Potential GDP and the Natural Unemployment Rate CHAPTER

Potential GDP and the Natural Unemployment Rate CHAPTER 8 EYE ONS Classical macroeconomics Keynesian macroeconomics New macroeconomics Demand of labor Supply of labor Quantity of labor demanded Quantity of labor supplied Potential GDP Great Depression Union wage Efficiency wage Union wage Production function Diminishing returns Job rationing Job search

CLASSICAL vs KEYNESIAN CLASSICAL KEYNESIAN MONETARISTS Agree with Classical View but add idea that fluctuations in the quantity of money influence the business cycle Works Well Will Fluctuate and Growth will Slow Cannot Improve Market Performance Works but is Unstable DEPRESSION &HIGH UNEMPLOYMENT Occur & Will Fix Itself Natural consequence Occur when households and businesses do not spend enough on consumption and investment DISPUTED In the 30’s, The Great Depression - 25% unemployment - 30% Decrease Prdxn TWO Possible Problems: 1. Slow rate of RGDP Increase 2. Persistent Inflation Great Depression Cause: natural Fix: none Cause: too little consumer spending and investment Fix: Increase Govt Spending that could cause worse problems in the future Cause: large decrease in the quantity of money Fix: none Foundation Popular until 1930’s John Keynes, around 1930’s Milton Friedman MARKETS ECONOMY GOVERNMENT Must Spend to Counteract Decreased Private Spending Slow in growth rate of money = recession

KEYNESIAN ISSUES 1. Slow rate of RGDP Growth 1. Job creation is SLOW • Short Term = Decrease in Unemployment • Long Term = Increase in Unemployment 2. Inflation But “In the long run we are all dead” • 60’s saw increased inflation • 70’s saw explosion of inflation • 60’s & 70’s saw increased unemployment • 60’s & 70’s saw Slow RGDP growth

NEW ECONOMIC THEORY- Today’s Consensus Each School of Thought Provides Insight Classical – during expansion (at/near full employment) Keynesian – during recessions When spending is cut and the demand for most goods, services, and 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. Monetarists – 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. LT is more important than ST MACRO outcomes depend on MICRO choices Markets work well and adjust slowly to shocks Even a small slowdown in economic growth brings a huge cost in terms of a permanently lower level of income person.

EYE ON US ECONOMY The Lucas wedge is equivalent to 6 years’ real GDP. During the 1960 s, U. S. real GDP person expanded at 2. 9 percent a year. The red line shows the actual path of real GDP. The black line shows the path of real GDP if that growth rate has been maintained. The shaded wedge shows the lost output— equivalent to $284, 500 person. The Okun gap is equivalent to about 3 months’ real GDP. The red line shows the output gap—the percentage deviation of real GDP from potential GDP. When real GDP is below potential GDP, output is lost and the gap is negative. A negative gap is called an Okun gap. The Okun gap since the end of 1960 is equivalent to $12, 850 person. So smoothing the business cycle has a smaller payoff compared to the potentially huge payoff from restoring real GDP growth to its 1960 s rate.

POTENTIAL GDP < When is the economy at full employment? RGDP = Potential GDP < What is potential GDP? The amount of GDP that would be produced if the economy were at full employment < Can RGDP exceed PGDP? Yes, temporarily at the business cycle peak < Why does RGDP = PGDP? Because they fluctuate around each other – mathematically they are equal. < RGDP is made by using ALL factors of production. Land, Capital, Entrepreneurship are constant Labor IS NOT constant it depends on peoples choices THUS, RGDP depends on the quantity of labor employed

FUNDAMENTAL CAUSES OF UNEMPLOYMENT < Job Search Looking for a job < The amount of Job Search depends on < Demographic Change < Unemployment Benefits < Structural Change < Job Rationing RWR > equilibrium < RWR may be above equilibrium because < Efficiency Wage < Minimum Wage < Union Wage < RWR > Equilibrium Rate $QLD and #QLS #Natural Unemployment Rate

POTENTIAL GDP < Factors of Production Labor & Human Capital Physical Capital Land Entrepreneurship < All Factors of Production are FIXED at any given point in time EXCEPT LABOR Labor employed depends on choices of people RGDP produced depends on quantity of labor employed < Diminishing Returns Extra workers have less capital with which to work

LABOR DEMAND < Quantity of Labor Demanded < Demand for Labor FIRMS <$RWR = #QLD < Movement along the curve < Shift in the < curve Change in Productivity

LABOR SUPPLY < Quantity of Labor Supplied < Supply of Labor HOUSEHOLDS <#RWR = #QLS < Hrs/person # < Labor Force Participation Rate # < What matters to people is not the dollars they earn BUT What those dollars will buy!

GRAPH SHELLS DEMAND RWR SUPPLY LS RWR LS 1 LS 2 LD 1 LD LABOR CURVE SHIFTS: $ qty LS = $Wages (on y axis) $ qty LD = #Wages (on y axis) $ LS = #income taxes $ LD = $Productivity $ LS = #unemployment benefit $ LS = $population

GRAPH RELATIONSHIP < Notice Full Employment is achieved at EQUILIBRIUM < Notice the two graphs LINE UP at Qty of Labor Employed < When the economy is at Full Employment RGDP = PGDP

LABOR MARKET – Natural Unemployment Rate < Full Employment = Natural Unemployment Rate < IF RWR > Equilibrium Rate $QLD and #QLS #Natural Unemployment Rate < Main causes of unemployment at full Employment < Job Search < Demographic Change < Unemployment Benefits < Structural Change < Job Rationing < Efficiency Wage < Minimum Wage < Union Wage

EXERCISES Table Quantity of labor demanded (billions of hours per year) 0 1 2 3 4 5 Real GDP (billions of 2000 dollars) 0 5 9 12 14 15 5 4 3 2 1 Real wage rate (2000 dollars per hour) Table Quantity of labor supplied (billions of hours per year) Real wage rate (2000 dollars per hour) 1. 2. 3. 4. 5. 6. 7. 0 1 2 3 4 5 1. 50 2. 00 2. 50 3. 00 3. 50 4. 00 Draw Labor Market graph Draw Production Function Show relationship between graphs What is the equilibrium real wage rate What is the equilibrium employment What is potential GDP Show the effect of a significant decrease in labor productivity on both graphs

EXERCISES Table Quantity of labor demanded (billions of hours per year) 0 1 2 3 4 5 Real GDP (billions of 2000 dollars) 0 5 9 12 14 15 5 4 3 2 1 Real wage rate (2000 dollars per hour) Table Quantity of labor supplied (billions of hours per year) Real wage rate (2000 dollars per hour) 1. 2. 3. 4. 0 1 2 3 4 5 1. 50 2. 00 2. 50 3. 00 3. 50 4. 00 Draw Labor Market graph Draw Production Function Show relationship between graphs What is the equilibrium real wage rate 5. What is the equilibrium employment 6. What is potential GDP 7. Show the effect of a significant decrease in labor productivity on both graphs

EXERCISES Table Quantity of labor demanded (billions of hours per year) 0 1 2 3 4 5 Real GDP (billions of 2000 dollars) 0 5 9 12 14 15 5 4 3 2 1 Real wage rate (2000 dollars per hour) Table Quantity of labor supplied (billions of hours per year) Real wage rate (2000 dollars per hour) 1. 2. 3. 4. 5. 6. 7. 8. 0 1 2 3 4 5 1. 50 2. 00 2. 50 3. 00 3. 50 4. 00 $3 3 billion $12 billion Labor Demand Curve Shifts Left Production Function Curve Shifts down

EXERCISES The economy of Sweden has seen changes during the past 50 years, but the change has been steady and population growth has been modest. Sweden has high unemployment benefits, a high minimum wage, and strong labor unions. Use this information to answer 1 and 2. 1. 2. Does the unemployment that Sweden experiences arise primarily from job search or job rationing? Which of the factors listed suggest that Sweden has a higher natural unemployment rate than the United States and which suggest that Sweden has a lower natural unemployment rate than the United States? Does the unemployment that Sweden experiences arise primarily from job search or job rationing? • High Unemployment benefits = increased job search • High minimum wage & strong labor unions = job rationing • Thus, not possible to determine Which of the factors listed suggest that Sweden has a higher natural unemployment rate than the United States and which suggest that Sweden has a lower natural unemployment rate than the United States? • Lower modest population growth • Higher All others

EXERCISES The figure illustrates the labor market on Sandy Island. In addition (not shown in the figure), a survey tells us that when Sandy Island is at full employment, people spend 1, 000 hours a day in job search. Use this information to answer Exercises 3 and 4. 3. Find the full-employment equilibrium real wage rate and quantity of labor employed and calculate the natural unemployment rate. 4. If the government introduces a minimum wage of $4 an hour, how much unemployment is created? 3. Find the full-employment equilibrium real wage rate and quantity of labor employed and calculate the natural unemployment rate. • Equilibrium RWR = $3 • Equilibrium employment = 3, 000 hours per day • (1000 / (1000+3000)) x 100 = 25% 4. If the government introduces a minimum wage of $4 an hour, how much unemployment is created? • 2000 hours per day

EXERCISES The following events occur in the United States one at a time: • An oil embargo in the Middle East cuts supplies of oil to the United States. • The Anaheim Angels win the World Series. • U. S. labor unions negotiate wage hikes that affect all workers. • A huge scientific breakthrough doubles U. S. labor productivity. • Migration to the United States increases the working-age population. 1. Sort the items into four groups that Change: Production Function Shifts down Oil embargo Shifts up Scientific breakthrough Supply of Labor Increases increased migration Demand for Labor Increases scientific breakthrough Inc. prdctvty Do not Change any world series, union negotiation Union negotion does increase QLS and decrease QLD

EXERCISES The following events occur in the United States one at a time: • An oil embargo in the Middle East cuts supplies of oil to the United States. • The Anaheim Angels win the World Series. • U. S. labor unions negotiate wage hikes that affect all workers. • A huge scientific breakthrough doubles U. S. labor productivity. • Migration to the United States increases the working-age population. 2. Which of the events increase the equilibrium quantity of labor and which decrease the equilibrium quantity of labor? Increase Eq. Qty Labor scientific breakthrough and increased migration Decrease Eq. Qty Labor union negotiation higher wages 3. Which of the events raise the real wage rate and which of the events lower the real wage rate? Raise Eq. RWR scientific breakthrough and union negotiation Lower Eq. RWR increased migration 4. Which of the events increase potential GDP and which decrease potential GDP? Increase PGDP scientific breakthrough and increased migration Decrease PGDP oil embargo and union negotiated wage increase

EXERCISES . Labor hours (per day) Real GDP (dollars per year) 0 10 20 30 40 0 100 180 240 280 Real wage rate (dollars per hour) Quantity of labor demanded 1. 00 10 50 0. 80 20 40 0. 60 30 30 0. 40 40 20 Quantity of labor supplied (hours per day) 2. What is the quantity of labor employed, potential GDP, the real wage rate, and total labor income? RWR = $0. 60/hr Eq. Qty Labor = 30 hrs/day PGDP = 240/yr 3. Suppose that the government introduces a minimum wage of $0. 80 an hour. What is the real wage rate, the quantity of labor employed, potential GDP, and unemployment? Does the unemployment arise from job search or job rationing? Is the unemployment cyclical? Explain RWR = $0. 80/hr Qty Labor employed = 20 hrs/day PGDP = 180/yr Unemployment = 20 hrs per day due to job rationing from minimum wage

EXERCISES Tsunami Social Cost Yet to Come Relief experts estimate it could take up to a decade for some places to fully recover, and reconstruction will cost about $9 billion. . An assessment by the Indonesian government estimated total damage from the tsunami at $4. 5 billion to $5 billion. . Housing, commerce, agriculture, fisheries, and transport vehicles and services suffered losses of $2. 8 billion, or 63 percent of the total. CNN, 19 December 2005 2. Explain the effect of the tsunami on employment in Indonesia. Did Indonesia move along its production function or did its production function shift? How did Indonesia’s potential GDP change? Demand for Labor Decreased decreased productivity Supply of Labor Decreased Due to deaths Production function shifted down due to destruction Production function moved downward due to fall in employment PGDP decreases

FORMULAS RWR = Nominal Wage Rate Price Level

EYE on the U. S. PAST POTENTIAL GDP 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.

EYE on the U. S. PAST POTENTIAL GDP 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 in lies to the right of the European demand for labor.

EYE on the U. S. PAST POTENTIAL GDP 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.

EYE on the U. S. PAST POTENTIAL GDP 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.

EYE on the U. S. ECONOMY The Lucas Wedge and the Okun Gap During the 1960 s, U. S. real GDP person expanded at 2. 9 percent a year. The red line shows the actual path of real GDP. The black line shows the path of real GDP if that growth rate has been maintained. The shaded wedge shows the lost output— equivalent to $284, 500 person.

EYE on the U. S. ECONOMY The Lucas Wedge and the Okun Gap The red line shows the output gap—the percentage deviation of real GDP from potential GDP. When real GDP is below potential GDP, output is lost and the gap is negative. A negative gap is called an Okun gap. The Okun gap since the end of 1960 is equivalent to $12, 850 person.

EYE on the U. S. ECONOMY The Lucas Wedge and the Okun Gap Since the end of the 1960 s when the growth rate of real GDP slowed: • The Lucas wedge is equivalent to more than 6 years’ income. • The Okun gap is equivalent to about 3 months’ income. So smoothing the business cycle has a smaller payoff compared to the potentially huge payoff from restoring real GDP growth to its 1960 s rate.

EYE on the GLOBAL ECONOMY Potential GDP in the United States and European Union In 2008, potential GDP person in the United States was $44, 000 (in 2005 dollars). In 11 major European economies, potential GDP person was $32, 000—a gap of 38 percent. Part (a) of the figure shows this large difference.

EYE on the GLOBAL ECONOMY Potential GDP in the United States and European Union In the United States in 2008, the real wage rate was $34 an hour and in Europe, it was $29 an hour —a 17 percent gap. Part (b) of the figure shows this large difference. How can the average American produce 38 percent more than the average European but earn in wages only 17 percent more?

EYE on the GLOBAL ECONOMY Potential GDP in the United States and European Union The answer is that Americans work more than Europeans. 1. 48 out of every 100 Americans have jobs compared with 46 out of every 100 Europeans. 2. Europeans work shorter hours than Americans— 30. 5 hours a week compared to the 34 hours that Americans work—a 12 percent difference shown in part (c).

EYE on the PAST Average Unemployment Rates over Six Decades If we look back at the U. S. economy decade by decade, we can see through the ups and downs of the business cycle and focus on the broad trends. By looking at the average unemployment rates across the decades, we get an estimate of the movements in the natural unemployment rate.

EYE on the PAST Average Unemployment Rates over Six Decades During the 1950 s and 1960 s, the unemployment rate averaged less than 5 percent.

EYE on the PAST Average Unemployment Rates over Six Decades During the 1970 s and 1980 s, the average unemployment rate climbed to more than 7 percent.

EYE on the PAST Average Unemployment Rates over Six Decades The 1990 s and 2000 s saw the average unemployment rate fall but not quite back to the rate of the 1950 s and 1960 s.

EYE on the PAST Average Unemployment Rates over Six Decades You will be a member of the labor force in the 2010 s. The average unemployment rate of the second decade of the 2000 s will have a big effect on your job market success.

EYE on the GLOBAL ECONOMY Unemployment Benefits and the Natural Unemployment Rate Europe has much higher unemployment benefits than the United States. Are the higher unemployment benefits the source of Europe’s higher natural unemployment rate? To isolate the effects of unemployment benefits, we need to keep other things the same. Canada provides an experiment in which things are similar.

EYE on the GLOBAL ECONOMY Unemployment Benefits and the Natural Unemployment Rate Before 1980, unemployment rates in the United States and Canada were similar.

EYE on the GLOBAL ECONOMY Unemployment Benefits and the Natural Unemployment Rate The key change in the 1980 s was an increase in Canadian unemployment benefits.

EYE on the GLOBAL ECONOMY Unemployment Benefits and the Natural Unemployment Rate Almost 100 percent of Canada’s unemployed people receive benefits compared to 38 percent in the United States.

EYE on the GLOBAL ECONOMY Unemployment Benefits and the Natural Unemployment Rate Unemployed benefits appears to have a large effect on the natural unemployment rate.

EYE on the GLOBAL ECONOMY Unemployment Benefits and the Natural Unemployment Rate The gap narrowed after 2000 as cyclical unemployment rose less in Canada in the last two recessions.

EYE on the U. S. ECONOMY The Federal Minimum Wage The Fair Labor Standards Act of 1938 set the federal minimum wage in the United States at 25¢ an hour. Over the years, the minimum wage has increased and in 2009 it was $7. 25 an hour. Although the minimum wage has increased, it has not kept up with the rising cost of living.

EYE on the U. S. ECONOMY The Federal Minimum Wage The figure shows the real minimum wage rate in 2005 dollars from 1959 to 2009.

EYE on the U. S. ECONOMY The Federal Minimum Wage During the late 1960 s, the minimum wage in 2005 dollars was $7. 50 an hour.

EYE on the U. S. ECONOMY The Federal Minimum Wage The minimum wage decreased during the 1970 s and 1980 s and has fluctuated around $6 an hour since the mid-1980 s.

EYE on YOUR LIFE Natural Unemployment You will encounter natural unemployment at many points in your life. If you now have a job, you probably went through a spell of natural unemployment as you searched for it. When you graduate and look for a full-time job, you most likely will spend some more time searching for the best match for your skills and location preferences. In today’s world of rapid technological change, most of us must retool and change our jobs at least once and for many of us, more than once.

EYE on YOUR LIFE Natural Unemployment You might know an older worker who has recently lost a job and is going through the agony of figuring out what to do next. Although natural unemployment can be painful for people who experience it, from a social perspective, it is productive. It enables scarce labor resources to be re-allocated to their most valuable uses.