Download Lecture 13

L11200 Introduction to Macroeconomics 2009/10
Lecture 13:
Expanding the Model with Labour
Supply
Reading: Barro Ch.8
22 February 2010
Introduction
• Last time:
– Asked whether permanent shocks to technology
might explain the cyclical pattern of GDP
– Tested the idea by what it implied for other key
variables – evidence supports hypothesis
• Today
– Model has assumed fixed labour supply
– Now relax this assumption and draw new
conclusions
Variations in Labour Input
• More realistic model allows labour supply
– Households choose how much labour to supply
instead of L being fixed
C  (1/ P)  B  K  ( w / P)  L  i  ( B / P)  iK
– L now becomes Ls, a choice variable instead of a
fixed variable
– So households choose how many hours to work
and how many hours to spend at leisure
Work vs Leisure
• Now household faces a work / leisure decision
C  (1/ P)  B  K  (w / P)  LS  i  ( B / P)  iK
• As with consumption, decision involves
income and substitution effects
– If w/P increases, the return on work is greater, so
households substitute work for leisure
– If w/P increases, households have higher income
and so demand more leisure
Which effect dominates
• Net result depends on whether higher wage is
temporary or permanent
– If increased wage is temporary, then impact on
lifetime income is small, impact on current leisure
demand is small relative to substitution effect
– If increased wage is permanent, demand for
leisure increases 1:1 with the increased wage
– So temporary increases in wages are likely to
increase time spent working
Intertemporal Substitution Effects
• Changes in i generate a work now vs work
later choice
– Increases in i raised future consumption relative
to current consumption because future
consumption is cheaper
– Increases in i have same effect on leisure: future
leisure cheaper so demand less now and more
later
– Increases current labour supply
Empirical Evidence
• Can we explain the empirical evidence with
this model
– Two type of evidence: employment and hours
– The pattern of employment relative to GDP
– The pattern of hours worked relative to GDP
– Both are strongly procyclical
How would the model explain this?
• If changes in GDP are driven by changes in A,
this implies
– When A rises, MPL rises and demand for labour
increases
– Now wage and employment response depends
on elasticity of labour supply
– If substitution effect > income effect then labour
supply is upward sloping
Outcome
• Implies positive changes in A lead to increase
in w/P and increase in hours worked
– This depends on upward-sloping labour supply
curve
– For this to be the case, change in A must be nonpermanent.
– If change were permanent, labour supply would
not increase by as much or decrease
Assessing the Model
• Our macroeconomic model appears to fit the
data quite well
– Hypothesised that fluctuations in A might be
driving fluctuations in GDP
– In the model fluctuations in A imply certain
behaviour for consumption, investment, wages,
rental costs, interest rates and employment
– The data is consistent with the predictions of the
model
Problem
• This is an equilibrium model so there is no
place for unemployment of capital or labour
– ‘equilibrium’ model means markets are always in
equilibrium
– E.g. labour market: people don’t work because
they choose not to, zero unemployment
– Capital market: capital is always fully employed.
Voluntary Unemployment?
• In the model, all changes in employment are
voluntary
– In reality, we observe that unemployment rises
sharply during recessions
– Remember: unemployment is wanting to work but
not being able to find a job
– Are the unemployed just not willing to work at the
going wage rate?
Summary
• Developed model with flexible hours of work
– Households face choice over work (income,
consumption) versus leisure
– Income, substitution and intertemporal
substitution effects
– Model fits data well
• Next time: try to explain unemployment of
both capital (next time) and labour.