Real wage: nominal wage adjusted for changes in the price level. EX: wage goes from 6 dollars per hour to 12 but prices double so real wage stays the same.
Real wage= nominal wage/ price level
Provides measure of the purchasing power of wages.
Real wages declined during the 1st half of the 1990s and by 2002 were little changed from 1980.
Aggregate demand for labor depends on:
1 wages firms must pay
2. prices firms receive for the goods/services they provide.
3. prices they have to pay for imputs like raw materials and equipment.
The reason demand for labor quantity increases as real wage drops.
1. It pays to substitute workers in place of machines (if cheaper)
2. Profits are greater so there is greater Incentive to expand production and hire more workers.
Rise in wage affects:
1. People will want to work more because the opportunity cost of leisure is now higher
2. People will want to increase their leisure consumption because of their higher income.
Shifts in demand and supply of labor:
Shifts in supply occur because:
1. Young people reach working age
2. Old people retire
4. Social changes such as the entry of more women into the labor force in 1970
When more people start searching for jobs the supply of labor increases and real wages drop to absorb the unemployment.
Short run aggregate production function: relationship between employment and output with a fixed amount of capital. Measures GDP with employment
Diminishing return of labor: as more workers are hired (with a fixed amount of capital) the output goes up but at a diminishing rate
Reasons for diminishing returns of labor
1. Best workers are hired 1st and eventually less skilled workers are not as productive.
2. With a fixed capital there is limited machinery for all so at a certain point 4 people to one computer doesn’t increase productivity by much
Full employment level of output: equilibrium level of output potential GDP
Short run aggregate production function is shifted upward when:
1. Increases in the stock of plant and equipment
2. New technology allows for more production
Demand and equilibrium output
Total spending will = potential GDP if leakages at full employment = injections
Loanable funds market: supply of funds is allocated to those who wish to borrow
Disposable income: how much income a household has after paying taxes
Tax increases decrease disposable income
Households will reduce consumption and saving when disposable income falls
Real rate of interest: market interest rate-inflation interest rate corrected for changes in prices
EX: market interest rate= 5% inflation = 3% real rate of interest = 2%
Household saving is relatively