Chapter 6 The Full Employment Model

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Chapter 6The Full Employment Model
2
The Full-Employment Model

• In the long run, the U.S. economy creates jobs
  for all qualified workers.
• Full employment is possible if price, real wages
  and interest rates adjust to bring about an
  equilibrium in the labor, capital, and product
  markets.

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Nominal Wages, Price and Real Wages
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The Labor Market in the Full-Employment Model

• There are two distinct ways to think about this
  adjustment process.
• First, real wages, interest rates, and prices
  adjust quickly so that the labor, capital, and
  goods markets are always in equilibrium.
• Second, in the long run, real wages, interest
  rates, and prices adjust eventually.

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The Labor Demand Curve (a)

• The labor demand curve is downward sloping.

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The Labor Demand Curve (b)

• The labor demand curve is downward sloping for
  two reasons.
• First, labor is less expensive compared to other
  inputs.
• Second, labor is less expensive relative to the
  price of the output, so the value of labor's
  marginal product exceeds the wage.

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The Labor Supply

• The labor supply curve is vertical, or perfectly
  inelastic.
• An increase in the real wage has two effectsan
  income and a substitution effectthat work in
  opposite directions.
• The income effect a higher real wage makes
  workers better off, so workers want to buy more
  goods and leisure this means they supply less
  labor
• The substitution effect a higher real wage makes
  leisure more expensive
• In the U.S. labor market, the income and
  substitution effects almost exactly offset one
  another, so labor supply is constant when the
  real wage rises.

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Real Wage Matters to Workers

• Workers care about their real wage, not the
  nominal wage.
• w nominal wage amount of money workers get
  for working
• P aggregate price level (such as the CPI)
• The real wage is w/P the purchasing power
  workers get for working

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Wages and Price Levels

• If a worker's nominal wage doubles and all prices
  double, then w/P is constant and workers are no
  better or worse off.
• In the United States, aggregate real wages have
  been roughly constant since 1980, with a gradual
  decline in the early 1990s offset by a rise at
  the end of the 1990s.
• However, the average real wage in 2003 is only
  slightly above the average real wage in 1965.

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Shifts in the Labor Demand Curve

• The labor demand curve shifts to the right with
• An increase in the number or quality of machines
  workers use which increases workers' marginal
  productivity
• An improvement in technology which increases
  workers' productivity
• An increase in the price of machinery and
  equipment which makes labor relatively cheaper
• An overall expansion of the economy

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Effects of Changes in Investment and Technology
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Examples of Labor Supply Curve Shifts

• The labor supply curve shifts to the right with
• Increased immigration
• Increased labor force participation I.e. women
  since the 1970s

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The Labor Market Equilibrium in the 1990s

• The labor demand curve for skilled workers shifts
  to the right and the real wage paid to skilled
  workers increases.
• The labor demand curve for unskilled workers
  shifts to the left and the real wage paid to
  unskilled workers decreases.
• Technological change in the 1990s benefited
  skilled workers but hurt unskilled workers.

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The Labor Market Equilibrium in the 1990s (a)

• Information technologies during the 1990s
  increased the productivity of the skilled
  workers.
• However also decreased the demand for workers who
  could not use themunskilled workers.

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The Circular Flow of Income
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Product Market Equilibrium

• The equilibrium in the product, or goods, market
  depends on the adjustment of interest rates and
  equilibrium in the capital market.
• The full employment level of output, Yf, (or
  potential output) can be derived from the
  aggregate production function which gives the
  relationship between output and employment,
  holding technology and the capital stock fixed.

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The Short-Run Aggregate Production Function

• When employment increases output increases at a
  diminishing rate due to diminishing returns.
  Additional workers are less productive because
  they use less-productive machinery and equipment.
• In a full-employment economy, where all workers
  get jobs, they produce the full-employment level
  of output Yf.
• Yf is also potential GDP.

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Short-run Aggregate Production and Labor Market
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Equilibrium

• The entire output is eventually paid out to
  households as income.
• These income payments are just enough to buy all
  of the output.

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Investment

• Firms often spend more than they earn in order to
  purchase investment goods.
• To do this, they borrow funds.
• Investment is an injection into the spending
  stream.
• Equilibrium in the product market means leakages
  injections.
• Or savings investment
• How does savings come to equal investment?
• The real interest rate adjusts in the capital
  market so that the supply of savings equals the
  demand for savings, which is investment.

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Household Saving

• The capital market is the market for loanable
  funds.
• The supply of loanable funds is savings by
  households.
• Househols save
• For retirement
• For future consumption
• For emergencies
• For education for children
• To buy a new home or car
• Saving is a leakage from the expenditure stream.

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The Supply of Loanable Funds

• The savings, or supply of loanable funds, curve
  is vertical.
• An increase in r has no effect on savings
  because the substitution and income effects move
  in opposite directions and roughly offset one
  another.
• The income effect An increase in r means savers
  can achieve their savings goals by saving less
  which means they consume more.
• The substitution effect An increase in r rewards
  saving with greater returns, so households save
  more.

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Short-Run Loanable Funds Market
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Shifts in the Supply of Loanable Funds

• Household saving increases and the supply of
  loanable funds shifts right when
• After-tax income, or disposable income, Y T,
  rises
• That is, when Y, income, rises
• Or when taxes, T, fall

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The Demand for Loanable Funds

• Loanable funds are used to purchase new homes,
  new plants, machinery, and equipment.
• Investment, or the demand for loanable funds, is
  a downward sloping function of the interest rate.
• Firms invest if they expect the returns on adding
  extra capacity (i.e. profits) gt the costs of
  borrowing funds.
• The higher the real interest rate, the higher is
  the cost of funds and the lower is investment.

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Equilibrium in the Capital Market

• The interest rate adjusts so that S I, or
  leakages injections.
• This implies that the goods market is also in
  equilibrium.

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Demand Supply

• Demand consumption and investment (remember we
  are ignoring government and the foreign sector)
• Demand C I
• Supply is Yf, full-employment output
• Household income is divided between consumption
  and saving.
• C Sf which must equal output and income
• So Yf C Sf
• Or Sf Yf - C
• If in equilibrium leakages equal injections, Sf
  I.
• So I Yf - C
• Or C I Yf, which means Demand Supply

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The Introduction of PCs

• The real wage increases.
• The productivity of workers increases.
• Full-employment output increases, so aggregate
  income increases.
• Savings and investment increase.

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Women Enter the Work Force

• The participation of women in the labor force has
  increased since 1970.
• The real wage falls.
• Employment expands.
• Full-employment output income increases.
• Savings and investment increase while the real
  interest rate falls.