Transcript Chapter 23

© 2013 Pearson
Why do Americans earn more and
produce more than Europeans?
© 2013 Pearson
24
Potential GDP and the
Natural Unemployment Rate
CHAPTER CHECKLIST
When you have completed your
study of this chapter, you will be able to
1 Explain what determines potential GDP.
2 Explain what determines the natural unemployment rate.
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MACROECONOMIC APPROACHES AND PATHWAYS
The Three Main Schools of Thought
The three main approaches to macroeconomics are based
on three schools of thought:
• Classical macroeconomics
• Keynesian macroeconomics
• Monetarist macroeconomics
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MACROECONOMIC APPROACHES AND PATHWAYS
MACROECONOMIC APPROACHES AND PATHWAYS
Classical Macroeconomics
According to classical macroeconomics, the market
economy works well and delivers the best available
macroeconomic performance.
Aggregate fluctuations are a natural consequence of an
expanding economy with rising living standards.
Government intervention can only hinder the ability of
the market to allocate resources efficiently.
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MACROECONOMIC APPROACHES AND PATHWAYS
MACROECONOMIC APPROACHES AND PATHWAYS
Classical macroeconomics fell into disrepute during the
1930s, which was a decade of high unemployment and
stagnant production throughout the world.
Great Depression is a decade (the 1930s) of high
unemployment and stagnant production throughout the
world economy.
Classical macroeconomics predicted that the Great
Depression would end but gave no method for ending it
more quickly.
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MACROECONOMIC APPROACHES AND PATHWAYS
Keynesian Macroeconomics
According to Keynesian macroeconomics, the
market economy is inherently unstable and it requires
active government intervention to achieve full
employment and sustained economic growth.
John Maynard Keynes, in his book “The General Theory
of Employment, Interest, and Money,” began this school
of thought.
Keynes’ theory was that too little consumer spending
and investment led to the Great Depression.
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MACROECONOMIC APPROACHES AND PATHWAYS
Keynes’ solution to depression and high unemployment
was increased government spending.
But Keynes predicted that his policy aimed at curing
unemployment in the short term might increase it in the
long term.
This prediction became reality during the 1960s and
1970s, when inflation exploded, growth slowed, and
unemployment increased.
The global recession of 2008–2009 and fear of another
great depression revived interest in Keynesian ideas.
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MACROECONOMIC APPROACHES AND PATHWAYS
Monetarist Macroeconomics
According to monetarist macroeconomics, the
classical view of the world is broadly correct, but in
addition to fluctuations that arise from the normal
functioning of an expanding economy, fluctuations in
the quantity of money also generate the business cycle.
A slowdown in the growth rate of money brings
recession and a large decrease in the quantity of money
brought the Great Depression.
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MACROECONOMIC APPROACHES AND PATHWAYS
Milton Friedman was the most prominent monetarist.
The view that monetary contractions are the sole source
of recessions is held by few economists today.
But the view that the quantity of money plays a role in
economic fluctuations is accepted by all economists and
is part of today’s consensus.
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MACROECONOMIC APPROACHES AND PATHWAYS
Today’s Consensus
Each of the earlier schools provides insights and
ingredients that survive in today’s consensus.
Classical macroeconomics provides the story of the
economy at or close to full employment.
But the classical approach doesn’t explain how the
economy performs in the face of a major slump in
spending.
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MACROECONOMIC APPROACHES AND PATHWAYS
Keynesian macroeconomics takes up the story in a
recession or depression.
When spending is cut and the demand for most goods
and services and the demand for labor all decrease,
prices and wage rates don’t fall but the quantity of goods
and services sold and the quantity of labor employed do
fall and the economy goes into recession.
In a recession, an increase in spending by governments,
or a tax cut that leaves people with more of their earnings
to spend, can help to restore full employment.
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MACROECONOMIC APPROACHES AND PATHWAYS
Monetarist macroeconomics elaborates the Keynesian
story by emphasizing that a contraction in the quantity of
money brings higher interest rates and borrowing costs,
which are a major source of cuts in spending that bring
recession.
Increasing the quantity of money and lowering the
interest rate in a recession can help to restore full
employment.
And keeping the quantity of money growing steadily in
line with the expansion of the economy’s production
possibilities can help to keep inflation in check and can
also help to moderate the severity of a recession.
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MACROECONOMIC APPROACHES AND PATHWAYS
Another component of today’s consensus is the view that
the long-term problem of economic growth is more
important than the short-term problem of recessions.
Even a small slowdown in economic growth brings a
huge cost in terms of a permanently lower level of income
per person.
The Road Ahead
We follow the new consensus and begin with an
explanation of what determines potential GDP and the
pace at which it grows.
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24.1 POTENTIAL GDP
Potential GDP is the value of real GDP when all the
economy’s factors of production are fully employed.
We produce the goods and services that make up real
GDP by using factors of production: labor and human
capital, physical capital, land, and entrepreneurship.
At any given time, the quantities of human capital,
physical capital, land, entrepreneurship, and the state of
technology are fixed.
But the quantity of labor is not fixed.
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24.1 POTENTIAL GDP
The quantity of labor employed depends on the choices
of people and businesses.
So real GDP produced depends on the quantity of labor
employed.
To describe the relationship between real GDP and the
quantity of labor employed, we use a relationship called
the production function.
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24.1 POTENTIAL GDP
The Production Function
Production function is a relationship that shows the
maximum quantity of real GDP that can be produced as
the quantity of labor employed changes and all other
influences on production remain the same.
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24.1 POTENTIAL GDP
Figure 24.1 shows
the production
function.
100 billion hours of
labor can produce
$9 trillion of real
GDP at point A.
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24.1 POTENTIAL GDP
200 billion hours of
labor can produce $13
trillion of real GDP at
point B.
300 billion hours of
labor can produce $16
trillion of real GDP at
point C.
The production function
PF is a limit to what is
attainable.
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24.1 POTENTIAL GDP
The production function
is a boundary between
the attainable and the
unattainable.
The production function
displays diminishing
returns: The tendency
for each additional hour
of labor employed to
produce successively
smaller additional
amounts of real GDP.
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24.1 POTENTIAL GDP
The Labor Market
The Demand for Labor
Quantity of labor demanded is the total labor hours
that all the firms in the economy plan to hire during a
given time period at a given real wage rate.
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24.1 POTENTIAL GDP
Demand for labor is the relationship between the
quantity of labor demanded and real wage rate when all
other influences on firms’ hiring plans remain the same.
The lower the real wage rate, the greater is the quantity
of labor demanded.
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24.1 POTENTIAL GDP
Figure 24.2
shows the
demand for
labor.
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24.1 POTENTIAL GDP
1. If the real wage
rate rises from
$50 to $80 an
hour, the
quantity of labor
demanded
decreases.
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24.1 POTENTIAL GDP
2. If the real wage
rate falls from
$50 to $25 an
hour, the
quantity of labor
demanded
increases.
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24.1 POTENTIAL GDP
The Supply of Labor
Quantity of labor supplied is the number of labor
hours that all the households in the economy plan to
work during a given time period and at a given real
wage rate.
Supply of labor is the relationship between the
quantity of labor supplied and the real wage rate when
all other influences on work plans remain the same.
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24.1 POTENTIAL GDP
Figure 24.3
shows the
supply of labor.
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24.1 POTENTIAL GDP
1. If the real
wage rate falls
from $50 to
$25 an hour,
the quantity of
labor supplied
decreases.
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24.1 POTENTIAL GDP
2. If the real
wage rate
rises from $50
to $75 an
hour, the
quantity of
labor supplied
increases.
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24.1 POTENTIAL GDP
The quantity of labor supplied increases as the real
wage rate increases for two reasons:
• Hours per person increase as the real wage rate
increases.
• The labor force participation rate increases as
the real wage rate increases.
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24.1 POTENTIAL GDP
Labor Market Equilibrium
A rise in the real wage rate eliminates a shortage of
labor by decreasing the quantity demanded and
increasing the quantity supplied.
A fall in the real wage rate eliminates a surplus of labor
by increasing the quantity demanded and decreasing
the quantity supplied.
If there is neither a shortage nor a surplus, the labor
market is in equilibrium.
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24.1 POTENTIAL GDP
Figure 24.4(a) shows
labor market equilibrium.
1. Full employment occurs
when the quantity of labor
demanded equals the
quantity of labor supplied.
2. Equilibrium real wage rate
is $50 an hour.
3. Full-employment quantity
of labor is 200 billion hours
a year.
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24.1 POTENTIAL GDP
Full Employment and Potential GDP
When the labor market is in equilibrium, the economy is
at full employment.
When the economy is at full employment, real GDP
equals potential GDP.
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24.1 POTENTIAL GDP
Figure 24.4(b) shows
potential GDP.
1. When the fullemployment quantity of
labor is 200 billion hours
a year,
2. Potential GDP is $13
trillion.
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24.2 THE NATURAL UNEMPLOYMENT RATE
So far, we’ve focused on the forces that determine the
quantity of labor employed.
Now we look at what determines the unemployment rate
when the economy is at full employment.
To understand the amount of frictional and structural
unemployment that exists at the natural unemployment
rate, economists focus on two fundamental causes of
unemployment:
• Job search
• Job rationing
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24.2 THE NATURAL UNEMPLOYMENT RATE
Job Search
Job search is the activity of looking for an acceptable
vacant job.
The amount of job search depends on
• Demographic change
• Unemployment benefits
• Structural change
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24.2 THE NATURAL UNEMPLOYMENT RATE
Demographic Change
An increase in the proportion of the population that is of
working age brings an increase in the entry rate into the
labor force and an increase in the unemployment rate.
This factor increased the unemployment rate during the
1970s and decreased it during the 1980s.
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24.2 THE NATURAL UNEMPLOYMENT RATE
Unemployment Benefits
An unemployed person who receives no unemployment
benefits faces a high opportunity cost of job search and
has an incentive to keep job search brief.
An unemployed person who receives generous
unemployment benefits faces a lower opportunity cost
of job search and has an incentive to search for longer.
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24.2 THE NATURAL UNEMPLOYMENT RATE
Structural Change
Labor market flows and unemployment are influenced
by the pace and direction of technological change.
Technological change can bring a structural slump, as it
did during the 1970s.
As some industries contracted in the 1970s, labor
turnover increased, job search increased, and the
natural unemployment rate increased.
Technological change can bring a structural boom, as it
did during the 1990s.
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24.2 THE NATURAL UNEMPLOYMENT RATE
Job Rationing
Job rationing occurs when the real wage rate is
above the full-employment equilibrium level.
The real wage rate might be set above the fullemployment equilibrium level for three reasons:
• Efficiency wage
• Minimum wage
• Union wage
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24.2 THE NATURAL UNEMPLOYMENT RATE
Efficiency Wage
If a firm pays only the going market wage, employees
have no incentive to work hard because they know that
even if they are fired for shirking, they can find another
job at a similar wage rate.
So some firms pay an efficiency wage.
Efficiency wage is a real wage rate that is set above
the full-employment equilibrium wage rate to induce
greater work effort.
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24.2 THE NATURAL UNEMPLOYMENT RATE
The Minimum Wage
If the government sets a minimum wage above the
equilibrium wage rate, unemployment results.
Union Wage
Labor unions operate in some labor markets and they
agree a money wage rate with employers.
Union wage is a wage rate that results from collective
bargaining between a labor union and a firm.
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24.2 THE NATURAL UNEMPLOYMENT RATE
Job Rationing and Unemployment
The above-equilibrium real wage rate decreases the
quantity of labor demanded and increases the quantity
of labor supplied.
If the real wage rate is above the full-employment
equilibrium level, the natural unemployment rate
increases.
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24.2 THE NATURAL UNEMPLOYMENT RATE
Figure 24.5 shows how
job rationing increases
the natural unemployment
rate.
An efficiency wage rate
1. Decreases the quantity
demanded—job rationing.
2. Increases the quantity
of labor supplied.
3. Increases the natural
unemployment rate.
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Why Do Americans Earn More and Produce
More than Europeans?
The quantity of capital per worker is greater in the United
States than in Europe.
U.S. technology, on the average, is more productive than
European technology.
These differences between the United States and Europe
mean that U.S. labor is more productive than European
labor.
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Why Do Americans Earn More and
Produce More than Europeans?
Because U.S. labor is
more productive than
European labor, U.S.
employers will pay more
for a given quantity of labor
than European employers
will pay.
1. The U.S. demand for
labor curve lies to the
right of the European
demand for labor curve.
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Why Do Americans Earn More and Produce
More than Europeans?
2. Higher European income
taxes and unemployment
benefits mean that the
European supply of labor
lies to the left of the U.S.
supply.
3. Americans work longer
hours than Europeans.
4. The equilibrium real
wage rate in the United
States is higher than in
Europe.
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Why Do Americans Earn More and Produce
More than Europeans?
Because U.S. labor is
more productive than
European labor, the U.S.
production function lies
above the European
production function.
3. Americans work longer
hours than Europeans.
5. Potential GDP is higher
in the United States
than in Europe.
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