Macroeconomic Theory and its Application I

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Macroeconomic Theory and its Application I Powered By Docstoc
					  The Economy at Full
Employment: The Classical
        Model

        Chapter 3
Teaching Assistant

Mashiur Rahman

Office Hours: T & Th: 1:00 pm to
 1:30 pm

Office: 555 Fletcher Argue Building
Macroeconomic Model

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

 Variables whose values are
 determined by the model.

Exogenous Variables:

 Variables whose values are
 determined outside the model.
Classical Model:


  A classical model is a macroeconomic
  model that explains how Real GDP and
   other variables are determined at full
               employment.
 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.
The Canadian Economy at Full
Employment:
   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
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)
Approach objectives in four
steps:


   The short run production function
   The demand for labor
   The supply of labor
   Labor market equilibrium.
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.
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.
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.
 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/P=MP i.e. marginal product is

        equal to the real wage rate
 The lower the real wage, greater the

  quantity of labor employed.
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.
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.
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
Changes in the Supply of Labor:

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