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Unformatted text preview: 7 The Economy at Full Employment Chapter Summary Classical models are economic models that assume wages and prices adjust freely to changes in demand and supply. Classical models were the primary means of explaining economic behavior until the Great Depression. Yet during the Great Depression, unemployment was rampant—nearly 25 percent of the labor force was unemployed. Economists subsequently began to develop models that explained persistent unemployment. We will discuss alternative models to the classical model later. Classical models were based on the premise that labor markets determined the output level of an economy. In other words, real factors of production such as labor and capital produce output for an economy. From there, we will look at how a given labor force produces goods and services. Here are the main points of the chapter: • Models that assume wages and prices adjust freely to changes in demand and supply are called classical models. They are useful to understand how the economy operates at full employment. • Full-employment output, or potential output, is the level of GDP produced from a given supply of capital when the labor market is in equilibrium. Potential output is fully determined by the supply of factors of production in the economy. • Increases in the stock of capital raise the level of full-employment output and real wages. • Increases in the supply of labor will raise the level of full-employment output but lower the level of real wages. • The full-employment model has many applications. Many economists use it to study the effects of taxes on potential output. Others have found the model useful in understanding economic fluctuations in models of real business cycles. • At full employment, increases in government spending must come at the expense of other components of GDP. In a closed economy, either consumption or investment must be crowded out. In an open economy, net exports can be crowded out as well. Decreases in government spending will crowd in other types of spending. Applying the Concepts After reading this chapter, you should be able to answer these three key questions: 1. Although we normally think that increased immigration will reduce wages, what factors could cause increased immigration to raise wages? 2. Why are differences in the amount of labor supply across countries an important determinant of economic performance? 94 Chapter 7 3. Do differences in taxes and government benefits explain why Europeans work substantially fewer hours per year than do Americans or the Japanese? ¡ Study Tip Starting in this chapter, you learn about macroeconomic theory. Theories are based on models that attempt to depict reality. A model is a descriptive representation of the reality under study. Think of building a model car. You have an idea of how the car should look from the picture on the box. You then build the car from the parts included in the box until you complete the model. The model car is still not exactly the same as a real car, but it does you complete the model....
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This note was uploaded on 10/25/2009 for the course ECON 81509 taught by Professor X.song during the Spring '09 term at Mesa CC.
- Spring '09