at low wage work more, but at very
  high wage work less. Thus ambiguous result. It
  gives us backward bending supply curve.

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• Work today versus work later
• Real interest rate plays a role.
• The opportunity cost of working today versus work
  later need to be considered.
• The labor supply curve
• The relationship between the quantity of labor
  supplied and the real wage rate.
• Its upward sloping

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Changes in the Supply of Labor

• Changes in population influence naturally.
• Higher real interest rate, greater the tendency
  to work today

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Labor market equilibrium and Potential GDP

• Labor market equilibrium determines the real wage
  and the level of employment.
• If real wage exceeds the equilibrium, then excess
  labor supply this brings wage down to its
  equilibrium level.
• If real wage is below equilibrium, then excess
  demand and the real wage rate goes up to its
  equilibrium level.

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• At equilibrium, there is neither an excess supply
  nor an excess demand.
• Potential GDP short run production function
  shows the relationship between real GDP and the
  quantity of labor employed. At the labor market
  equilibrium, employment is at its full employment
  level. And the quantity of real GDP produced by
  the full employment quantity of labor is
  potential GDP.