# Macroeconomic Theory and its Application I

Document Sample

```					  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.
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
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.

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