In this chapter, we continue to study the full employment macroeconomy

In this chapter, we continue to study the full employment macroeconomy. We want to understand in particular two big questions: so how many workers are there that want to work and how many will be employed if the workforce is fully employed, and the second question is once we have all that output the aggregate production of the economy-the gross domestic product-how will that be allocated between consumption today-what we eat today, what we use in a short period of time, our clothing, our food, our entertainment-versus what we save for the future in the form of investments, of new capital? How much of our aggregate gross domestic product is consumed and how much is saved? So these are the two questions that we're going to look at in this chapter, and all the way through we're going to assume that this is a fully-employed economy. Not one with big ups and downs in employment and production, but one that is smoothly operating with all those who want to work, working, and therefore, companies and enterprises producing based on that level of employment. Using our tools, we can determine a lot of interesting macroeconomic variables, and we'll see that the interest rate is a key variable for the macroeconomy, and we can say a bit about how it's actually determined at the macroeconomic level. So the question of full employment comes down to this. Workers want to work to earn an income to be able to buy things and to be able to put money in the bank for the future; businesses want to hire workers in order to make profits; and the question of full employment is at what level of work is the amount of work that people in the economy want to offer to firms in return for their wages equal to the amount of work that businesses want to buy from workers in order to maximize profits? And for those who have studied introductory economics before, we often find that balance-two sides of the market-by looking at the supply of work and the demand for work, or supply and demand balance, and economics for about 150 years now, has drawn supply curves and demand curves and looked at the place where they meet as the balance of supply and demand to help us understand those variables. So let's start with the workers: how much do workers want to work? We have a choice. We can say, okay, I really want time off, maybe I want part-time work, maybe I want to take the year off and go see the world, maybe for someone that retirement age, I am not interested in earning more income, I'll just live on my saving from this point onward, maybe Social Security payments, so I will leave the labor force, or for you, young students, you may say I need to be in school right now, I can't go to work, or I need to go to work to pay off the tuition, and so you have a choice, and this is the question of how many people in this society of working age would actually like to be in the labor force. One key determinant of that is how good is the pay? What is the the wage level that you get for working? Of course, as macroeconomists we say what is the pay, but for real work there are millions of people each one negotiating their own salaries or facing a specific level of wages, but as macroeconomists, we're always taking averages, we're always looking at the average wage in the economy. For example, in the United States, a particular job may $20 an hour. We're interested in not only $20 an hour, but how much does $20 actually buy in terms of rent, food, and other goods and services. So instead of merely talking about the wage in dollars or in pesos or in kroner or in some other currency, we want to talk about the real wage, which is the wage relative to the average price level. You'll recall from the first module that we talked about average prices in the economy using a price index and so here we want to take the wage level and divide it by the price of goods and services to get a sense of the real purchasing power of those earnings. We call that the real wage. We write it sometimes as W divided by P: the wage in currency units divided by the price of goods and services. And this is a major determinant of how much people want to work. In general, but it's not guaranteed, but in general, if the real wage is high that will bring more people into the workforce. They'll say, I could really earn a lot right now, maybe I'll use it for saving, maybe I'll use it for a future vacation time, but the wage is high, I'm in there, I want a job, whereas if the real wage level is low people say it's not really useful to go to work. So we usually assume that there is an upward sloping labor supply curve. That's the line that you see going up that says, as the real wage is higher, as measured on the vertical axis, the amount of work the workers would like to offer to say, I'm available, I want a job, that would also tend to rise. And so we call that an upward sloping labor supply schedule. By the way, it's not automatic because suppose that you really need a thousand bucks for something and you have a job that is offering twenty dollars an hour, you might say, okay, I'll put in fifty hours of work, then I have what I need. But suppose that the wage is actually twice that, it's forty dollars an hour; you might say, I'm just going to put in twenty-five hours of work. So it's possible that a higher real wage actually leads to a smaller offer of work, not a larger offer work. That will be true for some people, but in general we're going to assume that a higher real wage elicits more desire of people in the economy to offer their labor time in return for the income that they can earn. Now what about a business? How many workers does a business want? Businesses are generally looking at one main variable, and the one main thing that they're looking at is their bottom line. Should I hire more workers? Yes, if that will raise profits, no, if it will lower profits. Let's just say businesses are not very sentimental about this in general; they're looking to maximize their profits. At least that's the working assumption that we make when we're studying a market economy filled with private sector businesses that are out to make money. And then when you think about it, businesses are also very much influenced by the wage level relative to the price of their output. If the wage is very high that they have to pay to hire a worker because other firms are able to pay that, compared to the price of their output, they're going to say, I can't make money on that. It's going to cost me more to hire that worker than the value of the output that's going to come from that worker. Whereas if the wage is low that they have to pay compared to the price of their output, then they'll say, I should hire more workers given the extra production that I'm going to get from them and the good price that I'm going to get for selling that extra production, that's more profits. On average, that means also that the amount of workers that all of the businesses in the economy want will be a negative or downward-sloping function of the real wage level. If the real wage is high, more businesses than not will say, I can't afford those workers, in fact, I have to lay off some workers, whereas if the real wage is low, businesses will say by hiring more workers I can increase output and sell that incremental output at a profit compared to the increased payroll costs. So that leads to a downward-sloping labor demand curve. Now for an economist and I hope for you it's second nature when you say, whoa, an upward sloping supply curve and a downward sloping demand curve, the balance is when they meet; when the number of workers that businesses want to hire is equal to the amount of work that workers want to offer at that wage. And voila! here you see that balance, where the labor demand curve, downward-sloping, the labor supply curve, upward-sloping, meet, and at that intersection on the horizontal axis measures the total amount of employment in this fully- employed economy because everyone that wants to work at that wage is finding work, and on the vertical axis measures the real wage that those workers are getting-remember that's an average over lots of different kinds of workers and lots of different kinds of occupations. But there you have it; the level of full employment in the economy. We can then go back to our aggregate production function once again, as we did earlier, and say now we know how many workers there are working at full employment, and use the aggregate production function to tell us that at that level of full employment, the total output in the economy is given by the vertical level on the aggregate production function curve. So what have we found? We have found the level of full employment; think of it as the millions of workers that would be employed if all who want to work have a job, and then we have found the full employment output of the economy, which is the amount of production measured by the gross domestic product that occurs when employment is at its full employment level. Now, this full employment output level that you see on the graph is sometimes also called potential gross domestic product. It's the level of output that's potentially available when all who want to work are employed by firms who want to hire them. Why is it called potential GDP? Because often it's the case that not everyone that wants to work is able to find a job, and in that case the total amount of employment in the economy will be less than the full employment, and the total amount of output measured by the gross domestic product will be below the potential output of the economy. And when an economy moves quickly from something approximating full employment and potential output to less than full employment and gross domestic product less than the potential, that's what we call a business cycle downturn or, equivalently, an economic recession.