College of Business Administration
Extra Assignment: Chapter 29 & 30
ECON 1311
Introduction to Macroeconomics
Sasha Sami Bukhari
201101761
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Chapter 29: Unemployment and the Foundations of Aggregate Demand
Definitions:
Business Recessions: is in which employments and output fall and unemployment rises.
Aggregate supply: describes the behavior of the production side of the economy.
Aggregate supply curve: or AS curve, is the schedule showing the level of total national output
that will be produced at each possible price level, other things held constant.
Potential output (potential GDP): is the maximum sustainable output that can be produced
without triggering rising inflationary pressures.
Keynesian Macroeconomics: is associated with the upward-slopping, short-run aggregate
supply curve. In this situation, changes in aggregate demand have a significant effect on output.
Classical Economics: this is the long-run approach that states that changes in aggregate demand
affect prices but have no effect on real output.
Unemployment rate: is the number of unemployed divided by the total labor force.
Okun’s Law: states that for every 2 percent that GDP falls relative to potential GDP, the
unemployment rate rises about 1 percentage point.
Equilibrium unemployment: arises when people become unemployed voluntarily as they move
from job to job or into or out of the labor force. This is also sometimes called Frictional
unemployment, or Voluntary unemployment, because people cannot move immediately between
jobs.
Structural unemployment: signifies a mismatch between the supply of and the demand for
workers.
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Cyclical unemployment: exists when the overall demand for labor declines in business-cycle
downturns, as described in the Keynesian business-cycle theory.
Questions:
1. What is the distinction between short-run and long-run aggregate supply?
Short-run
In the short-run, it is the interaction of aggregate supply and demand that determines businesscycle fluctuations, inflations, unemployment recessions, and booms. The upward-sloping, shortrun aggregate supply curve is associated with the analysis called Keynesian macroeconomics. In
this situation, changes in aggregate demand have a significant effect on output. In other words, if
aggregate demand falls because of a monetary tightening or a falloff in consumer spending, this
will lead to falling output. In terms of our curves, this means that the Aggregate Supply curve is
upward-sloping, so a decline in Aggregate Demand will lead to a decline in both prices and
output.
Long-run
In the long-run, it is the growth of potential output working through aggregate supply which
explains the trend in output and living standards. The long-run approach is sometimes called
classical macroeconomics. This holds that changes in AD affect prices but have no effect on real
output. In the long-run, prices and wages adjust fully to changes in aggregate demand. The
classical or long-run Aggregate Supply curve is vertical; changes in Aggregate Demand therefore
have no effect on output.
2. What are the key determinants of aggregate supply?
There are seven main determinants of aggregate supply the first one being Potential output or
potential GDP. Potential output is the maximum sustainable output that can be produced without
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triggering rising inflationary pressures. Over the long run, aggregate supply depends primarily
upon potential output, hence long-run AS is determined by the same factors which influence
long-run economic growth: the quantity and quality of labor, the supply if capital and natural
resources, and the level of technology. Also production costs such as wages, import prices, and
other input costs affect the impact on aggregate demand as well.
3. What are input costs?
Businesses have certain costs that are inflexible in the short run. There are fixed costs and
variable costs. Fixed costs are costs that must be paid no matter what the company is making,
while variable costs are usually covered later on. Changes in production costs will affect
aggregate supply in the short-run. Inputs however can also affect supply behaviors. Some input
costs include wages, import prices, and other input costs. These examples are ones in which
lower costs will increase Aggregate Supply, meaning that the AS curve shifts downwards.
4. How do growth in Potential output and cost increase affect aggregate supply?
Growth in potential output with unchanged production costs shifts the Aggregate Supply curve
rightward. While when production costs increases, let’s say because of higher wages, but with
unchanged potential output, the AS curve shifts vertically upward.
5. What are sticky wages?
Some elements of business costs are inflexible or sticky in the short-run. As a result of this
inflexibility, businesses can profit from higher levels of aggregate demand by producing more
output. And the perfect example for a “sticky” cost would be wages.
6. How do you measure unemployment?
There are four types of measurements for unemployment and they are:
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Employed: these are people who perform any paid work, as well as those who have jobs
but are absent from work because of illness, strikes, or vacations.
Unemployed. Persons are classified as unemployed of they do not have a job, have
actively looked for work in the prior 4 weeks, and are currently available for work.
Not in the labor force, not looking for work.
Labor force: people who are either employed or unemployed.
7. State the impacts of unemployment.
Unemployment is an economic problem because it represents waste of a valuable resource.
Unemployment is a major social problem because it causes enormous suffering as
unemployment workers struggle with reduced incomes.
There are two sectors impacted by unemployment the first one being economic and the second
social.
Economics Impact
An increase of unemployment, the economy is in effect throwing away the goods and services
that the unemployment workers could have produced. The economic losses during periods of
high unemployment are the greatest documented wastes in a modern economy. They are many
times larger than the estimated inefficiencies from microeconomic waste due to monopoly or
from the waste induced by tariffs and quotas.
Social Impact
No dollar figure can adequately convey the human and psychological toll of long periods of
persistent involuntary unemployment. Not only does it destroy families but it also increases the
rate of personal tragedies in the society as a whole.
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8. Explains Okun’s Law.
Okun’s law state that for every 2% that GDP falls relative to potential GDP, the unemployment
rate rises about 1% point. Okun’s law provides the vital link between the output market and the
labor market. It describes the association between short run movements in real GDP and changes
in unemployment.
9. What are the economic interpretations of unemployment?
Equilibrium Unemployment arises when people become unemployed voluntarily as they move
from job to job or into and out of the labor force. This is also called frictional unemployment
because people cannot move instantaneously between jobs. This kind of unemployment is
equilibrium because firms and workers are on their supply and demand schedule. Some
economists label this voluntary unemployment to denote that people are unemployed because
they prefer that state over other labor market states. Involuntary unemployment is the result of
sticky wages which do not fall in response to excess supply in the labor market.
Disequilibrium Unemployment
This occurs when the labor market or macroeconomy is not functioning properly and some
qualified people who are willing to work at the going wage cannot find jobs. Two example of
disequilibrium are structural and cyclical unemployment. Structural unemployment signifies a
mismatch between the supply of and the demand for workers. Mismatch can occur because the
demand for one kind of labor is rising while the demand for another kind is falling and markets
do not quickly adjust.
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Cyclical unemployment exists when the overall demand for labor declines in business-cycle
down-turns. This means that fewer people are required to produce the desired level of output,
and employment must therefore fall. Disequilibrium unemployment that labor markets are not at
their supply-and-demand equilibrium.
Different types of unemployment suggest different policy responses. Frictional and/or voluntary
unemployment is perhaps not very troublesome. Cyclical unemployment can be reduced by
policies which smooth out the troughs of the business cycle. Structural unemployment requires
more than that; the structurally unemployed frequently need retraining to acquire new skills.
Chapter 30: Inflation
Definitions:
Inflation definition: is measured as a rate of change in a price index from one period. It occurs
when the general level of prices are rising.
Anticipated inflation: can be handled by advance planning.
Unanticipated inflation: can cause distributional effects from lenders to borrowers.
Consumer price index (CPI): measures the cost of a market basket of consumer goods and
services relative to the cost of that bundle during a particular base year.
GDP deflator: is the price of all the different components of GDP.
Low Inflation: is characterized by prices that rise slowly and predictably.
Galloping Inflation: inflation in the double-digit or triple-digit range of 20,100, 200 percent per
year.
Hyperinflation: is when prices are rising a million or even a trillion percent per year.
Demand-pull inflation: occurs when aggregate demand rises more rapidly than the economy’s
productive potential, pulling prices up to equilibrate aggregate supply and demand.
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Cost-push inflation: is when inflation increases because of increases in costs rather than
because of increases in demand.
Supply-shock inflation: is inflation resulting from rising costs during periods of high
unemployment and slack resources utilization.
Philips curve: shows the relationship between the unemployment rate and inflation.
Questions:
1. How do we calculate inflation?
We calculate inflation by using price indexes-weighted averages of the prices of thousands of
individual products.
2. What are the strains of inflation? And explain.
Low Inflation: prices rise slowly and predictably. In this case prices are stable and people trust
money. (It is single digit range in a year)
Galloping Inflation: it is a very high inflation which is in double or triple-digit range of 20,100,
200 percent per year. It happens in countries that have weak government, war, or revolution.
People hold only a very small amount of money in their pockets because it is risky.
Hyperinflation: prices rise a million or even a trillion percent per year.
Features in hyperinflations:
Real money stock (measured by the money stock divided by the price level) falls drastically.
Relative prices become highly unstable.
3. What is the most damaging inflation?
The most damaging inflation is the unbalanced and unanticipated.
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4. What is the best prescription for an economy?
The best prescriptions for an economy are stable prices with only a small annual increase. (Low
inflation)
5. What are the effects of inflation?
A redistribution of income and wealth among different groups.
Distortions in the relative prices and outputs of different goods, or sometimes in output
and employment for the economy as a whole.
6. What are the impacts of economy efficiency?
It harms economic efficiency
It affects total output
7. What is the relationship between inflation and the economic efficiency?
It distorts prices and price signals.
Distorts the use of money because people will not hold as much money during inflation
Distorts effect of inflation on taxes.
Menu costs of inflation: the idea that when prices are changed, firms must spend real
resources adjusting their prices.
8. When does demand-pull inflation occurs?
Demand-pull inflation occurs when aggregate demand rises more than the economy’s productive
potential which pulls the prices up to equilibrate aggregate supply and demand.
9. What is the relationship between unemployment and inflation?
Unemployment falls and workers become scarce, wages are bid up and the inflationary process
accelerates.
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10. When does the damage of demand-pull inflation occurs?
It occurs when government engage in deficit spending (When a government's expenditures
exceed its revenues, causing or deepening a deficit) and rely on the monetary printing press to
finance their deficits.
11. When does cost-pull inflation occurs?
Cost-pull inflation occurs when inflation increases because of increases in costs rather than
because of increases in demand.
12. What does cost-pull inflation leads to?
Economic slowdown
A syndrome called stagflation or stagnation with inflation
13. When does supply-shock inflation occurs? How could it lead to stagflation?
Supply-shock inflation occurs when inflation resulting from rising costs during periods of high
unemployment and slack resources utilization. It can lead to the policy dilemma of stagflation
when output declines at the same time as inflation is rising.
14. What does Philips curve states?
Philips curve shows the relationship between the unemployment rate and inflation. The basic
idea is that when output is high and unemployment is low, wages and prices tend to rise more
rapidly.
15. When does Philips curve occur?
This occurs because workers and unions can press more strongly for wage increases when jobs
are plentiful and firms can more easily raise prices when sales are brisk.
16. Explain the short/long turn Philips curve?
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On the short-run Philips curve, as you move leftward on the Phillips curve by reducing
unemployment, the rate of price and wage increase indicated by the curve becomes
higher.
In the long run, Phillips curve is vertical, not downward sloping.
17. What are the situations which state of economy can be divided in terms of the
NAIRU?
Excess demand: When markets are extremely tight, with low unemployment and high
utilization of capacity.
Excess Supply: In recessionary situations, with high unemployment and idled factories.
Neutral pressures: Sometimes the economy is operating “in neutral”.
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