potential gdp and the natural unemployment rate

Potential GDP and theNatural Unemployment Rate CHAPTER8

EYE ONS

Classical macroeconomics Great DepressionKeynesian macroeconomics Union wageNew macroeconomics Efficiency wageDemand of labor Union wageSupply of labor Production functionQuantity of labor demanded Diminishing returnsQuantity of labor supplied Job rationingPotential GDP Job search

CLASSICAL vs KEYNESIAN

CLASSICAL KEYNESIAN MONETARISTSWorks WellWill Fluctuate and Growth will SlowCannot Improve Market

Performance

Occur & Will Fix ItselfNatural consequence

In the 30’s, The Great Depression- 25% unemployment- 30% Decrease Prdxn

Cause: naturalFix: none

Popular until 1930’s

MARKETSECONOMY

GOVERNMENT

DEPRESSION &HIGHUNEMPLOYMENT

DISPUTED

Great Depression

Foundation

Works but is Unstable

Must Spend to CounteractDecreased Private Spending

Occur when households andbusinesses do not spendenough on consumption andinvestment

TWO Possible Problems:1. Slow rate of RGDP

Increase2. Persistent Inflation

Cause: too little consumer spending and investment

Fix: Increase Govt Spending that could cause worse problems in the future

John Keynes, around 1930’s

Agree with Classical View

but add idea that fluctuations in thequantity of money

influence the business

cycle

Slow in growth rate of money = recession

Cause: large decrease in the quantity of money

Fix: none

Milton Friedman

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

• 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 recessionsWhen 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 shocksEven a small slowdown in economic growth brings a huge cost in terms of a

permanently lower level of income per person.

EYE ON US ECONOMY

The Lucas wedge is equivalent to 6 years’ real GDP.

During the 1960s, U.S. real GDP per 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

per 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 per

person.

So smoothing the business cycle has a smaller payoff compared to the potentially huge payoff from restoring real GDP growth to its 1960s 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 ProductionLabor & Human CapitalPhysical CapitalLandEntrepreneurship

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 RWR = QLD

Movement along the curve

Shift in the curve

Change in Productivity

LABOR SUPPLY

Quantity of Labor Supplied Supply of Labor 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

CURVE SHIFTS: qty LS = Wages (on y axis) LS = income taxes LS = unemployment benefits LS = population

LD

LS1RWR

LABOR

LS2

LD1LD2

LSRWR

LABOR

DEMAND SUPPLY

CURVE SHIFTS: qty LD = Wages (on y axis) LD = Productivity

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

TableQuantity 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 15Real wage rate (2000 dollars per hour) 5 4 3 2 1

TableQuantity of labor supplied (billions of hours per year)

0 1 2 3 4 5

Real wage rate (2000 dollars per hour) 1.50 2.00 2.50 3.00 3.50 4.00

1. Draw Labor Market graph2. Draw Production Function3. Show relationship between graphs4. What is the equilibrium real wage rate5. What is the equilibrium employment6. What is potential GDP7. Show the effect of a significant decrease in labor productivity

on both graphs

EXERCISES


0 1 2 3 4 5



0 1 2 3 4 5


1. Draw Labor Market graph2. Draw Production Function3. Show relationship between graphs4. What is the equilibrium real wage

rate5. What is the equilibrium employment6. What is potential GDP7. Show the effect of a significant

decrease in labor productivity on both graphs

EXERCISES


0 1 2 3 4 5



0 1 2 3 4 5


1. 2. 3. 4. $35. 3 billion6. $12 billion7. Labor Demand Curve Shifts Left8. Production Function Curve Shifts

down

EXERCISESThe 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.Does the unemployment that Sweden experiences arise primarily from job search or job rationing?

2.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?

1. 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

2. 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

Supply of Labor

Demand for Labor

Do not Change any

Shifts down Oil embargoShifts up Scientific breakthrough

Increases increased migration

Increases scientific breakthrough Inc. prdctvty

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?

3.Which of the events raise the real wage rate and which of the events lower the real wage rate?

4.Which of the events increase potential GDP and which decrease potential GDP?

Increase Eq. Qty Labor scientific breakthrough and increased migrationDecrease Eq. Qty Labor union negotiation higher wages

Raise Eq. RWR scientific breakthrough and union negotiationLower Eq. RWR increased migration

Increase PGDP scientific breakthrough and increased migrationDecrease PGDP oil embargo and union negotiated wage increase

EXERCISES

.

2.What is the quantity of labor employed, potential GDP, the real wage rate, and total labor income?

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 = $0.60/hr Eq. Qty Labor = 30 hrs/day PGDP = 240/yr

RWR = $0.80/hr Qty Labor employed = 20 hrs/day PGDP = 180/yrUnemployment = 20 hrs per day due to job rationing from minimum wage

Laborhours

(per day)

Real GDP(dollars

per year)

0 010 10020 18030 24040 280

Realwage rate(dollars

per hour)

Quantity of labor demanded

Quantity of labor supplied

(hours per day)

1.00 10 500.80 20 400.60 30 300.40 40 20

EXERCISES

Tsunami Social Cost Yet to ComeRelief 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 deathsProduction function shifted down due to destructionProduction function moved downward due to fall in employmentPGDP decreases

FORMULAS

Nominal Wage RatePrice Level

RWR =

EYE on the PAST

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.

Why Do Americans Earn More and Produce More than Europeans?

EYE on U.S. POTENTIAL GDP

EYE on the PAST

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 PAST

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 PAST

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 1960s, U.S. real GDP per 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 per person.



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 per person.



Since the end of the 1960s 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 1960s rate.

EYE on the GLOBAL ECONOMY

In 2008, potential GDP per person in the United States was $44,000 (in 2005 dollars).

In 11 major European economies, potential GDP per person was $32,000—a gap of 38 percent.

Part (a) of the figure shows this large difference.

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?



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


During the 1950s and 1960s, the unemployment rate averaged less than 5 percent.

EYE on the PAST


During the 1970s and 1980s, the average unemployment rate climbed to more than 7 percent.

EYE on the PAST

The 1990s and 2000s saw the average unemployment rate fall but not quite back to the rate of the 1950s and 1960s.


EYE on the PAST

You will be a member of the labor force in the 2010s.

The average unemployment rate of the second decade of the 2000s will have a big effect on your job market success.



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.

Unemployment Benefits and theNatural Unemployment Rate


Before 1980, unemployment rates in the United States and Canada were similar.



The key change in the 1980s was an increase in Canadian unemployment benefits.




Almost 100 percent of Canada’s unemployed people receive benefits compared to 38 percent in the United States.



Unemployed benefits appears to have a large effect on the natural unemployment rate.



The gap narrowed after 2000 as cyclical unemployment rose less in Canada in the last two recessions.


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.



The figure shows the real minimum wage rate in 2005 dollars from 1959 to 2009.



During the late 1960s, the minimum wage in 2005 dollars was $7.50 an hour.



The minimum wage decreased during the 1970s and 1980s and has fluctuated around $6 an hour since the mid-1980s.

EYE on YOUR LIFE

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.

Natural Unemployment

EYE on YOUR LIFE

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.

Natural Unemployment

potential gdp and the natural unemployment rate

Documents

growth rate of money

quantity of goods

quantity of moneyfix

years real gdp

economic growth

govt spending

recessionswhen spending

actual path of real