C h a p t e r

THE ECONOMY AT
FULL EMPLOYMENT:
THE CLASSICAL
MODEL**

C h a p t e r Key I d e a s
Our Economys Anchor
A. The economy is like a boat on a rolling sea. Potential GDP provides an anchor for the economy.
B. The Classical Model explains how potential GDP is determined.
C. Specifically, forces of demand and supply in labor and capital markets determine the real wage
rate, the real interest rate, and the level of potential GDP.

Outline
I.

The Classical Model: A Preview

The Classical Model is introduced.
1. There are two distinct categories of variables that describe macroeconomic performance:
a) Real variables: real GDP, employment and unemployment, the real wage rate,
consumption, saving, investment, and the real interest rate.
b) Nominal variables: the price level (CPI or GDP deflator), the inflation rate, nominal
GDP, the nominal wage rate, and the nominal interest rate.
2. The separation of macroeconomic performance into a real part and a nominal part is the
basis of the classical dichotomy.
3.

The classical dichotomy states: At full employment, the forces that determine real
variables are independent of those that determine nominal variables.

4.

The classical model is a model of an economy that determines the real variables at full
employment.
Most economists believe that the economy fluctuates around full employment, but that the
classical model provides powerful insights into the level of full employment and potential
GDP around which the economy fluctuates.

5.

* This is Chapter 24 in Economics.

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II. Real GDP and Employment

A. Production Possibilities
1. The production possibilities frontier (PPF) is the boundary between those combinations of
goods and services that can be produced and those that cannot.
2. Figure 8.1(a) illustrates a
production possibilities frontier
between leisure time and real GDP.
3. The more leisure time forgone, the
greater is the quantity of labor
employed and the greater is the real
GDP.
4. The PPF showing the relationship
between leisure time and real GDP
is bowed-out, which indicates an
increasing opportunity cost: As real
GDP increases, each additional unit
of real GDP costs an increasing
amount of forgone leisure.
5. Opportunity cost is increasing
because the most productive labor
is used first and as more labor is
used, the labor used becomes
increasingly less productive.
B. The Production Function
1.

2.

3.

The production function is the

relationship between real GDP and
the quantity of labor employed
when all other influences on
production remain the same.
One more hour of labor employed
means one less hour of leisure,
therefore the production function is
the mirror image of the leisure
time-real GDP PPF.
Figure 8.1(b) illustrates the
production function that
corresponds to the PPF shown in
Figure 8.1(a).

III. The Labor Market and Potential GDP

A. The Demand for Labor
1.

The quantity of labor demanded is the labor hours hired by all the firms in the
economy.

THE ECONOMY AT FULL EMPLOYMENT: THE CLASSICAL MODEL

2.

The demand for labor, Figure 8.2,

is the relationship between the
quantity of labor demanded and the
real wage rate when all other
influences on firms hiring plans
remain the same.

3.

The real wage rate is the quantity

of good and services that an hour of
labor earns.
a)

4.

169

The money wage rate is the

number of dollars an hour of
labor earns.
b) The average real wage rate is the
average money wage rate divided
by the price level multiplied by
100.
c) It is the real wage rate, not the
money wage rate, that determines
the quantity of labor demanded.
The demand for labor depends on the
marginal product of labor, which
is the additional real GDP produced
by an additional hour of labor when all other influences on production remain the same.
a) The marginal product of labor is calculated as the change in real GDP divided by the
change in the quantity of labor employed.
b) The marginal product of labor diminishes as the quantity of labor employed increases,
other things remaining the same. Diminishing marginal product occurs because all the
labor employed works with the same fixed capital and technology, and is an example of
the law of diminishing returns.
c) The diminishing marginal product of labor limits the demand for labor.

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5.

The demand for labor is the

marginal product of labor. Figure
8.3 shows the production function,
PF, in part (a). The production
function determines the marginal
product of labor. And the marginal
product of labor curve is the
demand for labor curve in part (b).
a) Firms hire more labor as long
as the marginal product of
labor exceeds the real wage
rate.
b) Eventually, with the
diminishing marginal product
of labor, the extra output from
an extra hour of labor is exactly
what the extra hour of labor
costs, which is the real wage
rate. At this point, the profitmaximizing firm hires no more
labor.
c) When the marginal product of
labor changes, the demand for
labor changes. If the marginal
product of labor increases, the
demand for labor shifts
rightward.
B. The Supply of Labor
1.

The quantity of labor supplied

is the number of labor hours that all
the households in the economy
plan to work at a given real wage
rate.

2.

The 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.
The quantity of labor supplied increases as the real wage rate increases for two reasons:
a) Hours per person increase because the higher the real wage rate, the higher the
opportunity cost of not working. There is an opposing income effect. The higher real
wage rates increase household income, which increases the demand for leisure. An
increase in the demand for leisure is the same thing as a decrease in the quantity of
labor supplied. The opportunity cost effect is usually greater than the income effect
over the relevant range for most U.S. workers, so a rise in the real wage rate brings an
increase in the quantity of labor supplied.
b) Labor force participation increases because higher real wage rates induce some people
who choose not to work at lower real wage rates to enter the labor force.

3.

THE ECONOMY AT FULL EMPLOYMENT: THE CLASSICAL MODEL

4.

The labor supply response to an

increase in the real wage rate is
positive but small. A large
percentage increase in the real wage
rate brings a small percentage
increase in the quantity of labor
supplied. Figure 8.4 illustrates a
labor supply curve.

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C. Labor Market Equilibrium and Potential GDP

1. Labor market equilibrium occurs when
the real wage rate is such that the quantity
of labor demanded is equal to the quantity
of labor supplied. Figure 8.5(a) illustrates
labor market equilibrium.
2. Labor market equilibrium is fullemployment equilibrium.
3.

The level of real GDP at full employment

is potential GDP. Note that in Figure
8.5(a), labor market equilibrium occurs at
200 billion labor hours. Referring back to
the production function in Figure 8.1,
repeated as Figure 8.5(b), 200 billion
labor hours means that potential GDP is
$10 trillion.

IV. Unemployment at Full Employment

A. Unemployment always is present.
1. The unemployment rate at full
employment is called the natural rate of
unemployment.
2.

The natural unemployment rate is always

positive; that is, there is always some
unemployment because of job search and
job rationing.
B. Job Search
1.
2.

Job search is the activity of workers

looking for an acceptable vacant job.
All unemployed workersfrictionally,
structurally, and cyclically unemployed
search for new jobs, and while they search
many are unemployed. Job search
unemployment, and how it relates to

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173

the natural unemployment rate, is

illustrated in Figure 8.6.
3. Job search can be affected by:
a) Demographic change. As more
young workers entered the labor
force in the 1970s, the amount
of frictional unemployment
increased as they searched for
jobs. Frictional unemployment
might have fallen in the 1980s
as those workers aged. Twoearner households might increase
search, because one member
can afford to search longer if the
other still has income.
b) Unemployment compensation.
The more generous unemployment compensation payments become, the lower the
opportunity cost of unemployment, so the longer workers search for better
employment rather than any job. More workers are covered now by unemployment
insurance than before, and the payments are relatively more generous.
c) Structural change. An increase in the pace of technological change that reallocates jobs
between industries or regions increases the amount of search.
C. Job Rationing
1.
2.

Job rationing is the practice of paying a real wage rate above the equilibrium level and
then rationing jobs by some method.
Job rationing can occur for two reasons:
a)

A firm pays an efficiency wage, which is a real wage rate set above the fullemployment equilibrium wage rate that balances the costs of benefits of this higher
wage rate to maximize the firms profit. The higher wage rate attracts the most
productive workers and then gives them the incentive to be productive so they do not
lose their high-paying jobs.

b) A minimum wage is the lowest wage rate at which a firm may legally hire labor. If
the minimum wage is set above the equilibrium wage rate, job rationing occurs
D. Job Rationing and Unemployment
1. If the real wage rate is above the equilibrium wage, regardless of the reason, there is a
surplus of labor that adds to unemployment and increases the natural unemployment rate.
2. Most economists agree that efficiency wages and minimum wages increase the natural
unemployment rate.
a) Card and Krueger have challenged this view and argue that an increase in the
minimum wage works like an efficiency wage, making workers more productive and
less likely to quit.
b) Hamermesh argues that firms anticipate increases in the minimum wage and cut
employment before they occur. Therefore, looking at the effects of minimum wage
changes after the change occurs misses the effects.
c) Welch and Murphy say regional differences in economic growth, not changes in the
minimum wage, explain the Card and Krueger theory.

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V. Investment, Saving, and the Interest Rate

A. Potential GDP depends on the quantity of productive resources, including capital.
1.

The capital stock is the total amount of plant, equipment, buildings, and inventories,
physical capital.
2. Gross investment is the purchase of new capital. Depreciation is the wearing out and
scrapping of the capital stock. Net investment equals gross investment minus depreciation;
net investment is the addition to the capital stock. Investment is financed by saving, which
equals income minus consumption.
3. The return on capital is the real interest rate , which is equal to the nominal interest
rate adjusted for inflation. The real interest rate is approximately equal to the nominal
interest rate minus the inflation rate.
B. Investment Decisions
Business investment decisions are influenced by:
1. The expected profit rate. The expected profit rate is relatively high during expansions and
relatively low during recessions. Increases in technology can increase the expected profit
rate. Taxes affect the expected profit rate because firms are concerned about the after-tax
profit rate.
2. The real interest rate. The real
interest rate is the opportunity cost
of investment. An increase in the
real interest rate decreases the
number of investment projects that
are profitable.
C. Investment Demand
1.

2.

Investment demand is the

relationship between investment
and the real interest rate, other
things remaining the same.
The investment demand curve,
illustrated in Figure 8.7, plots the
relationship between investment
demand and the real interest rate.
a) The investment demand curve
slopes downward. A rise in the
real interest rate (say from 4
percent to 6 percent) decreases
the quantity of planned
investment demanded (from
$1.2 trillion at A to $1.0
trillion at B) along investment
demand curve ID in Figure 8.7.

b) If the expected profit rate increases, the investment demand curve shifts rightward.
D. Saving Decisions
1. Households divide their disposable income between consumption expenditure and saving.
2. Saving is affected by the real interest rate, disposable income, wealth, and expected future
income.

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175

3.

The higher the real interest rate,

the greater is a households
opportunity cost of consumption
and so the larger is the amount of
saving.
4. The larger disposable income, the
greater is a households saving.
5. The greater is a households wealth,
the greater is its consumption and
the less is its saving.
6. The higher a households expected
future income, the greater is its
current consumption and the lower
is its current saving.
E. Saving Supply
1.

Saving supply is the relationship

between saving and the real interest
rate, other things remaining the
same.
2. Figure 8.8 shows a saving supply
curve, which slopes upward because
a rise in the real interest rate
increases saving.
F. Equilibrium in the Capital Market
1. In the U.S. economy, there are many interrelated capital markets. Because funds can flow
from one market to another, we can think about the capital market as a whole.
2. The real interest rate is determined by investment demand and saving supply.

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3.

In Figure 8.9, ID is the investment

demand curve, SS is the supply of
saving curve, and the equilibrium
real interest rate is 6 percent. At the
equilibrium real interest rate, there
is neither a shortage nor surplus of
saving.

VI. The Dynamic Classical Model

A. The Classical Model also has
implications for how the economy
changes over time.
B. Changes in Productivity
1.
2.

Labor productivity is real GDP

per hour of labor.
Three factors influence labor
productivity.
a) Physical capital: An increase in
capital increases labor
productivity.
b) Human capital: Human
capital is the knowledge and
skill that people have obtained
from education and on-thejob-training. An increase in human capital increases labor productivity.
c) Technology: An increase in technology increases labor productivity.

3.

When labor productivity increases, the production function shifts upward and potential
GDP increases.

THE ECONOMY AT FULL EMPLOYMENT: THE CLASSICAL MODEL

C. An Increase in Population
1. Figure 8.11 (mislabeled as Figure
8.12) illustrates the effects from an
increase in population.
2. An increase in population increases
the supply of labor and the supply
of labor curve shifts rightward. The
equilibrium real wage rate falls and
the equilibrium quantity of
employment increases.
3. The increase in employment leads
to a movement up along the
production function so that
potential GDP increases. However,
diminishing returns means that
potential GDP per hour of work
decreases.

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D. An Increase in Labor Productivity

1. Figure 8.12 (mislabeled as Figure
8.11) illustrates the effects from an
increase in labor productivity.
2. An increase in labor productivity can
be the result of an increase in
physical capital, an increase in
human capital, or an advance in
technology. In all cases, the
production function shifts upward
and the demand for labor increases
so that the demand for labor curve
shifts rightward. The increase in the
demand for labor raises the
equilibrium real wage rate and
increases the equilibrium quantity of
employment.
3. The increase in employment leads to
a movement up along the production
function. In addition, the increase in
labor productivity shifted the
production function upward. Both
effects increase potential GDP. The
upward shift of the production
function means that potential GDP
per hour of work increases.

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179

E. Population and Productivity in the United States

1. In the United States, over the past
two decades, both the population
and labor productivity have
increased.
2. Figure 8.13 illustrates these effects.
3. The increase in the demand for
labor exceeded the increase in the
supply of labor so that the real wage
rate rose. Employment increased as a
result of both the increase in the
demand for labor and the increase in
the supply of labor.
4. The increase in productivity shifted
the production function upward.
That, combined with the increase in
employment, increased potential
GDP.

Reading Between the Lines

A news article discusses how productivity growth jumped in the third quarter of 2003. The analysis shows
the effect of the increase in productivity on the production function and the demand for labor. It also
discusses how productivity feeds into long-term economic growth.

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New in the Seventh Edition

This chapter synthesizes the material on the labor market and the capital market presented in Chapters 7
and 8 of the Sixth Edition. The material is presented in the context of the Classical Model of full
employment and potential GDP.

Te a c h i n g S u g g e s t i o n s

1.

2.

Chapter 8 clearly explains to students how potential GDP is determined, what changes potential
GDP, why there is ever-persistent unemployment in our economy, and the functioning of the capital
market.
One way to motivate students in the study of the labor underpinnings of the macroeconomy is to
address the topic of wages. Students readily understand the difference in money wages versus real
wage rates. Ask them how much they think their money wages have increased during the past 12
months. Their answers provide an opportunity to work out the percentage change in their wages and
then compare it to the percentage change in the CPI or GDP deflator. Use your own percentage
increase in wages as an opening example if thats not too depressing. If youre like most professors,
your real wage rate is falling!
This real wage rate discussion then allows you to ask the class: why has your real wage rate fallen and
why have real wage rates for some of the students and in other occupations gone up? And, on
average, do they think real wage rates are going up or down? These questions always generate some
interest, particularly if you pose another question about the future trend of real wage rates. They also
let you introduce the idea that in macroeconomics, were concerned with the averages and aggregates
rather than the details of the distribution. You can move from these introductory ideas to set up the
need for the Classical Model presented in this chapter.
The Classical Model: A Preview
This Classical Model makes extensive use of the demand and supply model of Chapter 3. It applies it
to the labor market. It also applies it to the market for financial capital in which demand is
investment demand, supply is saving supply, and price is the real interest rate, which is both the
return to saving and the opportunity cost of investment. Once the student understands these parallels
of the Classical Model with the basic demand and supply analysis, the mechanics of this chapter will
be relatively straightforward.
Real GDP and Employment
Building and using a toolkit. As you introduce the tradeoff between goods (real GDP) and leisure
time, use the opportunity to remind the students that learning economics is like building and using a
toolkit. And here we use the PPF tool yet again. Keep reminding your students that economics is not
a subject that you memorize (and forget after the exam). It is more like learning to drive a car
something that eventually comes naturally and is never forgotten.
Making it personal. This topic is one that can benefit from drawing on the personal experiences of
students who have jobs and who make some choices with respect to hours per week to work, study,
and take leisure. They get the PPF for leisure and GDP quickly.
Simple examples. Changes in labor productivity are conveniently illustrated with simple concrete
examples. To see how physical capital increases productivity, contrast building a dam using shovels
and buckets, then shovels and wheelbarrows, then a front-end loader and a truck. To see how human
capital increases productivity, contrast the speed with which a student who has learned to type can
produce an essay with the speed at which a two-finger typist can accomplish the same task.

THE ECONOMY AT FULL EMPLOYMENT: THE CLASSICAL MODEL

3.

181

The Labor Market and Potential GDP

Marginal product of labor. Although you are teaching a macroeconomics course, you cant neglect
some crucial microeconomic underpinnings. And the marginal product of labor is one of these
underpinnings. You can though avoid being too technical and can focus on the intuition. Some of
your students might have completed the principles of microeconomics and seen the concept of
marginal productivity before. This background enables you to encourage their participation in a
classroom discussion on this topic. Also, drawing on the life experience of students with jobs whose
work hours change from day to day or week to week can be useful. Get the students to see intuitively
that it is not worth while for a firm to hire an hour of labor unless the value of the production of that
labor at least covers the wage cost to the firm.
Labor supply. Your main goal in teaching this topic is to explain why in total, hours increase as the
real wage rate increases. Again, drawing on the life experience of students with jobs whose work
hours change from day to day or week to week can be useful. The two key points are: Even though
some workers might have a backward-bending labor supply curves (playing golf on weekday
afternoons when the wage rate rises enough), most have upward-sloping labor supply curves. The
labor force participation rate increases as the real wage rate increases. These two features of individual
behavior imply that the supply curve to labor in aggregatethe supply of aggregate hoursincreases
as the real wage rate rises, other things remaining the same.
Is immigration bad for us? Many people think that immigration is bad for existing citizens and
lowers their living standard. Part of the popular political discussion, especially in Europe during
2002, has a racist dimension, which you will want to avoid. But the raw economic dimension is
worth examining. When you discuss the effects of an increase in population, you will conclude that
an increase in population, ceteris paribus, increases real GDP but lowers real GDP per person and
lowers the real wage rage. You might then ask: does this outcome mean that immigration is bad for
us?
The answer, of course, is absolutely not. Historically, immigrants have brought capital and
entrepreneurship, and been some of the most creative sources of technological change. When you
combine the effects of capital accumulation and technological change with an increase in population,
you see that real GDP increases but the change in the wage rate is ambiguous. Add the historical fact
that capital accumulation and technological change have outstripped population growth, and you
reach the conclusion that immigration has been (and probably continues to be) a positive economic
force.
Why the Luddites were wrong. This chapter provides you with a wonderful opportunity to explain to
your students why the Luddites were wrongand why the modern neo-Luddite movement is wrong.
(You can learn more than you need to know about Luddism and the Luddites, ancient and modern,
at http://carbon.cudenver.edu/~mryder/itc_data/luddite.html)
The Dynamic Classical Model. Explain that more capital and more productive capital that uses new
technologies increases productivity, shifts the production function upward, and shifts the demand for
labor curve rightward. Real GDP increases and on the average, the real wage rate rises.
You might then spend a few minutes agreeing that capital accumulation and technological change
decrease the demand for the labor that the new capital replaces. But it increases the demand for other
types of laborcomplementary labor. People must acquire more skillsome people learn to work
with the new capital, some learn how to maintain it in good condition, some learn how to build it,
some learn how to market and sell it, some learn to design new ways of using it, some work on
thinking up new goods and services to produce with it, and so on. All of these people are more
productive that they were before.
New technologies that create new products have even more obvious effects on productivity. The
development of the CD in the early 1980s is a good example. Suddenly thousands of people became

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4.

very productive converting the heritage of recorded music into digital format, cleaning up the sound,
and making and selling millions of CDs. The same type of thing is now happening with the DVD.
If you want to get side-tracked into philosophical disputes about man and machines, we cant help
you in that area!
Unemployment at Full Employment
Where is unemployment in the demand and supply diagram? Thoughtful students often ask about
the relationship between the (microeconomic-based) labor demand and labor supply model and
unemployment. They cant see any unemployment in labor market equilibrium. Where is it, they
want to know.
Explain that in the labor market, people use their time in two economically productive ways: they
work and they job search. Working is supplying labor and this is the activity that the demand-supply
model shows. It shows the quantity of labor demanded and supplied and the price (real wage rate)
that equates the quantities demanded and supplied. The demand and supply model does not
determine the quantity of job-search activity. People supply job-search activity because firms have
imperfect information about job seekers and workers have imperfect knowledge about available jobs.
During the time spent on job search, people are unemployed. You can draw a diagram if you wish
that shows the quantity of job search on the x-axis and the real wage rate on the y-axis. The higher
the real wage rate, other things remaining the same, the greater is the amount of job search activity.
The equilibrium wage rate determined by demand and supply in the labor market determines the
point on the job search curve at which the labor market operates and determines the quantity of jobsearch unemployment.
Only if there were no uncertainty would the supply of job search (and unemployment) be zero. In
such a case, a person out of work would not need to search for a new job. He or she would simply
report to the new job on the day the worker knew that the job started! Thus, workers would never be
unemployed because they would never search for jobs. Clearly, this happy state of affairs is not a
description of reality.
One way to dramatize the fact that natural unemployment never hits zero is to bring in data on
unemployment rates during World War II. Here are the numbers for the United States. Tell the
students that more than 6 million people, mainly men, were recruited into the armed forces and that
millions of others, mainly women, were mobilized to produce arms. Ask the students to guess the
unemployment rate at the peak of war activity. Few will guess the unemployment rates correctly. (It
is pretty remarkable that the rate could have fallen to such a low level.)
Civilian population and labor force, 19411945
Civilian labor force

Year

Civilian
population

Total

Employment

Unemployment

Not in labor
force

Labor force
participation
rate

Thousands of persons 14 years of age and over

Employment-topopulation
ratio
Percent

Unemployment rate

1941

99,900

55,910

50,350

5,560

43,990

56.0

50.4

9.9

1942

98,640

56,410

53,750

2,660

42,230

57.2

54.5

4.7

1943

94,640

55,540

54,470

1,070

39,100

58.7

57.6

1.9

1944

93,220

54,630

53,960

670

38,590

58.6

57.9

1.2

1945

94,090

53,860

52,820

1,040

40,230

57.2

56.1

1.9

Source: Economic Report of the President, 2002

5.

Investment, Saving, and the Interest Rate

Definitions and the meaning of investment in economics. The student has met the key definitions of
this section in Chapter 5, but to be absolutely sure that they are remembered, this chapter repeats

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183

them. It is worth emphasizing that in economics, capital and investment without any
qualification mean physical capital and purchase of newly produced physical capital goods. Everyday
usage of investment as the purchase of stocks or bonds can lead to confusion. So it is worth getting
these matters clear right from the start.
Real versus nominal interest rate. To drive home the distinction between the nominal interest rate
and real interest rate, you might like to use the example of 30-year fixed rate mortgage. Get the
students to use the past 10-year average as a guide to the rate of increase in housing prices, and
calculate the real interest rate on a 30-year fixed rate mortgage. The student can get a quote for a 30year fixed rate mortgage at http://www.bankrate.com/bhn/subhome/mtg_m1.asp and can find the
price increases in your own region at
http://www.homestore.com/Finance/HousePriceIndex/default.asp?gate=realtor
Confusing saving and investment. Some of your students will confuse saving and investment. And
this confusion will lead them to be puzzled by the slope of the investment demand curve. You can
help all your students avoid this confusion by hitting it head on. Ask them the following question: If
the interest rate rises, Im going to put more money in my savings account, stock market, or
whatever. So why do we say that a higher interest rate decreases investment? In the ensuing
discussion, get the students to see that placing funds in a savings account, stock market, or whatever,
is saving, which does increase if the interest rate rises (other things remaining the same). Remind
them that investment demand refers to the demand by firms (and households) for physical capital
goods. By explicitly tackling this source of confusion, you can simultaneously explain why
investment and saving respond in opposite directions to a change in the interest rate.
Why the interest rate is the opportunity cost of making an investment. An explicit numerical example
can help to make this idea clear.
Scenario 1: The firm has no funds but can borrow any amount it chooses at an interest rate of 8
percent a year. It can use the funds to invest in any or all of seven projects that have expected profit
rates shown in the table. (The interest component of cost has not been counted in calculating the
expected profit ratethat is, the expected profit rate is before paying interest.)
Project
Funds needed
Expected profit rate
1
$200,000
25
2
$200,000
15
3
$200,000
10
4
$200,000
7
5
$200,000
5
6
$200,000
3
7
$200,000
1
Ask your class to say what the firm does.
Get the students to Figure out and explain why the firm borrows $600,000 and invests in projects 1,
2, and 3. It earns an expected profit of 17 percent on project 1, 7 percent on project 2, and 2 percent
on project 3.
Scenario 2: Everything is the same as in Scenario 1 except that the firm has $1,400,000, which it
can use to invest in any or all of seven projects that have expected profit rates shown in the table.
Again, ask your class to say what the firm does.
Get the students to Figure out and explain why the firm uses $600,000 of its funds to invest in
projects 1, 2, and 3.

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If necessary, modify the table as follows to get them to see that the firm can earn 8 percent by lending
the remaining $800,000 to other firms.
Project
Funds needed
Expected profit rate
1
$200,000
25
2
$200,000
15
3
$200,000
10
3A
Any amount (+/)
8
4
$200,000
7
5
$200,000
5
6
$200,000
3
7
$200,000
1
Saving Decisions. The book is very clear on why the real interest rate, disposable income, wealth, and
expected future income should all influence saving and how. A potential problem is that brighter
students who have fully understood substitution and income effects will see that an increase in the
real interest rate raises the opportunity cost of consumption now, but also raises current and expected
future disposable income for those with net financial assets, so the overall impact on saving is
theoretically ambiguous. The best response is probably to simply assert that empirically we have
reason to believe that, in the United States at least, the substitution effect outweighs the income
effect and the saving supply schedule can be confidently presumed to be upward sloping, although
perhaps fairly inelastic.

The Big Picture

Where we have been
This chapter builds on the definitions and measurement of real GDP and the labor market, described
in Chapters 5 and 6. And it looks behind the aggregate supply curves described in Chapter 7. It also
uses the demand and supply model explained in Chapter 3. The chapter explains how full
employment equilibrium real GDP, employment, real wage rate, the natural rate of unemployment,
the capital stock, and the real interest rate are determined and looks at the forces that change them.
Where we are going:
Chapter 8 is the first of two chapters that explain aggregate supply and economic growth. Chapter 9
explains the process of economic growth first encountered in Chapter 4 and then partially studied in
this chapter, Chapter 8. Chapters 8 is also useful as a foundation for the study of the business cycle.

THE ECONOMY AT FULL EMPLOYMENT: THE CLASSICAL MODEL

185

O v e r h e a d Tr a n s p a r e n c i e s
Transparency
45

Text Figure
Figure 8.1

46
47
48
49
50
51
52

Figure 8.2
Figure 8.3
Figure 8.4
Figure 8.5
Figure 8.7
Figure 8.8
Figure 8.9

Transparency title
Production Possibilities and the Production
Function
The Demand for Labor
Marginal Product and the Demand for Labor
The Supply of Labor
The Labor Market and Potential GDP
Investment Demand
Saving Supply
Equilibrium in the Capital Market

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Additional Discussion Questions

1.

Does the marginal product of labor always show diminishing returns or is it possible that constant or
even increasing returns might occur? Why or why not?

2.

Unemployment is bad for the unemployed individual and bad for the nation. Hence the
government should force the unemployment rate to 0 percent. Comment on this assertion,
discussing both its feasibility and its desirability.

3.

How can the actual unemployment rate to be less than the natural unemployment rate?

4.

If the demand for a firms product decreased, what would be the likely impact on the firms demand
for labor? Why?

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CHAPTER 8

5.

What is the difference between the real wage rate and the money wage rate?

6.

Does an increase in the real wage rate shift the labor demand curve? Why or why not?

7.

When labor becomes more productive, what happens to the equilibrium real wage rate and level of
employment?

8.

Why is the supply of labor curve so steep? What might explain the low responsiveness of the quantity
of labor supplied to changes in the real wage rate?

9.

Why does the arrival of more young workers into the labor force increase the natural unemployment
rate?

10. What is the argument that the minimum wage does not contribute to unemployment? What are the
rebuttals?
11. If it is made easier to immigrate to the United States, what should be expected to be the impact on
potential GDP and the real wage rate?
12. How would you expect an increase in the age at which workers qualify for full Social Security
retirement benefits to change the natural unemployment rate?
13. What is the opportunity cost of consumption and how does an increase in that opportunity cost
influence the allocation of income to consumption and saving?
14. Explain why and how investment depends on the real interest rate.
15. If the actual real interest rate differs from the equilibrium real interest rate, what forces drive the real
interest rate to the equilibrium real interest rate?
16. Suppose that capital equipment became more productive and hence more profitable. What happens
to the real interest rate?
17. Suppose that people decide to increase their saving. What effect does this change have on the
equilibrium quantity of investment? Why?
18. In a recession, the personal saving rate as a percentage of disposable income often goes up, but total
saving goes down. Explain.
19. If you expected inflation to accelerate and were about to buy a house, would you want to take out a
fixed rate or a variable rate mortgage? Why?

THE ECONOMY AT FULL EMPLOYMENT: THE CLASSICAL MODEL

187

Answers to the Review Quizzes

Page 186

(page 558 in Economics)

1.

2.

3.

4.

5.

6.

The leisure hoursreal GDP PPF shows the amount of possible real GDP that can be produced at
different amounts of leisure. The production function is the relationship between real GDP and the
amount of labor employed. The amount leisure is related to the amount of labor. For each extra hour
of labor there is one less extra hour of leisure available. Therefore, the production function reverses
the direction of the horizontal, x-axis in the diagram, and is like the mirror image of the PPF. Real
GDP in the PPF decreases as more and more leisure leads to less and less real GDP and in the
production function increases as more and more labor leads to more real GDP.
The bowed-out shape of the leisure hours-real GDP PPF shows that the opportunity cost of each
extra hour of leisure is increasing. This means that for each extra hour ever increasing amounts of real
GDP must be forgone. The reason for increasing opportunity cost is that the most productive labor
is used first and as more labor is used it is increasingly less productive.
A rise in the real wage rate brings a decrease in the quantity demanded of labor because of
diminishing returns in production. As more and more labor is employed, it is increasingly less
productive. Firms seek to maximize profits, which means that they continue to employ labor as long
the marginal product exceeds the real wage rate paid. The last hour of labor hired is that hour where
the marginal product is equal to the real wage rate. If the real wage rate increases, the firm then finds
that the marginal product of the last labor hour is less than the real wage rate. This decreases profits,
so the firm reduces the amount of labor it employs until once again the marginal product of the last
hour of labor employed is equal to the real wage rate.
An increase in the real wage rate increases the quantity of labor supplied for two reasons: the average
hours supplied per person increases; and the labor force participation rate increases.
i. When the real wage rate increases, so does the opportunity cost of leisure, which means that
many households are willing to supply more labor. The households income increases, which
increases the demand for normal goods, one of which is leisure time. This income effect is
smaller for most households than the opportunity cost effect, so the average hours per person
increases.
ii. When the real wage rate increases, the relative value of other uses of time decreases. This means
that more people who had previously chosen not to be part of the labor force because the real
wage rate was less than the value of other uses of their time are now more likely to find the real
wage rate higher than the value of their alternatives and chose to enter the labor force. The key
relevant groups are most likely to be students, those keeping house full-time, and younger
retirees.
If the real wage rate is above or below the full-employment level there is a surplus or shortage of labor
that then causes the real wage rate to adjust. For example, if the real wage rate is above the fullemployment level, there is a surplus of labor. The real wage rate falls. If the real wage rate is below
the full-employment level, there is a shortage of labor and the real wage rate rises. In either case, the
real wage rate adjusts until the surplus or shortage is eliminated and the labor market is in
equilibrium at full-employment.
Potential GDP is determined from the labor market equilibrium. When the labor market is in
equilibrium, there is full employment. The amount of employment at full employment in turn
determines the amount of potential GDP via the production function.

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Page 189

(page 561 in Economics)

1.

2.

3.

4.

5.

Page 194

The economy always experiences unemployment, even when the labor market is in equilibrium.
There are two principle reasons for this: job search and job rationing. The amount of unemployment
at full employment is called the natural unemployment rate.
There are three main factors that cause the natural unemployment rate to fluctuate: demographic
changes; unemployment compensation; and structural changes. Demographic changes such as
changes in the birth rate or changes in the number of workers per household leads to changes in the
natural unemployment rate. The more generous unemployment benefits, the greater is the natural
unemployment rate. The decline of industries is a structural change that can lead to an increase in
the natural unemployment rate. Changes in the institutional arrangements in the labor market, or
information flows (such as the internet), may also change the natural rate.
Job rationing is the practice of paying a real wage rate above the equilibrium level and then rationing
jobs by some method. The two main methods are efficiency wages and the minimum wage.
Efficiency wages exist because firms believe they can maximize profits by offering a higher wage. This
wage rate balance the extra productivity gains at a higher wage against the extra cost. Minimum
wages are legislated by the government and establish a legal minimum that serves to ration jobs if the
minimum wage is above the equilibrium wage.
An efficiency wage is set above the market equilibrium in an attempt to hire more productive workers
and reduce job turnover. At the efficiency real wage rate there is a surplus of labor. Employment is
less and unemployment is greater than with a market equilibrium real wage rate.
The minimum wage creates unemployment if it is set higher than the equilibrium wage. Then, just as
with the case of an efficiency wage, there is a labor surplus. Less labor is employed than if the wage
rate was lower. The surplus of labor is equal to the amount of unemployment. The more the
minimum wage exceeds the equilibrium wage, the greater is the surplus and the greater is the amount
of extra unemployment generated.

(page 566 in Economics)

1.

2.

3.

4.

Page 199

If the real interest rate falls and nothing else changes, the quantity of investment demanded increases.
Conversely, if the real interest rate rises and everything else remains the same, the quantity of
investment demanded decreases. Movements along the investment demand curve illustrate these
events.
If the expected profit rate increases and nothing else changes, investment increases and the
investment demand curve shifts rightward. If the expected profit decreases and everything else
remains the same, investment decreases and the investment demand curve shifts leftward.
An increase in the real interest rate increases the quantity of saving; a decrease in the real interest rate
decreases the quantity of saving. An increase in disposable income increases saving; a decrease in
disposable income decreases saving. An increase in wealth decreases saving; a decrease in wealth
increases saving. An increase in expected future income decreases saving; a decrease in expected future
income increases saving.
The real interest rate is determined by saving supply and investment demand.

(page 571 in Economics)

1.
2.

An increase in population, increases labor supply, which leads to an increase in employment. Real
GDP increases, but because of diminishing returns real GDP per hour of work falls.
An increase in capital shifts the production function higher so that labor productivity increases. As a
result, the demand for labor increases, which leads to a higher real wage rate and an increase in full
employment. Potential GDP increases because the production function shifts upward and because
full employment increases.

THE ECONOMY AT FULL EMPLOYMENT: THE CLASSICAL MODEL

3.

189

An increase in technology shifts the production function higher so that labor productivity increases.
As a result, the demand for labor increases, which leads to a higher real wage rate and an increase in
full employment. Potential GDP increases because the production function shifts upward and
because full employment increases.

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Answers to the Problems

1.

a.

The table shows Crusoes production function. It replaces leisure with labor and labor equals 12
hours a day minus leisure hours. The graph is similar to Fig. 8.1(b) on page 181 (Fig. 24.1(b) on
page 553 in Economics). It plots labor on the x-axis and real GDP on the y-axis. As labor
increases from zero to 12 hours a day, real GDP increases from $0 to $30 a day.

Crusoes Production Function

Labor
Real GDP
(dollars per day)

b.

2.

a.

(dollars per day)

0
0
2
10
4
18
6
24
8
28
10
30
12
30
When labor increases from 0 to 2 hours a day, the marginal product of labor is $5. When labor
increases from 2 to 4 hours a day, the marginal product of labor is $4. When labor increases
from 4 to 6 hours a day, the marginal product of labor is $3. When labor increases from 6 to 8
hours a day, the marginal product of labor is $2. When labor increases from 8 to 10 hours a day,
the marginal product of labor is $1. When labor increases from 10 to 12 hours a day, the
marginal product of labor is $0. Marginal product is the change in real GDP divided by the
change in labor hours.
The table shows Nauticas production function. It replaces leisure with labor and labor equals
100 hours a day minus leisure hours. The graph is similar to Fig. 8.1(b) on page 181 (Fig.
24.1(b) on page 553 in Economics). The graph plots labor on the x-axis and real GDP on the yaxis. As labor increases from zero to 100 hours a day, real GDP increases from $0 to $75 a day.

Nauticas Production Function

Labor
Real GDP
(hours per day)

(dollars per day)

0
20
40
60
80
100

0
25
45
60
70
75

b.

3.

a.

When labor increases from 0 to 20 hours a day, the marginal product of labor is $25. When
labor increases from 20 to 40 hours a day, the marginal product of labor is $20. When labor
increases from 40 to 60 hours a day, the marginal product of labor is $15. When labor increases
from 60 to 80 hours a day, the marginal product of labor is $10. When labor increases from 80
to 100 hours a day, the marginal product of labor is $5. Marginal product is the change in real
GDP divided by the change in labor hours.
The demand for labor schedule is the same as the marginal product of labor schedule. The
marginal product of labor schedule is described in solution 1(b). The marginal product must be
aligned with the midpoint of the change in labor. So, for example, the marginal product of $5

THE ECONOMY AT FULL EMPLOYMENT: THE CLASSICAL MODEL

191

an hour is aligned with 1 hour of work, the midpoint between 0 and 2 hours. The graph plots a
marginal product of $5 at 1 hour and a marginal product of $1 at 9 hours of labor and is a
straight line between these points. At 2 hours of labor, the marginal product is $4.50.
Crusoes Demand Schedule
Real wage rate
Quantity of labor demanded
(dollars per hour)

5.00
4.00
3.00
2.00
1.00
0.00
b.

(hours per day)

1
3
5
7
9
11

The table below lists hours of labor from zero to 12 a day. Against each hour, the wage rate at
which Crusoe is willing to supply labor is $4.50 an hour. Crusoes supply curve is horizontal at
$4.50 an hour.
Crusoes Supply Schedule
Real wage rate
Quantity of labor supplied
(dollars per hour)

c.

d.

(hours per day)

4.50
0
4.50
2
4.50
4
4.50
6
4.50
8
4.50
10
4.50
12
The full-employment equilibrium real wage rate is $4.50 an hour, and the quantity of labor
employed is 2 hours a day. The full-employment equilibrium real wage rate is $4.50 an hour
because Crusoe is willing to work any number of hours at this wage rate. The equilibrium level
of employment is 2 hours a day because this is the number of hours at which Crusoes marginal
product of labor is $4.50 an hour.
Potential GDP is $10 a day. Potential GDP is $10 a day because this quantity of real GDP is
produced when labor is 2 hours a day.

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4.

a.

The demand for labor is Nauticas marginal product. The marginal product of labor schedule is
described in solution 2(b). The marginal product must be aligned with the midpoint of the
change in labor. So, for example, the marginal product of $45 an hour is aligned with 10 hours
of work, the midpoint between 0 and 20 hours. The graph plots a marginal product of $45 at
10 hours and a marginal product of $15 at 7 hours of labor and is a straight line between these
points. At 50 hours of labor, the marginal product is $25.
Nauticas Demand Schedule
Real wage rate
Quantity of labor demanded

b.

(dollars per hour)

(hours per day)

25
20
15
10
5

10
30
50
70
90

The table below lists hours of labor from 10 to 70 a day. The wage rate at which people in
Nautica are willing to supply 10 hours of labor is $10 an hour. For each 50 cent increase in the
real wage rate, they are willing to supply an additional hour. So for each $5 increase in the real
wage rate, the people of Nautica are willing to supply an additional 10 hours.
Nauticas Supply Schedule
Real wage rate
Quantity of labor supplied

(dollars per hour)

c.

d.

5.

a.
b.
c.

(hours per day)

10
10
15
20
20
30
25
40
30
50
35
60
40
70
The full-employment equilibrium real wage rate is $20 an hour, and the quantity of labor
employed is 30 hours a day. The full-employment equilibrium real wage rate is $20 an hour
because at this wage rate 30 hours will be supplied; because when the marginal product of 30
hours is $20, 30 hours will be demanded. Equilibrium is where the quantity demanded of labor
is equal to the quantity supplied.
Nauticas potential GDP is a bit more than $700 a day. You know that at 20 hours of labor,
Nautica produces $500 of real GDP and at 40 hours of labor, Nautica produces $900 of real
GDP. At 30 hours of labor, Nautica can produce real GDP of a bit more than the midpoint of
$500 and $900. (More because the PPF bows outward.)
Yes.
Yes.
No.
The firm receives a total revenue of $17 million. It spends $16 million ($10 million on the
plant, $3 million on labor and $3 million on fuel). Before paying interest, the firm has a surplus
of $1 million. If the interest rate is 5 percent a year, the interest cost is $0.5 million. If the
interest rate is 10 percent a year, the interest cost is $1 million. If the interest rate is 15 percent a

THE ECONOMY AT FULL EMPLOYMENT: THE CLASSICAL MODEL

193

year, the interest cost is $1.5 million. So the firm earns a profit at 5 percent, breaks even at 10
percent, and incurs a loss at 15 percent. The firm will not invest to incur a loss.
6.

a.
b.
c.

Yes.
Yes.
No.
The firm receives a total revenue of $40 million. It spends $36 million. Before paying interest,
the firm has a surplus of $4 million. If the interest rate is 5 percent a year, the interest cost on
the $36 million it invests in the project is $1.8 million. If the interest rate is 10 percent a year,
the interest cost is $3.6 million. If the interest rate is 15 percent a year, the interest cost is $5.4
million. So the firm earns a profit at 5 percent, earns a smaller profit at 10 percent, and incurs a
loss at 15 percent. The firm will not invest if it incurs a loss, which it will at an interest rate of
15 percent.

7.

a.

8.

b.
a.

9.

b.
a.

The graph has saving on the x-axis and the interest rate on the y-axis. Three points are plotted at
$10,000 and 4 percent; $12,500 and 6 percent; and $15,000 and 8 percent. The saving supply
curve passes through these points.
Saving decreases, and the saving supply curve shifts leftward.
The graph has saving on the x-axis and the interest rate on the y-axis. Three points are plotted at
$10,000 and 4 percent; $15,000 and 6 percent; and $20,000 and 8 percent. The saving supply
curve passes through these points.
Saving decreases, and the saving supply curve shifts leftward.
Potential GDP would decrease.
A crack down on illegal immigrants and millions of workers returned to their country of origin
would decrease the supply of labor. The equilibrium quantity of labor would decrease. Full
employment would decrease and potential GDP would decrease.
Employment would decrease.
A crack down on illegal immigrants and millions of workers returned to their country of origin
would decrease the supply of labor. The equilibrium quantity of labor would decrease.
The real wage rate would rise.
When the supply of labor decreases, there is a movement up the demand for labor curve and the
real wage rate rises.

b.

c.

10. a.

b.

c.

11. a.

b.

Potential GDP would increase.

A freeing up of immigration into the United States would increase the supply of labor. The
equilibrium quantity of labor would increase. Full employment would increase and potential
GDP would increase.
Employment would increase.
A freeing up of immigration into the United States would increase the supply of labor. The
equilibrium quantity of labor would increase.
The real wage rate would fall.
With no change in the demand for labor an increase in the supply of labor would create a
movement up the demand for labor curve and the real wage rate would fall.
Potential GDP would increase.
A increase in investment that increased productivity would increase the demand for labor. The
equilibrium quantity of labor would increase. Full employment would increase and potential
GDP would increase.
Employment would increase.
A increase in investment that increased productivity would increase the demand for labor. The
equilibrium quantity of labor would increase.

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c.

The real wage rate would rise.

When the demand for labor increases, there is a movement up the supply of labor curve and the
real wage rate rises.

12. a.

Potential GDP would decrease.

A severe drought that brought a fall in productivity would decrease the demand for labor. The
equilibrium quantity of labor would decrease. Full employment would decrease and potential
GDP would decrease.
Employment would decrease.
A severe drought that brought a fall in productivity would decrease the demand for labor. The
equilibrium quantity of labor would decrease.
The real wage rate would fall.
When the demand for labor decreases, there is a movement down the supply of labor curve and
the real wage rate falls.

b.

c.