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8. Potential GDP and the Natural Unemployment Rate. CHAPTER. EYE ONS. Classical macroeconomics Great Depression Keynesian macroeconomics Union wage New macroeconomics Efficiency wage Demand of labor Union wage Supply of labor Production function

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8

Potential GDP and the

Natural Unemployment Rate

CHAPTER

EYE ONS

Classical macroeconomics Great Depression

Keynesian macroeconomics Union wage

New macroeconomics Efficiency wage

Demand of labor Union wage

Supply of labor Production function

Quantity of labor demanded Diminishing returns

Quantity of labor supplied Job rationing

Potential GDP Job search


Classical vs keynesian
CLASSICAL vs KEYNESIAN

Agree with

Classical View

but add idea that

fluctuations in the

quantity 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

Works but is Unstable

Must Spend to Counteract

Decreased Private

Spending

Occur when households and

businesses do not spend

enough on consumption and

investment

TWO Possible Problems:

1. Slow rate of RGDP Increase

2. 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

CLASSICAL KEYNESIAN MONETARISTS

MARKETS

ECONOMY

GOVERNMENT

DEPRESSION &HIGH

UNEMPLOYMENT

DISPUTED

Great Depression

Foundation

Works Well

Will Fluctuate and

Growth will Slow

Cannot Improve Market Performance

Occur & Will Fix Itself

Natural consequence

In the 30’s, The Great

Depression

  • 25% unemployment

  • 30% Decrease Prdxn

    Cause: natural

    Fix: none

    Popular until 1930’s


Keynesian issues
KEYNESIAN ISSUES

  • Slow rate of RGDP Growth

    • Job creation is SLOW

    • Short Term = Decrease in Unemployment

    • Long Term = Increase in Unemployment

  • 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

But “In the long run we are all dead”


New economic theory today s consensus
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 per person.


Eye on us economy
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
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
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 gdp1
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

FIRMS

LABOR DEMAND

  • $RWR = #QLD

    • Movement along the curve

    • Shift in the curve

    • Change in Productivity

  • Quantity of Labor Demanded

  • Demand for Labor


Labor supply

HOUSEHOLDS

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

DEMAND SUPPLY

GRAPH SHELLS

RWR

RWR

LS1

LS

LS2

LD2

LD

LD1

LABOR

LABOR

  • CURVE SHIFTS:

  • $ qty LS = $Wages (on y axis)

  • $ LS = #income taxes

  • $ LS = #unemployment benefits

  • $ LS = $population

  • CURVE SHIFTS:

  • $ qty LD = #Wages (on y axis)

  • $ LD = $Productivity


Graph relationship
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

LABOR MARKET – Natural Unemployment Rate


Exercises
EXERCISES

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


Exercises1
EXERCISES

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


Exercises2
EXERCISES

$3

3 billion

$12 billion

Labor Demand Curve Shifts Left

Production Function Curve Shifts down


Exercises3

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.

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?

EXERCISES

  • 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


Exercises4
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.

Find the full-employment equilibrium real wage rate and quantity of labor employed and calculate the natural unemployment rate.

If the government introduces a minimum wage of $4 an hour, how much unemployment is created?

  • 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%

  • If the government introduces a minimum wage of $4 an hour, how much unemployment is created?

    • 2000 hours per day


Exercises5

  • 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 embargo

  • Shifts up  Scientific breakthrough

    • Increases  increased migration

  • Increases scientific breakthrough Inc. prdctvty

  • world series, union negotiation

  • Union negotion does increase QLS and decrease QLD

  • EXERCISES


    Exercises6

    • 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.

    • Which of the events increase the equilibrium quantity of labor and which decrease the equilibrium quantity of labor?

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

    • Which of the events increase potential GDP and which decrease potential GDP?

    EXERCISES

    Increase Eq. Qty Labor scientific breakthrough and increased migration

    Decrease Eq. Qty Labor  union negotiation higher wages

    Raise Eq. RWR  scientific breakthrough and union negotiation

    Lower Eq. RWR increased migration

    Increase PGDP  scientific breakthrough and increased migration

    Decrease PGDP  oil embargo and union negotiated wage increase


    Exercises7

    . time:

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

    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

    EXERCISES

    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/yr

    Unemployment = 20 hrs per day due to job rationing from minimum wage


    Exercises8

    Tsunami Social Cost Yet to Come time:

    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

    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?

    EXERCISES

    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

    Nominal Wage Rate time:

    RWR =

    Price Level

    FORMULAS


    EYE on U.S. POTENTIAL GDP time:

    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 U.S. POTENTIAL GDP time:

    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 U.S. POTENTIAL GDP time:

    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 U.S. POTENTIAL GDP time:

    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.


    The Lucas Wedge and the Okun Gap time:

    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 Lucas Wedge and the Okun Gap time:

    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.


    The Lucas Wedge and the Okun Gap time:

    • 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.


    Potential GDP in the United States and European Union time:

    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 time:

    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?


    Potential GDP in the United States and European Union time:

    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).


    Average Unemployment Rates over Six Decades time:

    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.


    Average Unemployment Rates over Six Decades time:

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


    Average Unemployment Rates over Six Decades time:

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


    Average Unemployment Rates over Six Decades time:

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


    Average Unemployment Rates over Six Decades time:

    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.


    Unemployment Benefits and the time:

    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.


    Unemployment Benefits and the time:

    Natural Unemployment Rate

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


    Unemployment Benefits and the time:

    Natural Unemployment Rate

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


    Unemployment Benefits and the time:

    Natural Unemployment Rate

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


    Unemployment Benefits and the time:

    Natural Unemployment Rate

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


    Unemployment Benefits and the time:

    Natural Unemployment Rate

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


    The Federal Minimum Wage time:

    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 Federal Minimum Wage time:

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


    The Federal Minimum Wage time:

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


    The Federal Minimum Wage time:

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


    Natural Unemployment time:

    • 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 time:

    • 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.


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