THEORY OF EMPLOYMENT

PART 2

Potential GDP and the Natural Unemployment Rate

CHAPTER

39

C H A P T E R

C H E C K L I S T

When you have completed your study of thi s chapter, you will be able to
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Explain classical macroeconomics and Keynesian macroeconomics. Th e two main school of thought

Explain the forces that determine potential GDP and the real wage rate an d full employment.

Explain the forces that determine the natural unemployment rate.

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MACROECONOMIC APPROACHES
Classical macroeconomics A body of theory about how a market economy w orks and why it experiences economic growth an d fluctuations. The classical view is that free markets work we ll and deliver the best available macroeconomi c performance. The economy will fluctuate, and growth will slo w down from time to time. But no government remedy can improve the perf ormance of the market.

Classical Economic Theory

Refers to the theory first proposed by Adam Smith in An Inquiry into the Nature and Causes of the Wealth of Nations. Classical theory was the predominant theory in industrialized nations from the time of Adam Smith until the Great Depression.

The Self-Regulating Economy

The ideal quantity of total output is the quantity that will yield full employment of labor. The quantity of total output that results in full employment of labor is called Natural Real GDP. According to classical theory, a market economy is self-regulating and will automatically adjust to Natural Real GDP.
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Marx and Market Instability

Karl Marx argued that market economies do not automatically adjust to Natural Real GDP. Marx said that market economies would be unstable because of inadequate demand.

CLASSICAL VIEW
Says law: Supply will create its own demand No government intervention Economy self adjusting recessions are temporary wages and prices are flexible and self adjus ting 6. against minimum wages 7. against welfare and government assistance 1. 2. 3. 4. 5.

Say s Law
Classical theory argues that inadequate demand cannot be a problem in a market economy due to Say s Law. Say s Law
Supply creates its own demand.
The act of production leads to equivalent income to resource owners.

 Supply creates its own demand. Production creates demand sufficient to purchase all goods and services produced. Say s law implies that there cannot be either (1) a general overproduction of goods (where supply in the economy is greater than demand in the economy) or (2) a general underproduction of goods (where demand in the economy is greater than supply in the economy).

Say s Law, Savings and Flexible Interest Rates

According to classical theory, flexible interest rates in the credit market cause any consumer savings to be exactly offset by business investment. This assumes that the quantity of both savings and investment is determined by the interest rate.

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Equilibrium in the Credit Market

S avings

Interest Rate Investment

Quantity of Savings and Investment

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An Increase in Savings is Offset by an Increase in Investment

S avings 1

S avings 2

Interest Rate Investment

Quantity of Savings and Investment

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In classical theory, the interest rate is flexible and adjusts so that saving equals investment. If saving increases and the saving curve shifts rightward the increase in saving eventually puts pressure on the interest rate and moves it downward. A new equilibrium is established where once again the amount households save equals the amount firms invest

MACROECONOMIC APPROACHES
Keynesian macroeconomics A body of theory about how a market economy w orks that stresses it inherent instability and the need for active government intervention to achieve full employment and sustained economic growth. John Maynard Keynes, in his book The General Theory of Employment, Interest, and Money, beg an this school of thought. Keynes theory was that too little consumer sp ending and investment lead to the Great Depres sion.

KEYNSIAN VIEW
Economy is not self adjusting recessions are long and can be permanent Major government intervention wages and prices are sticky and not self ad justing 5. put a floor and support to the economy a f ree falling economy 6. Support welfare and government assistance 7. Interest rates are not effective during rec ession 1. 2. 3. 4.