What is Labor Hypothesis?

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Labor Hypothesis​

Time-dated consumption goods (and services) were viewed as distinct commodities (like apples and oranges). The relative price of time-dated output is the real interest rate. Changes in the interest rate, like changes in any relative price, induce people to substitute across commodities (the substitution effect).

For example, an increase in the interest rate makes current consumption more expensive relative to future consumption, inducing people to save more.

The basic logic of this argument applies not only to consumption, but to leisure (and therefore labor) as well. To see how this works, let us combine the model developed in Chapter 2 with the model developed above (for the case of a small open economy). In particular, assume that individuals have preferences defined over both time-dated consumption and leisure.
 
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