Classical Macroeconomics: Equilibrium Output and

Employment

Macroeconomics originated in 1930s after the great depression in

1929.
The problems of great depression added urgency to the study of
macroeconomic questions.
The book containing the theory, The General Theory of
Employment, Interest and Money by J M Keynes published in 1936.
J M keynes termed Classicals to refer all the economists who had
written macroeconomic issues before 1936.
They are;
Adam Smith
Wealth of nations 1776
David Ricardo
Principles of Political Economy 1817
John Stauart Mill Principles of Political Economy 1848
A Marshall
Principles of Economics 1920
A C Pigou
Principles of Economics 1933.
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Classical Macroeconomics: Equilibrium Output and

Employment
Classicals and Neoclassicals differ on Microeconomic
issues
However, they are same on the macroeconomic issues
Classical economists emphasized the importance of real
factors in determining the wealth of nations
They believe on the free market mechanism concepts
Money plays the role of facilitating transations as the
medium of exchange
They also mistrusted the role of government
Stressed the role of individual self interest in solving
macroeconomic issues.

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Says Law
J B Say (1767 1832)
Law, Supply creats its own demand
Logic: the supply of goods generate sufficient income to
generate a demand equal to the supply of goods.
The law had two major conclusions,
(1) No General over production or under production
Value of total production = Cost of production
Cost of production = Wage + Rent + Interest + Profit
Wage + Rent + Interest + Profit = factor income
Factor income = Total expenditure
Total expenditure = value of total production
Total demand = total supply

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Says law
(2) No Unemployment
Full employment means actual output = potential output.
Total production is sufficient to maintain the economy at
the level of full employment.
Unemployment is a temporary phenomenon.
If there is unemployment in the economy, wages will
decrease, and demand for labour will increase, and hence
the unemployment will disappear.
However, classical economists did not rule out the
existence of voluntary and frictional unemployment.

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Voluntary Unemployment arises when;

(a) Potential workers are unwilling to work at the prevailing wage
rate.
(b) workers go on strike
(c) Unwilling to work due to the preference of leisure
(d) Do not want to work.
Frictional Unemployment arises when workers remain temporarily
out of job due to labour market imperfections, immobility of labour,
seasonal nature of occupation, technological changes, natural
disasters
The existence of voluntary and frictional unemployment was
consistent with classical postulate of full employment.

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Classical Theory of Employment and Output Outline

The Production Function

The Demand for Labor
The Supply of Labor
Labor Market Equilibrium
Unemployment
Relating Output and Unemployment: Okuns Law

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The Production Function

The production function summarizes the relationship

between total output and total input assuming a given
technology.

Y = F(K, N)
Parameter
y = total output
K = stock of capital
N = quantity of labour

(3.1)

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The Demand for Labor

How much labor do firms want to use?

Firm owners are the purchasers of labour (demand for
labour)

Assumptions
Hold

capital stock fixedshort-run analysis

Workers are all alike
Labor market is competitive
Firms maximize profits

The Demand for Labor

The marginal product of labor and labor
demand
The firm owner will employ the labour till the
point where the marginal cost of producing a
single output = marginal revenue received from
its sale.

MRPN = P MPN
(3.3)
W = MRPN is the same condition as w = MPN,
since W = P w and MRPN = P MPN

Demand for labour

MC = marginal labour cost (labour is the only input)
MC = W/MPN
Where W = wage and MPN = number of units produced
by additional units of labour.
With the condition of profit maximization as MC = P;
P = W/MPN
Or W/P = MPN
Or W = MPN.P (MRPN)
So, the firm owner will hire up to the point where
revenue obtained from additional output produced by
one more worker (MPN.P) is equal to the money wage
paid to the worker.

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The Demand for Labor

The marginal product of labor and labor demand: an
example
A change in the wage
Begin at equilibrium where W = MRPN
A rise in the wage rate means W MRPN, unless N is
reduced so the MRPN rises
A decline in the wage rate means W MRPN, unless N
rises so the MRPN falls

The Demand for Labor

How much labor do firms want to use?
Analysis at the margin: costs and benefits of
hiring one extra worker
If real wage (w) marginal product of labor
(MPN), profit rises if number of workers
declines
If w MPN, profit rises if number of workers
increases
Firms profits are highest when w = MPN
Note: w = (W/P)

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Summary

The Demand for Labor

Labor

demand curve shows relationship between

the real wage rate and the quantity of labor
demanded
It is the same as the MPN curve, since W/P =
MPN at equilibrium
So the labor demand curve is downward sloping;
firms want to hire less labor, the higher the real
wage

The Demand for Labor

Factors that shift the labor demand curve

Note: A change in the wage causes a movement
along the labor demand curve, not a shift of the
curve
Supply shocks: Beneficial supply shock raises
MPN, so shifts labor demand curve to the right;
opposite for adverse supply shock
Size of capital stock: Higher capital stock raises
MPN, so shifts labor demand curve to the right;
opposite for lower capital stock

The Demand for Labor

Aggregate labor demand

Aggregate labor demand is the sum of all firms
labor demand
Same factors (supply shocks, size of capital
stock) that shift firms labor demand cause shifts
in aggregate labor demand

Figure 3.6 The effect of a beneficial supply

shock on labor demand

Summary

The Supply of Labor

Supply of labor is determined by individuals
Aggregate supply of labor is the sum of individuals labor
supply
Labor supply of individuals depends on labor-leisure choice
The income-leisure trade-off
Utility depends on consumption and leisure
Need to compare costs and benefits of working another day
Costs: Loss of leisure time
Benefits: More consumption, since income is higher
If benefits of working another day exceed costs, work
another day
Keep working additional days until benefits equal costs

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Labour Supply
Horizontal

axis represents the leisure per day (24 hr. max)

Vertical axis represents the real income (W/P . Number of hours
worked)
U1 U2 U3 are the indifference curves and shows the combination of
income and leisure that the individual get equal satisfaction.
The slope of the indifference curve gives the rate at which individual
is willing to trade off leisure for income.
The increase in income that the individual gains to be just well off
after giving up an unit of leisure.
The cost of choosing each hour of leisure is the real wage, as the
individual is choosing not to work for each hour of leisure.
All the points on U2 yields greater satisfaction than U1.
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Labour Supply

Starting with 24 hours of leisure, the individual can

trade off leisure for income at the rate equal to hourly
real wage.
Hence, the slope of the budget line is the real wage.
Higher is the real wage, steeper is the budget line.
A rise is the wage rate, goods become cheaper and
leisure become costlier as each individual buys more
goods than before.

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The Supply of Labor

Real wages and labor supply

The labor supply curve (Fig. 3.3)
Increase in the current real wage should raise
quantity of labor supplied
Labor supply curve relates quantity of labor
supplied to real wage
Labor supply curve slopes upward because
higher wage encourages people to work more

The Supply of Labor

An

increase in the real wage has offsetting income

and substitution effects
Substitution effect: Higher real wage encourages
work, since reward for working is higher
Income effect: Higher real wage increases
income for same amount of work time, so person
can afford more leisure, so will supply less labor

The Supply of Labor

The

substitution effect and the income effect together: a

long-term increase in the real wage
The reward to working is greater: a substitution effect
toward more work
But with higher wage, a person doesnt need to work as
much: an income effect toward less work
The longer the high wage is expected to last, the stronger
the income effect; thus labor supply will increase by less
or decrease by more than for a temporary reduction in the
real wage

The Supply of Labor

Empirical

evidence on real wages and labor supply

Overall result: Labor supply increases with a
temporary rise in the real wage
Labor supply falls with a permanent increase in the
real wage

Figure 3.4 The labor supply curve of an

individual worker

The Supply of Labor

Factors that shift the labor supply curve

Wealth: Higher wealth reduces labor supply
(shifts labor supply curve to the left, as in Fig.
3.4)
Expected future real wage: Higher expected
future real wage is like an increase in wealth, so
reduces labor supply (shifts labor supply curve
to the left)

Figure 3.5 The effect on labor supply of an

increase in wealth

The Supply of Labor

Aggregate labor supply

Aggregate labor supply rises when current real
wage rises
Some people work more hours
Other people enter labor force
Result: Aggregate labor supply curve slopes
upward

The Supply of Labor

Aggregate labor supply

Factors increasing labor supply
Decrease in wealth
Decrease in expected future real wage
Increase in working-age population (higher
birth rate, immigration)
Increase in labor force participation (increased
female labor participation, elimination of
mandatory retirement)

Summary

Summary

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Equilibrium Output and Employment:

In the classical model the level of output and
employment is determined by real forces.
Monetary factors have no role to play in determining
the level of output and employment.
If price increases, the demand for labour curve will
shift to right and creates gap between demand and
supply and create pressures the wage to increase.
So, wage will increase till the W/P is same as earlier
to remove the gap between supply and demand.

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Aggregate Supply Function:

When the price increases from P1 > P2 > P3, the
wage increases from W1 > W2> W3, such that
W1/P1 = W2/P2 = W3/P3.

Hence, relating P and Y, the aggregate supply

function is vertical.
Whatever is the price, the output is not changed.

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Figure 3.10 Labor market equilibrium

Labor Market Equilibrium

Classical model of the labor marketreal wage adjusts quickly

Determines full-employment level of employment and marketclearing real wage
Problem with classical model: cant study unemployment

Labor Market Equilibrium

Full-employment output
Full-employment output = potential output = level
of output when labor market is in equilibrium
(3.4)
Y AF ( K , N )
affected by changes in full employment level or
production function (example: supply shock, Fig.
3.11)

Figure 3.11 Effects of a temporary adverse

supply shock on the labor market

Sources: Producer price index for fuels and related products and power from research.stlouisfed.org/fred2/series/PPIENG; GDP deflator
from research.stlouisfed.org/fred2/GDPDEF. Data were scaled so that the relative price of energy equals 100 in year 2000.

Unemployment
Why there are always unemployed people
Frictional unemployment
Search activity of firms and workers due to heterogeneity
Matching process takes time

Unemployment
Why there are always unemployed people
Structural unemployment
Chronically unemployed: workers who are unemployed a large part
of the time
Structural unemployment: the long-term and chronic
unemployment that exists even when the economy is not in a
recession
One cause: Lack of skills prevents some workers from finding longterm employment
Another cause: Reallocation of workers out of shrinking industries
or depressed regions; matching takes a long time

Unemployment

The natural rate of unemployment ( u )

natural rate of unemployment; when output and employment are

at full-employment levels
= frictional + structural unemployment
Cyclical unemployment: difference between actual unemployment
rate and natural rate of unemployment

u u

Relating Output and Unemployment:

Okuns Law

Relationship between output (relative to fullemployment output) and cyclical unemployment

Y Y
2(u u )
Y

(3.5)

Relating Output and Unemployment:

Okuns Law
Why is the Okuns Law coefficient 2, and not 1?
Other things happen when cyclical unemployment rises: Labor force
falls, hours of work per worker decline, average productivity of labor
declines
Result is 2% reduction in output associated with 1 percentage point
increase in unemployment rate

Relating Output and Unemployment:

Okuns Law

Alternative formulation if average growth rate of full-employment

output is 3%:
Y/Y = 3 2 u
(3.6)
Fig. 3.14 shows U.S. data

Figure 3.14 Okuns Law in the United

States: 1951-2008

Sources: Real GDP growth rate from Table 1.1.1 from Bureau of Economic Analysis Web site, www.bea.gov/bea/dn/nipaweb. Civilian unemployment rate for all civilian workers from Bureau of Labor Statistics Web
site, data.bls.gov.

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Labor Market Equilibrium

Application: output, employment, and the real wage during oil
price shocks
Sharp oil price increases in 19731974, 19791980, 20032008
(Fig. 3.12)

Figure 3.12 Relative price of energy,

1960-2008

Labor Market Equilibrium

Application: output, employment, and the real wage during oil
price shocks
Adverse supply shocklowers labor demand, employment, the real
wage, and the full-employment level of output
First two cases: U.S. economy entered recessions
Research result: 10% increase in price of oil reduces GDP by 0.4
percentage points

Unemployment

Measuring unemployment
Categories: employed, unemployed, not in the labor force
Labor Force = Employed + Unemployed
Unemployment Rate = Unemployed/Labor Force
Participation Rate = Labor Force/Adult Population
Employment Ratio = Employed/Adult Population
Table 3.4 shows current data

Table 3.4 Employment Status of the U.S.

Adult Population, June 2009

Unemployment
Changes in employment status
Flows between categories (Fig. 3.13)
Discouraged workers: people who have become so discouraged by
lack of success at finding a job that they stop searching

Figure 3.13 Changes in employment status

in a typical month (June 2007)

Unemployment
How long are people unemployed?
Most unemployment spells are of short duration
Unemployment spell = period of time an individual is continuously
unemployed
Duration = length of unemployment spell
Most unemployed people on a given date are experiencing
unemployment spells of long duration

Unemployment
How long are people unemployed?
Numerical example:
Labor force = 100; on the first day of every month, two workers
become unemployed for one month each; on the first day of every
year, four workers become unemployed for one year each
Result: 28 spells of unemployment during a year; 24 short (one
month), four long (one year); so most spells are short
At any date, unemployment = six; four have long spells (one
year), two have short spells (one month); so most unemployed
people on a given date have long spells