Potential GDP and the Natural Unemployment Rate

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1 CHAPTER CHECKLIST Potential GDP and the Natural Unemployment Rate Chapter Chapter 8 begins by introducing different macroeconomic schools of thought. The three main schools of thought are classical macroeconomics, Keynesian macroeconomics, and monetarist macroeconomics. Classical macroeconomics asserts that markets work well and, although the economy will fluctuate, no government intervention is needed. But classical macroeconomics couldn t explain why the Great Depression lasted so long. Keynesian economics was borne during the Great Depression and asserted that depressions were the result of too little spending. Keynesian economics calls for government intervention to assist the economy. Monetarist macroeconomics says that the classical approach is generally correct but that fluctuations in the quantity of money also create business cycles. The consensus view is that classical economics explains the economy when it is at or close to full employment and Keynesian economics applies in recessions and depressions. Monetarist economics explains inflation and also adds to the Keynesian view by suggesting other causes of recessions. The consensus view emphasizes that maintaining economic growth is more important than eliminating business cycle fluctuations because the Lucas wedge (the cost of slower economic growth) is much larger than Okun gaps (the cost of business cycle recessions). Explain what determines potential GDP. Potential GDP is the value of real GDP when all the economy s factors of production labor, capital, land, and entrepreneurial ability are fully employed. The production function shows the maximum quantity of real GDP that can be produced as the quantity of labor employed changes and all other influences on production remain the same. Its shape reflects diminishing returns, so that each additional hour of labor employed produces a successively smaller addition of real GDP. The quantity of labor employed is determined in the labor market. The quantity of labor demanded increases when the real wage rate falls and decreases when the real wage rate rises. The quantity of labor supplied increases when the real wage rate rises and decreases when the real wage rate falls. Labor market equilibrium occurs at the intersection of the labor supply curve and the labor demand curve. When the labor market is in equilibrium, the economy is at full employment. At this point real GDP, determined using equilibrium employment and the production function, equals potential GDP. Explain what determines the natural unemployment rate. The natural unemployment rate is the unemployment rate at full employment and consists of frictional and structural unemployment. The two fundamental causes of unemployment at full employment are job search, which is the activity of looking for an acceptable job, and job rationing, which occurs when the real wage rate exceeds the equilibrium wage rate creating a surplus of labor. The amount of job search depends on demographic change, unemployment benefits, and structural change. Job rationing occurs when there is an efficiency wage, a minimum wage, or a union wage because all of these factors force the real wage above the equilibrium real wage.

2 110 Part 3. THE REAL ECONOMY CHECKPOINT 8.1 Explain what determines potential GDP. Quick Review Production function The production function shows the maximum quantity of real GDP that can be produced as the quantity of labor employed changes and all other influences on production remain constant. Equilibrium in a market The equilibrium in a market occurs at the intersection of the demand and supply curves. Additional Practice Problem 8.1 Quantity of labor demanded hours per year) Real GDP (hundreds of billions of 2005 dollars) Real wage rate (2005 dollars per hour) The table above describes a small economy s production function and its demand for labor. The table below describes the supply of labor in this economy. Quantity of labor supplied hours per year) Real wage rate (2005 dollars per hour) a. Make graphs of the production function and the labor market. b. Does the production function show diminishing returns? c. What is the equilibrium employment, real wage rate, and potential GDP? d. Suppose that the population grows so that the quantity of labor supplied increases by 20 billion hours at every real wage rate. What is the effect on the real wage rate and on potential GDP? Solutions to Additional Practice Problem 8.1 1a. The production function is a graph of the first two columns of the first table. The figure to the right shows the relationship between labor and real GDP. The second figure to the right shows the labor market. The labor demand curve is the first and third columns in the first table. It shows the relationship between the real wage rate and the quantity of labor demanded. The labor supply curve is from the second table and shows the relationship between the real wage rate and the quantity of labor supplied. 1b. The production function shows diminishing returns because every additional 10 billion hours of labor employed increases real GDP by less. 1c. Find the equilibrium in the labor market. Then use the production function to determine how much GDP this full-employment quantity of labor produces, which is the potential GDP. Equilibrium employment is where the labor demand curve and the labor supply curve intersect. The second figure in part (a) shows that the equilibrium real wage rate is $30 an hour and the equilibrium em-

3 Chapter 8. Potential GDP and the Natural Unemployment Rate 111 ployment is 20 billion hours per year. The production function, in the first figure in part (a), shows that when 20 billion hours of labor are employed, GDP is $900 billion, so potential GDP equals $900 billion. Quantity of labor supplied hours per year) Real wage rate (2005 dollars per hour) d. The new labor supply schedule is given in the table above and shown in the figure. In the figure, the labor supply curve shifts rightward from LS1 to LS2. The equilibrium quantity of labor increases to 30 billion hours and the equilibrium real wage rate falls to $20. The production function in the first table in the practice problem shows that when employment is 30 billion hours, real GDP is $1,200 billion. So, the increase in the population increases potential GDP to $1,200 billion. Self Test 8.1 Fill in the blanks (Classical; Keynesian) macroeconomics asserts that government intervention is needed to achieve full employment. The consensus view believes that (classical; Keynesian; monetarist) macroeconomics best describes the economy at full employment. The relationship that shows the maximum quantity of real GDP that can be produced as the quantity of labor employed changes is (the production function; potential GDP). The quantity of labor demanded (increases; decreases) as the real wage rate falls and the quantity of labor supplied (increases; decreases) as the real wage rate falls. If the real wage rate exceeds the equilibrium real wage rate, there is a (shortage; surplus) of labor. When the labor market is in equilibrium, there is and real GDP equals. True or false 1. Classical macroeconomics says that markets work well and government intervention cannot improve on the performance of markets. 2. The consensus view asserts that the problem of business cycle fluctuations is much more important than the problem of sustaining economic growth. 3. Real GDP can exceed potential GDP permanently. 4. The production function shows how the quantity of labor hired depends on the real wage rate. 5. The nominal wage rate influences the quantity of labor demanded because what matters to firms is the number of dollars they pay for an hour of labor. 6. At the labor market equilibrium the real wage rate sets the quantity of labor demanded equal to the quantity of labor supplied. 7. When the labor market is in equilibrium, the economy is at full employment and real GDP equals potential GDP. Multiple choice 1. adopts the view that aggregate fluctuations are a natural consequence of an expanding economy. a. Classical macroeconomics b. Keynesian economics c. Monetarist macroeconomics d. The Lucas wedge e. The Okun gap

4 112 Part 3. THE REAL ECONOMY 2. Potential GDP a. is the quantity of GDP produced when the economy is at full employment of all resources. b. can never be exceeded. c. can never be attained. d. is another name for real GDP. e. is another name for nominal GDP. 3. With fixed quantities of capital, land, and entrepreneurship and fixed technology, the amount of real GDP produced increases when increases. i. the quantity of labor employed ii. the inflation rate iii. the price level a. i only. b. ii only. c. iii only. d. ii and iii. e. i, ii, and iii. 4. The production function graphs the relationship between a. nominal GDP and real GDP. b. real GDP and the quantity of labor employed. c. real GDP and capital. d. nominal GDP and the quantity of labor employed. e. real GDP and the supply of labor. 5. The quantity of labor demanded definitely increases if the a. real wage rate rises. b. real wage rate falls. c. nominal wage rate rises. d. nominal wage rate falls. e. supply of labor decreases. 6. The labor supply curve has a slope because as the real wage rate rises,. a. negative; firms hire fewer workers b. positive; the opportunity cost of leisure rises c. positive; the opportunity cost of leisure falls d. negative; households work more hours e. positive; firms offer more jobs 7. The real wage rate is $35 an hour. At this wage rate there are 100 billion labor hours supplied and 200 billion labor hours demanded. There is a a. shortage of 300 billion hours of labor. b. shortage of 100 billion hours of labor. c. surplus of 100 billion hours of labor. d. surplus of 300 billion hours of labor. e. shortage of 200 billion hours of labor. 8. In Figure 8.1, the equilibrium real wage rate is per hour and equilibrium employment is billions of hours per year. a. $50; 200 b. $10; 100 c. $30; more than 300 d. $20; 125 e. $30; In Figure 8.1, full employment is reached when employment is billions of hours a year. a. 150 b. 200 c. 250 d. more than 300 e. More information is needed about the nation s production function to answer the question.

5 Chapter 8. Potential GDP and the Natural Unemployment Rate When the labor market is in equilibrium, real GDP potential GDP. a. is greater than b. is equal to c. is less than d. might be greater than, less than, or equal to e. is not comparable to 11. Compared to the U.S. production function, the European production function is a. higher. b. lower. c. the same. d. lower than the U.S. production function at low levels of employment and higher than the U.S. production function at high levels of employment. e. higher than the U.S. production function at low levels of employment and lower than the U.S. production function at high levels of employment. Complete the graph Quantity of labor hours per year) Real GDP 2005 dollars) , The above table gives data for a nation s production function. In Figure 8.2, draw the production function. Label the axes. How are diminishing returns reflected? 2. Figure 8.3 illustrates the labor market for the nation with the production function given in the previous problem. In the figure, identify the equilibrium real wage rate and employment. Using the production function in Figure 8.2, what is the nation s potential GDP? 3. Using the data in Problems 1 and 2, suppose that both the labor supply and labor demand curves shift rightward by 10 billion labor hours and the production function does not change. What is the nation s potential GDP? Short answer and numeric questions 1. What are the differences between classical macroeconomics and Keynesian macroeconomics? 2. What is the relationship between equilibrium in the labor market and potential GDP? Be sure to explain the role played by the production function. 3. Suppose a nation s production function shifts upward. If the equilibrium quantity of labor does not change, what is the effect on the nation s potential GDP? 4. Suppose a nation s production function shifts upward and the equilibrium quantity of labor increases. What is the effect on the nation s potential GDP?

6 114 Part 3. THE REAL ECONOMY Additional Exercises (also in MyEconLab Test A) Quantity of labor demanded hours per year) Real GDP 2005 dollars) Real wage (2005 dollars per hour) Quantity of labor supplied hours per year) Real wage (2005 dollars per hour) This first table above describes an economy s production function and demand for labor. The second table above describes the supply of labor in this economy. Use the data in the tables to make graphs of the labor market and production function. What are equilibrium employment, real wage rate, and potential GDP? CHECKPOINT 8.2 Explain what determines the natural unemployment rate. Quick Review Job search Job search is the activity of looking for an acceptable vacant job. Job search is influenced by demographic changes, unemployment benefits, and structural change. Job rationing Job rationing is a situation that arises when the real wage rate is above the full-employment equilibrium level. An efficiency wage, a minimum wage, or a union wage can lead to job rationing. Additional Practice Problems Why do demographic changes affect the amount of job search? 2. What factors can keep the real wage rate above the full-employment level? How do these factors affect the amount of employment? 3. Since 1969, how has the real minimum wage generally changed in the United States? What effect would this trend have on the natural unemployment rate? Solutions to Additional Practice Problems Demographic changes affect the amount of job search because younger workers conduct more job search than do older workers. In particular, older workers generally have already settled into a career, whereas younger workers are often entering the labor market for the first time. As new entrants, younger workers must search for a job. In addition, younger workers often switch between jobs before settling upon their career and while they are switching, they are searching for a new job. 2. Job rationing, when the real wage rate is above the full-employment equilibrium level, is the result of efficiency wages, the minimum wage, and union wages. An efficiency wage is a real wage that a firm sets above the full-employment equilibrium level in order to motivate its workers to work harder. A minimum wage is a government regulation that sets the lowest wage legal to pay. A union wage is a wage rate negotiated between a labor union and a firm. Because these wage rates are above the full-employment level, the quantity of labor employed is less than it otherwise would be. 3. Since 1969 there has been a general downward trend in the real minimum wage. The drop was most prolonged between 1979 and 1989, after which the real minimum wage has generally hovered near $6 an hour. The general downward trend in the real minimum wage reduces the amount of job rationing, thereby decreasing the natural unemployment rate.

7 Chapter 8. Potential GDP and the Natural Unemployment Rate 115 Self Test 8.2 Fill in the blanks The unemployment rate at full employment is the. The activity of looking for an acceptable vacant job is called (job search; job rationing). An increase in unemployment benefits (decreases; increases) job search. Job rationing occurs when the real wage rate is (above; below) the equilibrium level. A minimum wage set above the equilibrium wage rate (creates; does not create) unemployment. If the real wage rate is above the fullemployment equilibrium level, the natural unemployment rate (increases; decreases). True or false 1. The amount of job search depends on a number of factors including demographic change. 2. An increase in unemployment benefits, other things remaining the same, will increase the amount of time spent on job search. 3. Job rationing has no effect on the natural unemployment rate. 4. Job rationing results in a shortage of labor. 5. Teenage labor is not affected by the minimum wage. Multiple choice 11. In the United States since 1960, the average unemployment rate was highest during the decade of the a. 1960s. b. 1970s. c. 1980s. d. 1990s. e. 2000s. 12. The two fundamental causes of unemployment at full employment are a. seasonal jobs and technological change. b. foreign competition and financial bankruptcies. c. job search and job rationing. d. decreases in labor productivity and more generous retirement benefits. e. demographic change and decreases in the demand for labor. 13. Job search is defined as a. the activity of looking for an acceptable, vacant job. b. saying you are looking for a job when you are actually not looking. c. attending school to increase your employability. d. equivalent to job rationing. e. being paid an efficiency wage. 14. The more generous the amount of unemployment benefits, the a. higher the opportunity cost of job search. b. lower the opportunity cost of job search. c. shorter the time spent searching until accepting a suitable job. d. shorter the time spent searching for a suitable job and the higher the opportunity cost of being unemployed. e. lower the natural unemployment rate. 15. Job rationing occurs if a. the minimum wage is set below the equilibrium wage rate. b. an efficiency wage is set below the equilibrium wage rate. c. a union wage is set below the equilibrium wage rate. d. the real wage rate is pushed above the equilibrium wage rate. e. the Lucas wedge is positive.

8 116 Part 3. THE REAL ECONOMY 16. Intel wants to attract the most productive and knowledgeable workers. To achieve this goal it could pay wage. a. an efficiency b. a minimum c. a nominal d. an equilibrium e. a Lucas wedge 17. Collective bargaining by unions can result in a union wage rate that is the equilibrium real wage rate and creates a of labor. a. above; surplus b. above; shortage c. below; surplus d. below; shortage e. equal to; surplus 19. In Figure 8.4, if there is any job rationing, the real wage rate must be per hour and employment is billion hours. a. less than $30; more than 150 b. equal to $30; equal to 150 c. less than $30; less than 150 d. more than $30; less than 150 e. less than $20; less than 150 Complete the graph 18. In Figure 8.4, of the wages listed below, there is the most job rationing and unemployment if the real wage rate equals a. $10 per hour. b. $20 per hour. c. $30 per hour. d. $40 per hour. e. None of the above is correct because at any real wage rate there is never any job rationing. 1. Figure 8.5 illustrates the labor market. a. What is the equilibrium wage rate? Equilibrium employment? b. What must a firm do to set an efficiency wage? c. Suppose the government imposes a minimum wage that creates a surplus of 60 billion hours of labor a year. What is the minimum wage? d. If a union negotiates on behalf of its members, what can you say about the range of wage rates the union will try to obtain? e. In your answers to (b), (c), and (d), is there any unemployment? Compare your answers to parts (b), (c), and (d). How does the employment that results in these situations compare with that in part (a)?

9 Chapter 8. Potential GDP and the Natural Unemployment Rate 117 Short answer and numeric questions Real wage rate (2005 dollars per hour) Quantity of labor demanded hours per year) Quantity of labor supplied hours per year) The above table gives the labor demand and labor supply schedules for a nation. a. What is the equilibrium wage rate? b. Suppose firms set an efficiency wage of $30 an hour. What is the effect of this wage rate? c. Suppose the government sets a minimum wage of $30 an hour. What is the effect of the minimum wage? d. Suppose unions negotiate a wage of $30 an hour. What is the effect of the union wage? e. How do your answers to parts (b), (c), and (d) compare? 2. The demographics of the United States are such that there will be an increase in young people entering the labor force between 2009 and What do you predict will be the effect on the U.S. unemployment rate? 3. Why do unemployment benefits affect the natural unemployment rate? 4. An efficiency wage is a wage that exceeds the equilibrium wage rate. Why would a firm pay an efficiency wage? Additional Exercises (also in MyEconLab Test A) 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 Exercises 1 and 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? Figure 8.6 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 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?

10 118 Part 3. THE REAL ECONOMY SELF TEST ANSWERS CHECKPOINT 8.1 Fill in the blanks Keynesian macroeconomics asserts that government intervention is needed to achieve full employment. The consensus view believes that classical macroeconomics best describes the economy at full employment. The relationship that shows the maximum quantity of real GDP that can be produced as the quantity of labor employed changes is the production function. The quantity of labor demanded increases as the real wage rate falls and the quantity of labor supplied decreases as the real wage rate falls. If the real wage rate exceeds the equilibrium real wage rate, there is a surplus of labor. When the labor market is in equilibrium, there is full employment of labor and real GDP equals potential GDP. True or false 1. True; page False; pages False; page False; page False; page True; pages True; page 197 Multiple choice 11. a; page a; page a; pages b; page b; pages b; pages b; pages e; pages a; page b; page b; page 198 Complete the graph 1. Figure 8.7 illustrates the production function. In the table, diminishing returns are demonstrated by the fact that each additional 10 billion hours of labor increases real GDP by a smaller amount. In the figure, diminishing returns are illustrated by the slope of the production function, which becomes less steep as the quantity of labor increases; pages The equilibrium real wage rate is $20 an hour and the equilibrium employment is 30 billion hours. Potential GDP is $900 billion; page If both the labor demand and labor supply curves shift rightward by 10 billion labor hours, then equilibrium employment increases by 10 billion hours to 40 billion hours. Potential GDP increases to $960 billion; page 197. Short answer and numeric questions 1. Classical macroeconomics believes that markets work well and government intervention cannot improve the economy. Keynesian economics believes that a market economy is unstable and needs government intervention to help it reach full employment and sustained economic growth; pages The equilibrium quantity of labor is the amount of full employment. The production function shows how much GDP this fullemployment quantity of labor produces and this quantity of GDP is potential GDP; page 197.

11 Chapter 8. Potential GDP and the Natural Unemployment Rate If the production function shifts upward, the amount of real GDP produced by every quantity of labor increases. The nation s potential GDP increases; pages 192, On both counts, the upward shift of the production function and the increase in employment, potential GDP increases; pages 192, 197. Additional Exercises (also in MyEconLab Test A) The equilibrium wage rate and employment is determined in the labor market, illustrated in Figure 8.8. The equilibrium quantity of labor is 3 billion hours and the equilibrium real wage rate is $3 an hour. This is the real wage rate at which the quantity of labor demanded equals the quantity of labor supplied. Potential GDP is the real GDP produced by the equilibrium quantity of labor. The production function in Figure 8.9 shows that 3 billion hours of labor produces potential GDP of $12 billion; pages CHECKPOINT 8.2 Fill in the blanks The unemployment rate at full employment is the natural unemployment rate. The activity of looking for an acceptable, vacant job is called job search. An increase in unemployment benefits increases job search. Job rationing occurs when the real wage rate is above the equilibrium level. A minimum wage set above the equilibrium wage rate creates unemployment. If the real wage rate is above the full-employment equilibrium level, the natural unemployment rate increases. True or false 1. True; page True; page False; pages False; pages False; page The demand for labor curve and supply of labor curve are illustrated in Figure 8.8. The production function is illustrated in Figure 8.9. Multiple choice 11. c; page c; page a; page b; page d; pages a; page a; page d; page d; pages

12 120 Part 3. THE REAL ECONOMY Complete the graph 1. a. The equilibrium wage rate is $30 and employment is 60 billion hours; page 197. b. An efficiency wage is set higher than the equilibrium wage rate, so the firm must set the wage rate above $30; page 203. c. A minimum wage of $50 an hour creates a labor surplus of 60 billion hours a year; pages d. The union will strive to set a wage rate that is higher than the competitive wage, so the union will try to set a wage that is higher than $30; pages e. In each of the answers to parts (a), (b), and (c), unemployment occurs. And in each of the answers, employment is less than 60 billion hours; page 204. Short answer and numeric questions 1. a. The equilibrium wage rate is $20 an hour because that is the wage rate at which the quantity of labor demanded equals the quantity supplied. Employment is 60 billion hours; page 197. b. If firms set an efficiency wage of $30 an hour, there is a labor surplus of 30 billion hours a year (170 billion hours supplied minus 140 billion hours demanded); pages c. If the government sets a minimum wage of $30 an hour, there is a labor surplus of 30 billion hour a year; pages d. If unions negotiate a wage of $30 an hour, there is a labor surplus of 30 billion hours a year; pages e. In each of the answers to parts (b), (c), and (d) there is a labor surplus of 30 billion hours a year. All three of the events raise the wage rate above its equilibrium and create unemployment. All three of the events lower employment; page The natural unemployment rate increases as more young people enter the labor force and search for jobs. The natural unemployment rate in the United States likely will increase between 2009 and 2014; page If unemployment benefits increase, the opportunity cost of job search decreases. Workers spend more time unemployed, searching for jobs and so the natural unemployment rate increases; page A firm pays an efficiency wage rate to motivate its employees to work hard. The employees work hard to avoid being let go because they know that if they have to take another job, they would probably be paid the lower equilibrium wage rate; page 203. Additional Exercises (also in MyEconLab Test A) 1. Of the factors mentioned, high unemployment benefits lead to increased job search. But a high minimum wage and strong labor unions lead to job rationing. So it is not possible to determine if Sweden s unemployment arises primarily from job rationing or job search; pages Of the factors mentioned, the only one that points toward Sweden having a lower natural unemployment rate than the United States is the modest population growth. All of the other factors high unemployment benefits, high minimum wage, and strong labor force unions point toward Sweden having a higher natural unemployment rate than the United States; pages The full-employment equilibrium real wage rate is $3 per hour and the full-employment quantity of labor is 3,000 hours per day. There are 1,000 hours per day of unemployed people searching for jobs, so the total labor force is 3,000 hours + 1,000 hours, which is 4,000 hours per day. The unemployment rate is (1,000 hours) (4,000 hours) 100, or 25 percent; page If the government introduces a minimum wage of $4.00 an hour, 4,000 hours of labor are supplied by households but only 2,000 hours of labor are demanded by firms. So the resulting unemployment is 4,000 hours 2,000 hours, or 2,000 hours per day; pages