Exploring Economics 4e Chapter 23

C H A P T E R

H E

C O N O M Y A T

U L L

M P L O Y M E N T

23.1

The Classical Long-Run Macroeconomic
Model

23.2

The Production Function

23.3

Investment, Saving, and the
Real Interest Rate

e know that the economy experiences peri-
ods of expansion and contraction, but we
also know that the economy does eventu-
ally return to full employment. In a world

where wages and other input prices are flexible
and adjust quickly to the forces of supply and
demand, the economy only temporarily strays from
full employment.

How much output can we produce at full

employment? Why not more? How do we
determine the amount of labor and capital we
need to operate the economy at full employment?

How does the labor market equilibrium help
determine employment real GDP and potential
GDP? In this chapter, we will answer these ques-
tions and also see how changes in population,
technology, and capital affect the potential
output of the economy. In the latter half of the
chapter, we look at how investment and saving
decisions determine the real interest rate. We
also examine how the government influences
saving, investment, and the real interest rate.
Finally, we look at saving and investment in the
open economy.

■

H E

C O N O M Y A T

U L L

M P L O Y M E N T

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S E C T I O N

23.1

T h e C l a s s i c a l L o n g - R u n
M a c r o e c o n o m i c M o d e l

■

What is the classical school?

■

What is Say’s law?

■

What was Keynes’s criticism of the classical
school?

■

What is the full-employment economy?

THE CLASSICAL SCHOOL AND SAY’S LAW

Historically, the two primary approaches to macroeco-
nomics have been the classical school and the
Keynesian school. Let’s begin with the classical school.
The classical school of thought believed that wages and
prices adjust quickly to changes in supply and demand.

Writing at the beginning of the nineteenth cen-

tury, the French economist Jean Baptiste Say formu-
lated a notion since dubbed Say’s law, which in its
simplest form states that “supply creates its own
demand.” More precisely, the production of goods
and services creates income for owners of inputs
(land, labor, capital, and entrepreneurship) used in
production, which in turn creates a demand for
goods. According to Say’s law, we need not worry
about output not being utilized; production creates
income, which creates demand for goods, which leads
to still more production. That is, Say’s law establishes
that full employment can be maintained because total
spending will be great enough for firms to sell all the
output a fully employed economy can produce. Say’s
ideas were incorporated into the teaching of econo-
mists of the late nineteenth century who were consid-
ered classical economists.

Before the 1930s, the problem of unemployment

was considered one that could be analyzed using
microeconomic analysis; indeed, macroeconomics as
we know it today did not exist. The theory that
evolved to analyze unemployment suggested that job-
lessness could be eliminated by market forces, in the
same way that shortages and surpluses of goods and
services are eliminated by movement in the relative
prices of those goods, as we discussed in Chapter 5.

Keynes’s Criticism of the Classical School

In 1936, John Maynard Keynes’s book, The General
Theory of Employment, Interest and Money, was pub-
lished. Along with Adam Smith’s The Wealth of Nations
in the eighteenth century, The General Theory of
Employment, Interest and Money was one of the most
influential books in economics. In his book, Keynes
attacked the classical economic theory. He pointed out

the naiveté of Say’s law: Not all income generated from
output need be used to buy goods and services; it can
also be saved, hoarded, or taxed away. Supply does not
automatically create an adequate demand. Keynes’s
severest attacks were against classical ideas about unem-
ployment. With unemployment rates at that time in the
double digits, where did the classicists go wrong?

To begin with, when a recession begins, wages

rarely fall quickly to a new equilibrium level consis-
tent with full employment. Long-term labor contracts
with unions, minimum wage laws, and other factors
often prevent wages from falling as quickly as the
classical model suggests. Thus, wage inflexibility pre-
vents the market solution from working rapidly
enough to avert a prolonged recession.

The Full-Employment Economy

The macroeconomic models presented in this text draw
from both schools of thought and emphasize the com-
monality between the two schools. However, in this
chapter, we begin with the long-run model (the classical
model), the economy at full employment, because both
schools agree that in the long run both wages and prices
adjust freely to changes in demand and supply and the
economy moves back naturally to its potential, full-
employment output level. That is, eventually (in the
long run) all markets adjust to their equilibrium values.
Recall that full employment does not mean zero unem-
ployment; rather it refers to zero cyclical unemploy-
ment. Some structural and frictional unemployment
occurs naturally in a dynamic and vibrant economy.

The actual output that the economy produces need

not be the same as potential output—what the economy
can produce without leading to inflation. If the econ-
omy is producing at less than its potential output, unem-
ployment is greater than the natural rate; if the economy
is producing at greater than its potential output, unem-
ployment is less than the natural rate, causing inflation-
ary pressures. That is, it is possible on the peak of a
business cycle that actual GDP can exceed potential
GDP but only for a short period of time. The problem
is that the causal observer often confuses potential and
actual output. When the economy is accelerating at a

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fast clip, some observers believe we are on a new growth
trajectory. And when the economy slows, some
observers confuse this change with doom and gloom.
But this chapter is not about the cycles of expansion and
contraction, it is about the full-employment economy—
the economy that experiences no boom or bust.

In later chapters that discuss monetary and fiscal

policy, we will use our model to examine business
cycles and short-run policy prescriptions that involve
government intervention to help the economy get
back to its long-run growth trajectory.

S E C T I O N

23.2

T h e P r o d u c t i o n F u n c t i o n

■

What is the short-run production function?

■

What are diminishing returns?

■

How does an increase in the stock of capital
affect the production function?

■

How many workers do we hire in the
full-employment economy?

■

How do we determine full-employment
output?

Recall from Chapter 3, that we use our scarce resources
(land, labor, capital, and entrepreneurship) to pro-
duce our goods and services—real GDP. However, at
any given period of time, capital, land, and entrepre-
neurship (and technology) are fixed. So the only factor
that is not fixed is labor. Therefore, at least in the
short run, real GDP depends on the quantity of labor
employed.

THE SHORT-RUN PRODUCTION FUNCTION

A short-run production function shows the maximum
amount of real GDP the economy can produce with dif-
ferent levels of labor while holding capital, land, and
entrepreneurship (technology) constant. Thus, the max-
imum quantity of real GDP (the potential output) in the
economy is determined by the amount of labor

employed. So, at least
for now, we will assume
that output (real GDP)
is a function of labor
employed. Later, we will
relax this assumption
and demonstrate the
impact that changes in
capital have on real GDP.

In fact, economists, usually write that Y (output) is a

function of K (capital) and L (labor): Y = f (K, L). Again,
we consider capital fixed in the short run because it takes
time for investment to change the stock of capital.
Today’s investment in machines, buildings, and factories
will take several years to yield an impact on output in
the economy. So, we say that the stock of capital is fixed
in the short run, and it is the changes to labor that

short-run produc-
tion function

the relationship between real GDP
and labor while holding capital,
land, and technology constant

S E C T I O N

C H E C K

Say’s law stated that “supply creates its own demand.”

Say’s law argued that full employment could be maintained in the economy.

Keynes rejected Say’s law because, in addition to spending income from production on goods and services, it can

go toward saving, hoarding, or taxes.

Potential real output is the level of real output the economy can produce without leading to inflation.

If the economy is producing less than potential output, unemployment is greater than its natural rate.

If the economy is temporarily producing more than potential output, unemployment is less than its natural rate.

What are the two primary approaches to macroeconomics?

Which school of thought emphasized that markets can rapidly adjust to changes?

Why was the double-digit unemployment of the Great Depression when Keynes wrote The General Theory of

Employment, Interest and Money helpful in leading to its general acceptance?

What would keep wages from falling quickly in a recession?

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Macroeconomic Foundations

change the level of output in the short run. In other
words, Y = f (K, L) where the stock of capital is fixed.

REAL GDP AND THE QUANTITY OF LABOR EMPLOYED

The production function shows the amount of real GDP
the economy can produce when we vary the amount of
labor, holding all other variables constant (capital, land,
and entrepreneurship). Two observations can be made.
One, the production function is a boundary between
what is attainable and what is unattainable (this con-
cept is similar to the production possibilities curve in
Chapter 3). In Exhibit 1, the shaded area underneath
the production function is attainable; the area beyond
the production function is unattainable.

Second, we confront diminishing returns—each

additional worker brings less output or real GDP.
Why? Because each successive worker has less capital
to work with. Notice in Exhibit 1, when labor
increases from L

to L

, output increases markedly

from Y

to Y

. However, when labor is increased from

to L

, output does not rise as rapidly—the princi-

ple of diminishing returns. Remember, capital is fixed
as we move along the production function curve. We
say that the increased crowding of the fixed input
(capital) causes marginal output to fall. For example,
imagine you owned a very small retail store with 500
square feet (the store is your fixed capital). If you
were to hire 21 workers (your variable input of
labor), what marginal contribution to your output
would come from that twenty-first worker? It is
unlikely that it would contribute to any additional
output, because workers would be running into each

other in this relatively small “fixed” space. In fact, it
is unlikely you would hire this worker because his
marginal contribution (the marginal benefit) would
not likely offset the wage (the marginal cost).

AN INCREASE IN THE STOCK OF CAPITAL

The production function shifts up when the stock of
capital increases as seen in Exhibit 2. At any level of
labor input, more output can be produced because as
we add capital each worker becomes more productive.
Both Hong Kong and Singapore experienced dramatic
increases in economic growth as a result of an increased
capital stock, coupled with stable labor force growth.

LABOR MARKET

In the preceding discussion about using the produc-
tion function, we learned that the level of output in
the economy is determined by the amount of labor
employed. Now, to find out how many workers to
hire in an economy, we will employ the supply and
demand analysis we developed in Chapters 4 and 5.

The labor market is illustrated in Exhibit 3(c). On

the horizontal axis, we measure the amount of labor
employed and on the vertical axis we measure the real
wage rate—the wage rate paid to employees after
adjusting for changes in the price level. In labor mar-
kets, it is important to remember that households
supply the labor and firms demand it.

The demand curve for labor is downward

sloping—an increase in the real wage rate means firms
will hire fewer workers. With a decrease in the real

An Increase in the Stock
of Capital

S E C T I O N

2 3 . 2

X H I B I T

Real GDP

(trillions of $)

Quantity of Labor

(millions of workers)

An Increase in

Capital Stock

(with increase in

capital stock)

When the stock of capital increases, the production
function shifts upward. The economy can now pro-
duce more output with a given quantity of labor.

The Short-Run
Production Function

S E C T I O N

2 3 . 2

X H I B I T

Real GDP

(trillions of $)

Quantity of Labor

(millions of workers)

Short-Run

Production

Function

Attainable

When capital is fixed, output (real GDP) increases
as labor input is added, but at a diminishing rate.

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wage rate, however, firms will hire more workers—see
Exhibit 3(a). The labor supply curve is upward sloping.
Workers must decide how much they want to work.
People will choose to work if they are compensated
enough to forgo other activities they must give up, such
as leisure, school, and parenting. Of course, each
person will value his or her time differently, but it is
safe to say that the labor supply curve for the whole
economy is upward sloping. As the real wage rate
increases, more people will decide they are better off
working than not working. Thus, at a higher real wage
rate for the economy, the quantity of labor supplied
increases, and at a lower real wage rate, the quantity of
labor supplied decreases, as shown in Exhibit 3(b).

In Exhibit 3(c), we find the labor market equilib-

rium. The equilibrium occurs at the point where the

labor demand and the labor supply curves intersect.
At this point, the quantity of labor demanded is equal
to the quantity of labor supplied. This point deter-
mines the level of employment and the level of real
wages for the economy. At the equilibrium, we are at
full employment—the number of people who want to
work will equal the number of firms that will want to
hire them. At this equilibrium, the economy does not
experience cyclical unemployment. The labor market
achieves full employment on its own through the
process of supply and demand.

SHIFTING LABOR DEMAND AND LABOR SUPPLY

Two main factors that can shift the labor demand
curve are productivity and changes in the capital

The Demand for and Supply of Labor

S E C T I O N

2 3 . 2

X H I B I T

a. Demand for Labor

b. Supply of Labor

Quantity of Labor

Real W

Demand

for Labor

Supply

Labor

W *

c. Demand for and Supply
of Labor

Quantity of Labor

Real W

The intersection of the demand for labor and the supply of labor determines the equilibrium wage, W*, and the
equilibrium level of employment, L*.

Shifting Labor Demand and Labor Supply

S E C T I O N

2 3 . 2

X H I B I T

Real W

Quantity of Labor

Real W

Quantity of Labor

a. An Increase in the
Demand for Labor

b. An Increase in the
Supply of Labor

With an increase in the demand for labor, real wages rise and the amount of employment increases. If the supply
of labor increases, real wages fall and employment increases.

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Macroeconomic Foundations

stock. For example, an increase in capital stock will
increase workers’ productivity and cause the labor
demand curve to shift to the right.

Factors that can shift the labor supply curve

include wealth, the size of the working age population,
the labor force participation rate, regulatory changes,
and attitudes toward work. For example, increased
wealth shifts the labor supply curve to the left because
workers can now afford more leisure, which means
fewer people would be willing to work at a given
wage rate. If immigration were to increase the work-
ing age population, the labor supply curve would shift
to the right. An increase in the labor force participa-
tion rate (an increase in the number of people who
want to work) would also shift the labor supply curve
to the right. In the United States, the labor force par-
ticipation rate for women increased from 34 percent
in 1950 to roughly 60 percent today. The elimination
of mandatory retirement will likely increase the par-
ticipation of many older workers. In Exhibit 4, we
highlight the factors that can shift the labor supply
and demand curves.

DETERMINING FULL-EMPLOYMENT OUTPUT

If we bring our supply and demand curves for labor
together with our short-run production function (short-
run because capital is fixed), we can determine how
much output the economy can produce when it is oper-
ating at full employment. In Exhibit 5(b), the intersec-
tion of the supply and demand curves for labor
determines the real wage rate, W*, and the full-
employment level of labor, L*. If we move up from L*
in Exhibit 5(b) to Exhibit 5(a), we can determine the
level of real output that can be produced by L* by con-
necting to the production function. At that point, we see
that our real output level is Y*. This full-employment
output level is also called the potential output. Recall
that full-employment output is potential output. It is the

Determining
Full-Employment Output

S E C T I O N

2 3 . 2

X H I B I T

Real GDP

(trillions of $)

Real W

age

Quantity of Labor

(millions of workers)

Quantity of Labor

(millions of workers)

Short-Run

Production

Function

Y *

Supply of

Labor

Demand for

Labor

In (b), the equilibrium level of output is determined
by the intersection of the supply of labor and demand
for labor at L* and the real wage at W *. Full-employ-
ment (potential) output is the level of output that is
produced when the labor market is in equilibrium, or
Y*, in (a).

using what you’ve learned

Using the Full-Employment Model

Using the full-employment model, what do you think would happen
to potential output if the United States increased taxes significantly

to pay for the anticipated costs in Social Security and Medicare as a result of
an aging population?

In Europe, workers tend to work about two-thirds as much as their
counterparts in the United States? Why? Nobel laureate Edward

Prescott believes that the answer is one word—

taxes. The effective tax rate

for the United States is 40 percent but close to 60 percent in Germany and
France and almost 65 percent in Italy. They have higher taxes and greater ben-
efits than workers in the United States. So, if the United States increased taxes
heavily to pay for the anticipated expenses associated with Medicare and
Social Security, Prescott believes the result of those greater benefits would be
a decrease in the labor supply and a fall in potential output—and a lower
standard of living.

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If we put the investment demand for the whole econ-
omy and national savings together, we can establish
the real interest rate in the investment and saving
market. We begin by revisiting investment, and then
follow with the introduction of the saving supply (SS)
curve and equilibrium.

Exhibit 1 shows the investment demand (ID) curve

for all the firms in the whole economy. The investment
demand curve is downward sloping, reflecting the fact
that investment spending varies inversely with the real
interest rate—the amount borrowers pay for their loans.

At a high real interest rate, firms will only pursue those
few investment activities that have even higher
expected rates of return. As the real interest rate falls,
additional projects with lower expected rates of return
become profitable for firms, and the quantity of invest-
ment demanded rises. In other words, the investment
demand curve shows the dollar amount of investment
forthcoming at different real interest rates. Because
lower interest rates stimulate the quantity of invest-
ment demanded, governments often try to combat
recessions by lowering interest rates.

S E C T I O N

C H E C K

A short-run production function shows the maximum amount of real GDP the economy can produce with different

levels of labor, holding capital, land, and entrepreneurship (technology) constant.

Along a short-run production function, real GDP is determined by the amount of labor employed.

A short-run production exhibits diminishing returns.

An increase in the stock of capital shifts the short-run production function upward.

An increase in either the capital stock or other source of productivity improvement will increase the demand for labor.

Increases in the supply of labor will be caused by decreases in wealth, an increase in the size of the working age popula-

tion, increases in the labor force participation rate, reductions in regulatory costs, or an increased willingness to work.

The intersection of the supply and demand curves for labor determines the real wage and full-employment level

of labor, which in turn determines the level of real output along a short-run production function.

Why do we consider capital fixed in the short run?

Why does the short-run production function exhibit diminishing returns?

How do the labor supply and demand curves determine real output?

What will an increase in immigration do to the labor supply? To real wages? To employment? To real output?

S E C T I O N

23.3

I n v e s t m e n t , S a v i n g , a n d t h e R e a l
I n t e r e s t R a t e

■

What is the investment demand curve?

■

What is the saving supply curve?

■

How is the real interest rate determined?

output level where the labor market is in equilibrium. It
is not the maximum amount of output the economy can
produce, because it could temporarily produce more.

How does the potential output change? We will

focus on two sources: population and labor produc-
tivity. For example, if an increase in population occurs
or a liberal immigration policy is passed through
Congress, the labor supply would increase, which

would lead to higher employment and a greater level of
potential real output. Or suppose labor productivity
increased as a result of an increase in physical capital,
human capital, or advances in technology. This increase
would lead to an increase in the demand for labor that
would shift the labor demand curve and lead to higher
real wages, greater employment, and an increase in
potential output.

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SHIFTING THE INVESTMENT DEMAND CURVE

Several other determinants will shift the investment
demand curve. If firms expect higher rates of return
on their investments for a given interest rate, the ID
curve will shift to the right, as seen in Exhibit 2. If
firms expect lower rates of return on their invest-
ments for a given interest rate, the ID curve will
shift to the left, also seen in Exhibit 2. Possible
investment demand curve shifters include changes
in technology, inventory, expectations, or business
taxes.

Technology

Product and process innovation can cause the ID curve
to shift rightward. For example, the development of
new machines that can improve the quality and the
quantity of products or lower the costs of production
will increase the rate of return on investment, inde-
pendent of the interest rate. The same is true for new
products such as handheld computers, the Internet,
genetic applications in medicine, or HDTV. Imagine
how many different firms increased their investment
demand during the computer revolution.

Inventories

When inventories are high and goods are stockpiled
in warehouses all over the country, the expected

rate of return on new investment is lower, causing
the ID curve to shift to the left. Firms with excess
inventories of finished goods have little incentive to
invest in new capital. Alternatively, if inventories
become depleted below the levels desired by firms,
the expected rate of return on new investment
increases as firms look to replenish their shelves to
meet the growing demand, and the ID curve shifts
to the right.

Expectations

If higher expected sales and a higher profit rate are
forecasted, firms increase investment in plant and
equipment, and the ID curve shifts to the right—more
investment will be desired at a given interest rate. If
lower expected sales and a lower profit rate are fore-
casted, the ID curve shifts to the left—fewer invest-
ments are desired at a given interest rate.

Business Taxes

If business taxes are lowered—such as with an invest-
ment tax credit—potential after-tax profits on invest-
ment projects increase and shift the ID curve to the
right. Higher business taxes lead to lower potential
after-tax profits on investment projects and shift the
ID curve to the left.

Shifts in the Investment
Demand Curve

S E C T I O N

2 3 . 3

X H I B I T

Real Interest Rate

xpected rate of return)

Quantity of Investment

(billions of dollars)

A B

A C

An increase in the
expected profit rate

A decrease
in the expected
profit rate

Investment demand depends on the expected rates of
return. For example, a higher expected profit rate
causes an increase in investment demand, shifting the
ID curve to the right from point A to point B. A lower
expected profit rate causes a decrease in investment
demand, shifting the ID curve to the left from point A
to point C. Any change in technology, inventory,
expectations, or business taxes can cause the invest-
ment demand curve to shift.

The Investment
Demand Curve

S E C T I O N

2 3 . 3

X H I B I T

Real Interest Rate

xpected rate of return)

Quantity of Investment

(billions of dollars)

A B

A C

An increase in the real interest
rate will lower the quantity of
investment demanded.

A decrease in the real interest
rate will raise the quantity of
investment demanded.

The relationship between the real interest rate and
the quantity of investment demanded is an inverse
one. At a higher real interest rate, firms will only
pursue investment activities that have the highest
expected return, and the quantity of investment
demanded falls—a movement from point A to point B.
As the real interest rate falls, projects with lower
expected returns become potentially profitable for
firms, and the quantity of investment demanded
rises—a movement from point A to point C.

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The Supply of National Saving

The supply of

national saving

comprises both pri-

vate saving and public saving. Households, firms, and
the government can supply savings. The saving supply

(SS) curve is upward
sloping, as seen in
Exhibit 3. At a higher
real interest rate, a
greater quantity of sav-
ings is supplied. Think
of the interest rate as

the reward for saving and supplying funds to finan-
cial markets. At a lower real interest rate, a lower
quantity of savings is supplied.

As with the investment demand curve, noninterest

determinants affect the saving supply curve. For exam-
ple, if disposable (after-tax) income were to rise, the
supply of savings would shift to the right—more savings
would occur at any given interest rate. If disposable
income fell, less saving would happen at any given inter-
est rate. Also, if you expected lower future earnings, you
would tend to save more now at any given interest
rate—shifting the saving supply curve to the right. If
you expected higher future earnings, you would tend to
consume more and save less now, knowing that more
income is right around the corner—shifting the saving
supply curve to the left. In Exhibit 4, we see that an
increase in disposable income or lower expected future
earnings would shift the saving supply curve to the
right. A decrease in disposable income or higher
expected future earnings would shift the saving supply
curve to the left.

In equilibrium, desired investment equals desired

national saving at the intersection of the investment
demand curve and the saving supply curve. The equi-
librium real interest rate is shown by the intersection of
these two curves, as seen in Exhibit 5. If the real inter-
est rate, r

, is above the equilibrium real interest rate,

r*, forces within the economy would tend to restore the
equilibrium. At a real interest rate that is higher than
the real equilibrium interest rate, the quantity of saving
supplied would be greater than the quantity of invest-
ment demanded, resulting in a surplus of saving at this
real interest rate. As savers (lenders) compete against
each other to attract investment demanders (borrow-
ers), the real interest rate falls. Alternatively, if the real
interest rate, r

, is below the equilibrium real interest

rate, r*, the quantity of investment demanded is greater
than the quantity of saving supplied at that interest rate
and a shortage of saving occurs. As investment deman-
ders (borrowers) compete against each other for the
available saving, the real interest rate is bid up to r*.

GOVERNMENT AND FINANCIAL MARKETS

We know from our earlier circular flow discussion
that the total output of firms equals the total
income of households—that is, in a simple economy
with just households and firms, where households

national saving

the sum of private and public
savings

Saving Supply (SS) Curve

S E C T I O N

2 3 . 3

X H I B I T

Real Interest Rate

A B

A C

Quantity of Saving

(billions of dollars)

An increase in the real interest
rate increases saving.

A decrease in the real interest
rate decreases saving.

A positive relationship between the real interest rate
and the quantity of saving supplied means that at a
higher real interest rate, a greater quantity of saving is
supplied—the movement from point A to point B. At a
lower real interest rate, a lower quantity of saving is
supplied—the movement from point A to point C.

Shifts in the Saving
Supply Curve

S E C T I O N

2 3 . 3

X H I B I T

Real Interest Rate

Quantity of Saving

(billions of dollars)

A B

A C

An increase
in saving supply

A decrease
in saving supply

Any change in determinants of saving supply other
than interest rates, such as disposable (after-tax)
income or expected future earnings, can cause the
saving supply curve to shift. An increase in disposable
income or lower expected future earnings would shift
the saving supply curve to the right, from point A to
point B. A decrease in disposable income or higher
expected future earning shifts the saving supply curve
to the left, from point A to point C.

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M O D U L E 6

Macroeconomic Foundations

spend all their incomes, total spending must equal
total output. Recall from our discussion of national
income accounts that GDP (or Y)

C I G

M). That is, aggregate expenditures (Y) must

equal the sum of its four components, C

I G

M). For simplic-

ity, we begin working
in a

closed economy,

without the complica-
tions introduced by
the international, or
net export (X

M),

component. In a closed

economy, net exports are zero because there is no
international trade—that is, exports are zero and
imports are zero. So we can now write

(1)

That is, GDP (Y) is the sum of consumption plus
investment plus government purchases. You might
ask, what does consumption have to do with financial

markets? If we subtract C and G from both sides of
the equation, we have

(2)

The left side of the equation (Y

C G) is what

remains of total income (Y) when you subtract con-
sumption and government purchases. This portion is
called national saving or saving (S) for short. If we
substitute S for Y

C G, we can write

(3)

That is, saving equals investment.

However, to truly understand what happens to

saving, we must add net taxes. Net taxes are total tax
revenues minus transfer payments (Social Security
benefits, welfare payments, and unemployment insur-
ance). Transfer payments are that part of tax revenues
the government takes from one part of the household
sector to give to another part of the household sector.
Combining equations (2) and (3), we can write the
saving equation as

(4)

This equation can be rewritten as

(5)

Because the two Ts cancel each other out in equation (5),
it is easy to see that these two equations are the same.
However, equation (5)
does

give

some

useful information. It
divides saving into pri-
vate saving and public
saving.

Private saving

is the amount of
income households
have left over after
consumption and net
taxes (Y

T C).

Public saving

is the

amount of income the government has left over after
paying for its spending (T – G).

Most people are familiar with the idea that house-

holds and firms can save but are less familiar with the
idea that the government can also save. If the govern-
ment collects more in taxes than it spends (T > G), it
runs a surplus and public saving is positive. If the gov-
ernment spends more than it collects in taxes (G > T),
it runs a deficit and public saving is negative. Next,
we use the tools of supply and demand to examine
how budget surpluses and budget deficits affect the
real interest rate, national saving, and investment.

closed economy

an economy with no international
trade—net exports are zero and
imports are zero

private saving

the amount of income households
have left over after consumption
and net taxes

public saving

the amount of income the govern-
ment has left over after paying for
its spending

Equilibrium in the Saving
and Investment Market

S E C T I O N

2 3 . 3

X H I B I T

Surplus of Saving

(real interest rate falls)

Shortage of Saving

(real interest rate rises)

Real Interest Rate

Quantity of Saving and Investment

Desired investment equals desired national saving at
the intersection of the investment demand curve and
the saving supply curve, the equilibrium in the saving
and investment market. The intersection of these two
curves shows the equilibrium real interest rate. At a
higher-than-equilibrium real interest rate, the quan-
tity of saving supplied would be greater than the
quantity of investment demanded, and a surplus of
saving would occur at this real interest rate. As savers
(lenders) compete against each other to attract invest-
ment demanders (borrowers), the real interest rate
falls. If the real interest rate, r

, is below the equilib-

rium real interest rate, r*, the quantity of investment
demanded is greater than the quantity of saving sup-
plied at that interest rate, and a shortage of saving
occurs. As investment demanders (borrowers) com-
pete against each other for the available saving, the
real interest rate is bid up to r*.

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The Economy at Full Employment

643

Budget Surpluses and Budget Deficits

First, let’s see how a budget surplus affects the real
interest rate and the amount of saving and investment.
In Exhibit 6, suppose that the government has a bal-
anced budget, the saving supply curve is SS

, and the

investment demand curve is ID, resulting in an equilib-
rium real interest rate equal to r

and an equilibrium

quantity of saving and investment equal to Q

. If the

government now runs a budget surplus—the govern-
ment receives more in tax revenues than it spends—
public saving increases, assuming that private saving is
unchanged. Because national saving is the sum of pri-
vate saving and public saving, national saving
increases, shifting the saving supply curve from SS

. What impact does this budget surplus (govern-

ment saving) have on the real interest rate, saving, and
investment? The increase in the saving supply from SS

to SS

leads to a decrease in the real interest rate to r

and an increase in equilibrium saving and investment
from Q

to Q

, as shown in Exhibit 6. The budget sur-

plus leads to an increase in the saving supply, a lower
real interest rate, and a larger amount of saving and
investment. This increase in capital formation will tend
to increase economic growth.

When the government spends more than it receives

in tax revenues, it experiences a budget deficit; the gov-
ernment is actually

dissaving

(saving negatively or bor-

rowing), which decreases national saving. That is, the

budget deficit reduces
the national supply of
saving, shifting the
saving supply curve left-
ward from SS

to SS

Exhibit 7. At the new
equilibrium, a higher
real interest rate and a
lower amount of saving
and investment occur.
When the real interest
rate rises because of the
government budget deficit, private investment
decreases. Economists call this relationship the

crowding-out effect

, a topic we will expand on in

Chapter 27, entitled “Fiscal Policy.” In sum, when the
government runs a budget deficit, it reduces national
saving, which leads to a higher real interest rate and
lower investment. Because investment is critical for
capital formation, long-term economic growth is
reduced by budget deficits.

SAVING AND INVESTMENT IN AN OPEN ECONOMY

In an open economy, individuals, firms, and govern-
ments are able to borrow from and lend to foreigners.
When foreigners supply more funds than they
demand, the result is a capital inflow. When foreigners

Effects of a Government
Budget Surplus

S E C T I O N

2 3 . 3

X H I B I T

Real Interest Rate

Quantity of Saving and Investment

Budget

Surplus

Positive

Public

Saving

Saving
Supply

Shifts

Right

When the government runs a budget surplus, public
saving is positive, increasing national saving and caus-
ing the saving supply curve to shift rightward from
SS

to SS

. This shift leads to a decrease in the real

interest rate to r

and an increase in equilibrium

saving and investment from Q

to Q

. The budget sur-

plus results in an increase in the saving supply, a
lower real interest rate, and larger amounts of saving
and investment. These factors cause increases in the
capital formation and economic growth.

dissaving

consuming more than total available
income

crowding-out effect

theory that government borrowing
drives up the interest rate, lowering
consumption by households and
investment spending by firms

Effects of a Government
Budget Deficit

S E C T I O N

2 3 . 3

X H I B I T

Real Interest Rate

Quantity of Saving and Investment

Budget

Deficit

Negative

Public

Saving

Saving
Supply

Shifts

Left

When the government runs a budget deficit, public
saving is negative, lowering the supply of national
saving and shifting the saving supply curve leftward
from SS

to SS

. At the new equilibrium, the result is a

higher real interest rate and a lower amount of
saving and investment. When the real interest rate
rises as a result of the government budget deficit, it
causes a decrease in private investment, known as the
crowding-out effect.

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M O D U L E 6

Macroeconomic Foundations

Saving and Investment in the Open Economy

S E C T I O N

2 3 . 3

X H I B I T

Saving
Supply

Domestic Real Interest Rate

Quantity of Saving and Investment

Capital

Outflow

Capital

Inflow

(Low r Capital outflow)

(High r Capital inflow)

(includes capital inflows

and outflows)

National Saving

Supply

When investment demand is strong, the domestic real interest rate is high and capital inflows from foreign coun-
tries increase the supply of saving, increasing the funds available for capital investment. When investment demand
is weak, the domestic real interest rate is low and capital flows out to foreign countries, lowering the supply of
saving and reducing the funds available for investment. That is, capital inflows encourage capital formation and
economic growth, and capital outflows hinder capital formation and reduce the rate of economic growth.

S E C T I O N

C H E C K

The investment demand curve is downward sloping, reflecting the fact that the quantity of investment demanded

varies inversely with the real interest rate.

At high real interest rates, firms will only pursue those few investment activities with still higher expected rates of

return. At lower real interest rates, projects with lower expected rates of return become profitable for firms, and

the quantity of investment demanded rises.

Technology, inventories, expectations, and business taxes can shift the investment demand curve at a given real

interest rate.

The supply of national saving is composed of both private saving and public saving.

The supply curve of savings is upward sloping. At a higher real interest rate, the quantity of savings supplied

increases. At a lower real interest rate, the quantity of saving supplied decreases.

Two non-interest determinants of the saving supply curve are disposable (after-tax) income and expected future earnings.

demand more funds than they supply, the result is a
capital outflow.

In Exhibit 8, we see that capital inflows from for-

eign countries add to the supply of national saving,
increasing the funds available for domestic capital
investment and causing the saving supply curve to be
positioned to the right of the national saving supply
curve. Capital outflows to foreign countries reduce
the saving supply, reducing the funds available for
domestic capital investment and causing the saving
supply curve to be positioned to the left of the
national saving supply curve, as shown in Exhibit 8.
That is, capital inflows encourage capital formation
and economic growth, and capital outflows hinder

capital formation and reduce the rate of economic
growth.

Notice in Exhibit 8 that when the real domestic

interest rate is low and investment demand is weak,
capital will flow out to foreign markets where the
real interest rate is higher (that is, a higher rate of
return on investment). When investment demand is
strong, the real domestic interest rate is high, caus-
ing an inflow of capital because foreigners will look
for a higher rate of return on their investments.
Global financial markets tend to move toward equi-
librium, at r

and Q

where the quantity of invest-

ment demand equals the quantity of saving supplied
including the net inflow and outflow of capital.

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C H A P T E R 2 3

The Economy at Full Employment

645

In equilibrium, desired investment equals desired national saving at the intersection of the investment demand

curve and the saving supply curve. If the real interest rate is above the equilibrium real interest rate, the quantity of

savings supplied is greater than the quantity of investment demanded at that interest rate; lenders will compete

against each other to attract borrowers and the real interest rate falls. If the real interest rate is below the equilib-

rium real interest rate, the quantity of investment demanded is greater than the quantity of savings supplied at

that interest rate; borrowers compete with each other for the available saving and drive the real interest rate up.

Private saving is the amount of income households have left over after consumption and net taxes.

Public saving is the amount of income the government has left over after paying for its spending.

10. National saving is the sum of private and public saving.

11.

Government saving (a budget surplus) increases the saving supply leading to a lower real interest rate and an

increase in equilibrium saving and investment.

12.

Government dissaving (a budget deficit) reduces the saving supply leading to a higher real interest rate and a

decrease in the equilibrium saving and investment.

13.

Capital inflows encourage capital formation and economic growth.

14.

Capital outflows hinder capital formation and reduce the rate of economic growth.

Why does the investment demand curve slope downward?

What factors can shift the investment demand curve?

Why does the saving supply curve slope upward?

What factors can shift the saving supply curve?

How is the real interest rate determined?

How are shortages and surpluses eliminated in the investment and saving market?

What would happen to the equilibrium interest rate and quantity of investment if both the investment demand

and saving supply curves shifted right? What if the investment demand curve shifted right and the saving supply

curve shifted left?

Why does Y

C G S in a simple, closed economy?

If net taxes rise, what happens to private saving? To public saving?

10. Other things equal, which direction will an increasing budget surplus change the equilibrium interest rate, the

saving supply curve, the level of investment in the economy, and the likely rate of economic growth?

11.

Could the crowding-out effect sometimes be called the crowding-in effect?

12.

Why is the supply of saving curve flatter in an open economy than in a domestic-only economy?

I n t e r a c t i v e S u m m a r y

Fill in the blanks:

1. Where wages and other input prices are flexible, the

economy would only temporarily stray from
_____________ employment.

2. Historically, the two primary approaches to macroeco-

nomics are the _____________ school and the
_____________ school.

3. The _____________ school assumed that market

wages and prices adjusted relatively quickly to
changes in the economy.

4. _____________ states that supply creates its own demand.

5. According to Say’s law, production creates

_____________, which creates demand for goods.

6. According to classical economists, _____________

could be eliminated by change in relative prices.

7. Not all _____________ generated from output need

be used to buy output because it can also be saved,
hoarded, or taxed away.

8. Reasons why wages may not all fall as quickly as the

classical economists assumed include _____________
and _____________.

9. Both the Keynesian and classical schools agreed that

in the _____________, wages and prices adjust freely
to changes in supply and demand.

10. _____________ output is the level of output the econ-

omy can produce without causing inflation.

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M O D U L E 6

Macroeconomic Foundations

11. If the economy is producing at less than potential real

output, _____________ is greater than the natural rate.

12. In the short run, the _____________ of production

that is not fixed is labor.

13. A short-run production function shows the maximum

amount of real GDP the economy can produce with
different levels of _____________, holding capital,
land, and entrepreneurship (technology) constant.

14. We consider capital fixed in the _____________ run

because it takes time for investment to change the
_____________ of capital.

15. The short-run production function is a boundary

between what is _____________ and what is
_____________.

16. The short-run production function exhibits

_____________, where additional workers add less
to real GDP because they have less capital to work
with per worker.

17. A short-run _____________ shifts up when the stock

of capital increases, allowing more real output to be
produced with a given amount of labor.

18. In labor markets, _____________ supply labor and

_____________ demand labor.

19. The labor demand curve is _____________ sloping

and the labor supply curve is _____________ sloping,
with respect to real wages.

20. The _____________ of the supply of labor and the

demand for labor determines the real wage rate and
the level of _____________ in the economy.

21. The two main factors that shift the labor demand

curve are changes in _____________ and changes in
the _____________.

22. Labor _____________ shifters include wealth, the

working age population, the labor force participation
rate, regulatory changes, and attitudes toward work.

23. The intersection of the labor supply and demand

curves determines the real wage and employment,
which in turn determines _____________ along a
short-run production function.

24. The _____________ interest rate is determined by

investment demand and national savings.

25. The investment _____________ curve for the economy

is downward sloping.

26. As the real interest rate falls, _____________ investment

projects become profitable, _____________ the dollar
amount of investment.

27. The investment _____________ curve shifters include

changes in technology, inventories, expectations, and
business taxes.

28. The supply of national saving comprises both

_____________ saving and _____________ saving.

29. At a _____________ real interest rate, a greater quan-

tity of saving will be supplied.

30. An increase in disposable income or lower expected

future earnings would shift the savings supply to the
_____________.

31. Desired investment equals desired _____________ at

the equilibrium real interest rate.

32. If the real interest rate was above equilibrium, the

quantity of savings _____________ would exceed the
quantity of investment _____________.

33. At a real interest rate below equilibrium, a

_____________ of saving would occur.

34. In a _____________ economy, GDP is the sum

of consumption plus investment plus government
purchases.

35. Public saving is positive as the government

_____________ more in taxes than it _____________.

36. Starting from a balanced budget, a government’s

move to a budget _____________ would increase
public saving and increase national saving, other
things equal.

37. If the government moved into a budget _____________,

it would result in negative public saving, reduced
national saving, a higher real interest rate, and reduced
levels of investment.

38. The crowding-out effect shows that government

budget _____________ tend to reduce investment, by
_____________ real interest rates.

39. If the government runs a budget _____________,

other things equal, it will tend to increase national
saving, decrease the real interest rate, increase the
amount of investment, and increase economic
growth.

40. When foreigners supply more funds than they

demand, a capital _____________ occurs.

41. Capital inflows from foreign countries _____________

to the supply of saving.

42. When the domestic real interest rate is

_____________, capital will tend to flow out
to foreign countries.

nswers: 1.

full 2.

classical; Keynesian 3.

classical 4.

Say’s law

5. income

6. joblessness

7. income

8. long-term labor contracts; minimum

wages 9.

long run 10.

Potential 11.

unemployment 12.

factor 13.

labor 14.

short; stock 15.

attainable; unattainable 16.

diminishing returns

17. production function

18. households; firms

19. downward; upward

20. intersection; employment

21.productivity; capital stock

22.supply

curve 23.

real output 24.

real 25.

demand 26.

more; increasing 27.

demand 28.

private; public 29.

higher 30.

right 31.

national saving 32.

sup-

plied; demanded 33.

shortage 34.

closed 35.

collects; spends 36.

surplus 37.

deficit 38.

deficits; raising 39.

surplus 40.

inflow 41.

add 42.

low

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C H A P T E R 2 3

The Economy at Full Employment

647

K e y Te r m s a n d C o n c e p t s

short-run production function 635
national saving 641
closed economy 642

private saving 642
public saving 642

dissaving 643
crowding-out effect 643

S e c t i o n C h e c k A n s w e r s

23.1 The Classical Long-Run Macroeconomic Model

1. What are the two primary approaches to macroeco-

nomics?

The classical school and the Keynesian school are the
two primary approaches to macroeconomics.

2. Which school of thought emphasized that markets

can rapidly adjust to changes?

The classical school emphasized that markets can
rapidly adjust to change.

3. Why was the double-digit unemployment of the

Great Depression when Keynes wrote The General
Theory of Employment, Interest and Money helpful
in leading to its general acceptance?

The classical school held that persistent high unem-
ployment would not occur in a market economy, so
the high unemployment in the Great Depression—a
central aspect of it—appeared to be something the
classical approach could not explain.

4. What would keep wages from falling quickly in a

recession?

The two reasons cited most often that prevent wages
from falling quickly in a recession are long-term
union contracts and minimum wage laws.

23.2 The Production Function

1. Why do we consider capital fixed in the short run?

Capital is fixed in the short run because it takes time
for investment to add to the capital stock.

2. Why does the short-run production function exhibit

diminishing returns?

Short-run production functions exhibit diminishing
returns because when additional workers are added,
each worker will have less capital to work with.

3. How do the labor supply and demand curves deter-

mine real output?

The labor supply and demand curves determine real
wages and the full-employment level of labor. The
level of employment then determines the level of real
output along a short-run production function.

4. What will an increase in immigration do to the labor

supply? To real wages? To employment? To real output?

An increase in immigration will cause the labor
supply to increase, real wages to decrease, employ-
ment to increase, and real output to increase.

23.3 Investment, Saving, and the Real Interest Rate

1. Why does the investment demand curve slope

downward?

As the real interest rate falls, additional investment
projects with lower expected rates of return become
profitable for firms, and the quantity of investment
demanded rises.

2. What factors can shift the investment demand curve?

The investment demand curve would increase
(shift to the right) if firms expect higher rates of
return on their investments; if product and process
innovation reduce the costs of production; if prof-
itable new products are developed; if inventories are
depleted below the levels desired by firms; if fore-
casts for future expected sales are strong; or if busi-
ness taxes are lowered. The investment demand
curve would decrease (shift to the left) in the oppo-
site situations.

3. Why does the saving supply curve slope upward?

At a higher real interest rate, the reward for saving
and supplying funds to financial markets is greater,
leading to an increased quantity of saving supplied.

4. What factors can shift the saving supply curve?

The saving supply curve would increase (shift to the
right) if disposable (after-tax) income rose or if people
expected lower future earnings. The saving supply
curve would decrease (shift to the left) if disposable
(after-tax) income fell or if people expected higher
future earnings.

5. How is the real interest rate determined?

The real interest rate is determined by the intersection
of the investment demand curve and the saving supply
curve, where desired investment equals desired
national saving.

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M O D U L E 6

Macroeconomic Foundations

6. How are shortages and surpluses eliminated in the

investment and saving market?

If the real interest rate was above the equilibrium
real interest rate, the quantity of savings supplied
would be greater than the quantity of investment
demanded—there would be a surplus of savings. As
savers (lenders) compete against each other to attract
investment demanders (borrowers), the real interest
rate will fall toward the equilibrium level. If the real
interest rate was below the equilibrium real interest
rate, the quantity of savings supplied would be less
than the quantity of investment demanded—there
would be a shortage of savings. As demanders (bor-
rowers) compete against each other to attract savers
(lenders), the real interest rate will rise toward the
equilibrium level.

7. What would happen to the equilibrium interest rate

and quantity of investment if both the investment
demand and saving supply curves shifted right? What
if the investment demand curve shifted right and the
saving supply curve shifted left?

Whenever both the supply and demand curves shift
in any market, we add up the separate effects on
price (interest rate) and quantity (of investment
funds) exchanged. When both the investment demand
and saving supply curves shifted right, each would
increase the quantity of investment funds exchanged,
but would have opposing effects on the interest rate,
making that change indeterminate without knowing
about the relative magnitudes of the changes.

When the investment demand curve shifted right

and the saving supply curve shifted left, both effects
would tend to increase the interest rate, but have
opposing effects on the quantity of investment funds
exchanged, making that change indeterminate without
knowing about the relative magnitudes of the changes.

8. Why does Y

C G S in a simple, closed

economy?

C G is what is left over from income after

spending on consumption and government purchases,
which is what is available for investment. But in
equilibrium, investment must equal saving.

9. If net taxes rise, what happens to private saving? To

public saving?

Increased net taxes reduce disposable income, which,
in turn reduces private saving. However, increased net
taxes move the government budget toward surplus,
increasing public saving.

10. Other things equal, which direction will an increasing

budget surplus change the equilibrium interest rate,
the saving supply curve, the level of investment in the
economy, and the likely rate of economic growth?

An increasing budget surplus would increase the saving
supply curve, which would decrease the equilibrium
interest rate and increase the equilibrium level of
investment in the economy, which would tend to
increase economy growth.

11. Could the crowding-out effect sometimes be called the

crowding-in effect?

Just as larger government budget deficits crowd out
investments by raising interest rates, smaller budget
deficits or larger government surpluses would tend
to reduce interest rates, increasing or crowding-in
investment.

12. Why is the supply of saving curve flatter in an open

economy than in a domestic-only economy?

As the interest rate in the United States rises, funds
from overseas will also be attracted by the higher
returns, so interest rates will rise less than they would
in a domestic-only economy.

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Ture or False

1. The economy could remain below full employment for a long time when wage and other input prices are flexible.

2. The Keynesian school of thought assumes that markets adjust quickly to wage and price changes.

3. Say’s law says that demand creates its own supply.

4. Say’s law was emphasized by the classical economists.

5. Macroeconomics as we know it today did not exist before the 1930s.

6. When Keynes wrote The General Theory of Employment, Interest and Money, unemployment was in double digits.

7. Wage rigidity could prevent market mechanisms from working rapidly enough to avert prolonged recessions.

8. Full employment means zero unemployment.

9. When real output exceeds potential real output, unemployment exceeds its natural rate.

10. Real GDP can exceed potential real GDP, but only for a short period of time.

11. On a given short-run production function, real GDP is determined by the amount of labor employed.

12. On a short-run production function, each additional worker adds less to real GDP than previous workers.

13. With more capital, a given level of labor input can produce more real output.

14. The labor supply and demand equilibrium occurs at full employment.

15. An increase in the capital stock will increase workers’ productivity, shifting the labor supply curve to the right.

16. The labor supply curve would increase if either wealth increased or the working age population increased.

17. As more people hit mandatory retirement age, the labor supply curve will decrease, other things equal.

18. The intersection of the supply and demand curves for labor determines the real wage and full-employment level of

labor, which in turn determines the level of real output along a short-run production function.

19. Investment spending varies inversely with the real interest rate, other things equal.

20. Governments might try to stimulate investment spending by lowering interest rates.

21. If businesses expect higher rates of return on their investments, it would shift the investment demand curve to the right.

22. Either an increase in business taxes or an increase in current inventories would shift the investment demand curve to

the left.

23. The supply of national savings is the sum of all private savings.

24. Increases in either current disposable income or expected future earnings will increase the savings supply curve.

25. If the real interest rate is below equilibrium, the quantity of investment demanded would be less than the quantity of

saving supplied.

26. At a real interest rate above equilibrium, a surplus of savings would occur.

27. If the government spends more money than it collects in taxes, the national saving is negative.

28. If the government goes from a balanced budget to a deficit, public saving would become negative and national saving

would decrease, other things equal.

29. A move toward a government budget surplus would increase national saving, reduce real interest rates, and increase

investment, other things equal.

30. A move toward a government budget deficit would tend to reduce private investment and reduce economic growth,

other things equal.

31. A move toward a government budget surplus would tend to decrease the real interest rate, other things equal.

32. When foreigners supply fewer funds than they demand, a capital outflow from the United States occurs.

33. Capital inflows cause the saving supply curve to be to the right of the national saving supply curve.

34. When the domestic real interest rate is high, capital will tend to flow out to foreign countries.

35. A decrease in expected future earnings would shift the supply of national savings curve to the right.

H A P T E R

2 3

S T U D Y

G U I D E

649

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36. An increase in disposable income would shift the supply of national savings curve to the right.

37. Lower real interest rates will shift the investment demand curve right.

38. Higher real interest rates will increase the quantity of saving supplied, but not change the saving supply curve.

39. If the investment demand curve shifted right, we would expect higher real interest rates and an increased quantity of

investment demanded to result.

40. If the saving supply curve shifted left, we would expect higher real interest rates and an increased quantity of invest-

ment demanded to result.

41. If the saving supply curve shifted right, it would cause a temporary surplus of saving, which would result in a lower

real interest rate.

Multiple Choice

1. The proposition that “supply creates its own demand” is called

a. Keynes law.
b. the classical law.
c. Say’s law.
d. the iron law of wages.

2. Say’s law was emphasized by

a. Keynesian economists.
b. classical economists.
c. both Keynesian and classical economists.
d. neither Keynesian nor classical economists.

3. Both Keynesian and classical economists agree that wages and prices adjust freely

a. in the short run and the long run.
b. in the short run but not in the long run.
c. in the long run but not in the short run.
d. in neither the short run nor the long run.

4. Which of the following is false?

a. Potential real GDP and potential output mean the same thing.
b. When real GDP is below potential GDP, unemployment is below its natural rate.
c. When real GDP is below potential GDP, unemployment is above its natural rate.
d. At full employment, real GDP equals potential GDP.

5. Which of the following is not held constant along a short-run production function?

a. capital
b. land
c. entrepreneurship
d. labor

6. Which of the following would not shift the labor supply curve?

a. wealth
b. the size of the capital stock
c. the labor force participation rate
d. attitudes toward work
e. All of the above would shift the labor supply curve.

7. If the size of the capital stock increased and the working age population increased, it would

a. increase the labor supply but not the labor demand.
b. increase the labor supply and increase the labor demand.
c. increase the labor demand but not the labor supply.
d. increase the labor supply and decrease the labor demand.

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8. A decrease in which of the following would increase the labor supply?

a. wealth
b. the working age population
c. the labor force participation rate
d. immigration
e. A decrease in each of these factors would decrease the labor supply.

9. Which of the following combinations would be caused by an increase in the labor supply?

a. higher real wages; higher real output
b. higher real wages; lower real output
c. lower real wages; higher real output
e. lower real wages; lower real output

10. Which of the following will not increase the investment demand curve?

a. higher expected rates of return on investment
b. lower business taxes
c. lower levels of current inventory
d. the development of profitable new technologies
e. All of the above will increase the investment demand curve.

11. An increase in which of the following would shift the investment demand curve to the left?

a. the expected profitability of investment
b. business takes
c. inventories
d. Increases in each of the above would shift the investment demand curve left.
e. Either b or c would shift investment demand left, but not a.

12. An increase in both business expectations and business taxes causes

a. investment demand to shift right.
b. investment demand to shift left.
c. investment demand to not change.
d. an indeterminate effect on investment demand.

13. When the government runs a budget deficit, which of the following would have to be negative?

a. public saving
b. private saving
c. national saving
d. investment

14. Other things equal, if the government runs a budget surplus, it will tend to

a. increase national saving.
b. decrease the real interest rate.
c. increase the amount of investment.
d. increase economic growth.
e. do all of the above.

15. Capital outflows to foreign countries tend to

a. make domestic real interest rates higher than they would otherwise have been.
b. reduce the funds available for domestic capital investment.
c. cause the saving supply curve to be to the left of the national saving supply curve.
d. do all of the above.

16. A lower real interest rate will

a. increase the investment demand curve.
b. decrease the investment demand curve.

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c. increase the dollar amount of investment but not change the investment demand curve.
d. decrease the dollar amount of investment but not change the investment demand curve.

17. Which of the following will not increase the investment demand curve?

a. the introduction of new profitable technology investment opportunities
b. business inventories that have fallen far below desired levels
c. a decrease in real interest rates
d. business expectations of higher future sales and profits
e. All of the above will increase the investment demand curve.

18. Which of the following will not result in an increase in the dollar amount of investment in

the investment and saving market?

19. A combination of the discovery of profitable new technological investment opportunities and

inventories that have fallen far below desired levels

a. would increase the investment demand curve.
b. would decrease the investment demand curve.
c. would leave the investment demand curve unchanged.
d. could either increase or decrease the investment demand curve.

20. A combination of higher business taxes, reduced expected future profitability of businesses, and

a reduction in the level of new profitable technological investment opportunities

21. A higher real interest rate will

a. increase the supply of national savings.
b. decrease the supply of national savings.
c. increase the dollar amount of national saving, but not shift the supply of national savings curve to the right.
d. decrease the dollar amount of national saving, but not shift the supply of national savings curve to the left.

22. If at a given interest rate, the quantity of savings supplied is less than the quantity of investment demanded,

a. there is a surplus of savings and real interest rates will rise.
b. there is a surplus of savings and real interest rates will fall.
c. there is a shortage of savings and real interest rates will rise.
d. there is a shortage of savings and real interest rates will fall.

23. An increase in the investment demand curve would

a. increase real interest rates.
b. decrease real interest rates.
c. increase the dollar amount of investment.
d. decrease the dollar amount of investment.
e. do both a and c.

24. An increase in the supply of national savings curve would

a. increase real interest rates.
b. decrease real interest rates.
c. increase the dollar amount of investment.

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d. do both a and c.
e. do both b and c.

25. When inventories are low, there is a _______ expected rate of return on new investment and

the investment demand curve shifts to the ________.

a. higher; right
b. higher; left
c. lower; right
d. lower; left

26. If you expected higher future earnings, you would tend to save _________ now at any given

interest rate shifting the saving supply curve to the _________.

a. more; right
b. more; left
c. less; right
d. less; left

27. At a higher than equilibrium real interest rate, the quantity of savings supplied would be ________ than the

quantity of investment demanded—there would be a _________ of savings at this real interest rate.

a. greater; shortage
b. greater; surplus
c. less than; shortage
d. less than; surplus

28. A budget deficit

a. adds to national savings.
b. lowers the interest rate.
c. increases private investment.
d. does none of the above, other things equal.

29. An increase in the interest rate

a. shifts the supply of saving curve to the right.
b. shifts the supply of saving curve to the left.
c. shifts the investment demand curve to the right.
d. shifts the investment demand curve to the left.
e. does none of the above.

30. An increase in expectations about the profitability of investment will tend to

a. increase both the interest rate and the level of investment.
b. decrease both the interest rate and the level of investment.
c. increase the interest rate and decrease the level of investment.
d. decrease the interest rate and increase the level of investment.

31. Suppose investors become pessimistic about the economy, lowering their expected returns on investment projects.

The results would include

a. a leftward shift in the supply of loanable funds.
b. a rightward shift in demand for loanable funds.
c. a smaller quantity of funds changing hands in the loanable funds market.
d. the interest rate falling.
e. both c and d.

32. If the equilibrium interest rate increases and quantity of funds traded in the loanable fund market decreases,

it could have been caused by

a. investors becoming more optimistic about profit prospects.
b. investors becoming more pessimistic about profit prospects.
c. households deciding to save less.
d. households deciding to save more.

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Problems

1. Why might governments sometimes try to combat recessions by lowering interest rates?

2. What would happen to the investment demand curve if new potentially profitable technologies

arise and business taxes are raised at the same time?

3. What would happen to the saving supply curve if there was both an increase in current disposable

income and people expected higher earnings in the near future?

4. Starting from equilibrium in the saving and investment market, what changes in saving supply or

investment demand would tend to cause a surplus of funds at the current interest rate? What changes
in saving supply or investment demand would tend to cause a shortage of funds at the current interest rate?

5. What happens to net taxes when transfer payments increase? When both taxes and transfer payments increase?

6. Other things equal, which direction will an increasing budget deficit change the equilibrium interest rate, the

saving supply curve, the level of investment in the economy, and the likely rate of economic growth, other things
equal?

7. Why will a given government budget deficit have a smaller effect on investment in an open economy than a closed

economy?

a. Show what the equilibrium real wage, quantity of labor, and real GDP would be.
b. Show what would happen to the equilibrium real wage, quantity of labor, and real GDP if the supply of labor

shifted right.

c. Show what would happen to the equilibrium real wage, quantity of labor, and real GDP if the supply of labor

shifted left.

a. What happens to the supply and demand curves if business expectations increase and new profitable technologies

are discovered?

b. What happens to the supply and demand curves if inventories increase and business taxes increase.
c. What happens to the supply and demand curves if regulatory costs increase and inventories decrease.

Real W

Quantity of Labor

Supply of Labor

Demand for

Labor

Real GDP

Quantity of Labor

Short-Run

Production

Function

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d. What happens to the supply and demand curves if disposable income increases and expected future earnings

decrease?

e. What happens to the supply and demand curves if disposable income decreases and expected future earnings

increase?

What happens to the supply and demand curves if taxes on current earnings decrease and expected future
earnings increase?

10.

a. What happens to the supply and demand curves if business expectations and disposable income both increase?
b. What happens to the supply and demand curves if profitable new technologies are invented and expected future

income increases?

c. What happens to the supply and demand curves if inventories increase and expected future income decreases?
d. What happens to the supply and demand curves if increasingly costly business regulations are imposed, along

with increased taxes on current earnings?

Real Interest Rate

Quantity of Saving and Investment

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