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The Neoclassical Growth Model with Elastic Labour Supply

In Chapter 3, we considered perfectly inelastic labour supply in the neoclassical growth model, in which case the level of labour (i.e., employment) never changes. In this chapter, we generalise the neoclassical growth model to allow for elastic labour supply chosen by the utility-maximising household. In summary, the supply of labour is determined by a substitution effect and an income effect, which are both influenced by changes in technology. Therefore, this modification of elastic labour supply allows for fluctuations in employment, which are an important feature of business cycles. The neoclassical growth model with elastic labour supply is essentially a special case of the real business cycle (RBC) model.