Unemployment
and the Foundations of Aggregate Supply
A. The Foundations of
Aggregate Supply
1.
Aggregate supply describes the
relationship between the output that businesses willingly produce and the
overall price level, other things being constant. The factors underlying
aggregate supply are (a) potential output, determined by the inputs of labor,
capital, and natural resources available to an economy, along with the
technology or efficiency with which these inputs are used, and (b) input
costs, such as wages and oil prices. Changes in these underlying factors will
shift the AS curve.
2.
A central distinction in AS analysis
is between the long run and the short run. The short run, corresponding to the
behavior in business cycles of a few months to a few years, involves the
short-run aggregate supply schedule. In the short run, prices and wages have
elements of inflexibility. As a result, higher prices are associated with
increases in the production of goods and services. This is shown as an
upward-sloping AS curve.
The short-run AS and AD analyses
are used in Keynesian analysis of the business cycle.
3.
The long run refers to periods associated
with economic growth, after most of the elements of business cycles have damped
out. In the long run, prices and wages are perfectly flexible; output is
determined by potential output and is independent of the price level. The
long-run aggregate supply schedule is vertical. The long-run AS and AD analyses
are used in the classical analysis of economic growth.
B. Unemployment
4.
The government gathers monthly statistics
on unemployment, employment, and the labor force in a sample survey of the
population. People with jobs are categorized as employed; people without jobs
who are looking for work are said to be unemployed; people without jobs who are
not looking for work are considered outside the labor force.
5.
There is a clear connection between
movements in output and the unemployment rate over the business cycle.
According to Okun's Law, for every 2 percent that actual GDP declines relative
to potential GDP, the unemployment rate rises 1 percentage point. This rule is
useful in translating cyclical movements of GDP into their effects on
unemployment.
6.
Economists distinguish between equilibrium
and disequilibrium 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.
7.
Disequilibrium unemployment occurs when
the labor market or the macroeconomy is not functioning properly and some
qualified people who are willing to work at the going wage cannot find jobs.
Two examples of disequilibrium are structural and cyclical unemployment.
Structural unemployment arises for workers who are in regions or industries
that are in a persistent slump because of labor market imbalances or high real
wages. Cyclical unemployment is a situation where workers are laid off when the
overall economy suffers a downturn.
8.
Understanding the causes of unemployment
has proved to be one of the major challenges of modern macroeconomics. The
discussion here emphasizes that involuntary unemployment arises because the
slow adjustment of wages produces surpluses (unemployment) and shortages
(vacancies) in individual labor markets. If inflexible wages are above
market-clearing levels, some workers are employed but other equally qualified
workers cannot find jobs.
9.
Wages are inflexible because of the costs
involved in administering the compensation system. Frequent changes of compensation
for market conditions would command too large a share of management time, would
upset workers' perceptions of fairness, and would undermine worker morale and
productivity.
10. A careful look at the unemployment statistics reveals
several regularities:
a.
Recessions hit all segments of the labor
force, from the unskilled to the most skilled and educated.
b.
A very substantial part of U.S.
unemployment is short-term. The average duration of unemployment rises sharply
in deep and prolonged recessions.
c.
In most years, a substantial amount of
unemployment is due to simple turnover, or frictional causes, as people enter
the labor force for the first time or reenter it. Only during recessions is the
pool of unemployed composed primarily of job losers.
d.
The difference in unemployment rates in
Europe and the United States reflects both structural policies and the
effectiveness of monetary management.
Inflation
A. Definition and Impact
of Inflation
1.
Recall that inflation occurs when the
general level of prices is rising. The rate of inflation is the percentage
change in a price index from one period to the next. The major price indexes
are the consumer price index (CPI) and the GDP deflator.
2.
Like diseases, inflations come in
different strains. We generally see low inflation in the United States (a few
percentage points annually). Sometimes, galloping inflation produces price
rises of 50 or 100 or 200 percent each year. Hyperinflation takes over when the
printing presses spew out currency and prices start rising many times each
month. Historically, hyperinflations have almost always been associated with
war and revolution.
3.
Inflation affects the economy by
redistributing income and wealth and by impairing efficiency. Unanticipated
inflation usually favors debtors, profit seekers, and risk-taking speculators.
It hurts creditors, fixed-income classes, and timid investors. Inflation leads
to distortions in relative prices, tax rates, and real interest rates. People
take more trips to the bank, taxes may creep up, and measured income may become
distorted.
B. Modern Inflation
Theory
4.
At any time, an economy has a given
expected inflation rate. This is the rate that people have come to anticipate
and that is built into labor contracts and other agreements. The expected rate
of inflation is a short-run equilibrium and persists until the economy is
shocked.
5.
In reality, the economy receives incessant
price shocks. The major kinds of shocks that propel inflation away from its
expected rate are demand-pull and supply-shock. Demand-pull inflation results
from too much spending chasing too few goods, causing the aggregate demand
curve to shift up and to the right. Wages and prices are then bid up in
markets. Supply-shock inflation is a new phenomenon of modern industrial economies
and occurs when the costs of production rise even in periods of high
unemployment and idle capacity.
6.
The Phillips curve shows the relationship
between inflation and unemployment. In the short run, lowering one rate means
raising the other. But the short-run Phillips curve tends to shift over time as
expected inflation and other factors change. If policymakers attempt to hold
unemployment below the NAIRU for long periods, inflation will tend to spiral
upward.
7.
Modern inflation theory relies on the
concept of the nonaccelerating inflation rate of unemployment, or NAIRU, which
is the lowest sustainable unemployment rate that the nation can enjoy without
risking an upward spiral of inflation. It represents the level of unemployment
of resources at which labor and product markets are in inflationary balance.
Under the NAIRU theory, there is no permanent tradeoff between unemployment and
inflation, and the long-run Phillips curve is vertical.
C. Dilemmas of
Anti-inflation Policy
8.
A central concern for policymakers is the
cost of reducing inflation. Current estimates indicate that a substantial
recession is necessary to slow expected inflation.
9.
Economists have put forth many proposals
for lowering the NAIRU; notable proposals include improving labor market
information, improving education and training programs, and refashioning
government programs so that workers have greater incentives to work.
Frontiers of
Macroeconomics
Frontiers of Macroeconomics
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A. The Economic Consequences of the Government Debt
1. Budgets are systems used by governments and organizations to plan and
control expenditures and revenues. Budgets are in surplus (or deficit) when the
government has revenues greater (or less) than its expenditures. Macroeconomic
policy depends upon fiscal policy, which comprises the overall stance of
spending and taxes.
2. Economists separate the actual budget into its structural and cyclical
components. The structural budget calculates how much the government would
collect and spend if the economy were operating at potential output. The cyclical
budget accounts for the impact of the business cycle on tax revenues,
expenditures, and the deficit. To assess fiscal policy, we should pay close
attention to the structural deficit; changes in the cyclical deficit are a result of changes in
the economy, while structural deficits are a cause of changes in the economy.
3. The government debt represents the accumulated borrowings from the public.
It is the sum of past deficits. A useful measure of the size of the debt is the
debt-GDP ratio, which for the United States has tended to rise during wartime
and fall during peacetime.
4. In understanding the impact of government deficits and debt, it is crucial
to distinguish between the short run and the long run. Review the box on page
638 and make sure you understand why a larger deficit can increase output in
the short run while decreasing output in the long run.
5. To the degree that we borrow from abroad for consumption and pledge
posterity to pay back the interest and principal on such external debt, our descendants
will indeed find themselves sacrificing consumption to service this debt. If we
leave future generations an internal debt but no change in capital stock, there
are various internal effects. The process of taxing Peter to pay Paula, or
taxing Paula to pay Paula, can involve various microeconomic distortions of
productivity and efficiency but should not be confused with owing money to
another country.
6. Economic growth may slow if the public debt displaces capital. This
syndrome occurs when people substitute public debt for capital or private
assets, thereby reducing the economy's private capital stock. In the long run,
a larger government debt may slow the growth of potential output and
consumption because of the costs of servicing an external debt, the
inefficiencies that arise from taxing to pay the interest on the debt, and the
diminished capital accumulation that comes from capital displacement.
B. Advances in Modern Macroeconomics
7. Classical economists relied upon Say's Law of Markets, which holds that
"supply creates its own demand." In modern language, the classical
approach means that flexible wages and prices quickly remove any excess supply
or demand and thereby reestablish full employment. In a classical system,
macroeconomic policy has no role to play in stabilizing the real economy,
although it will still affect the path of prices.
8. New classical macroeconomics holds that expectations are rational, prices
and wages are flexible, and unemployment is largely voluntary. The
policy-ineffectiveness theorem holds that predictable government policies
cannot affect real output and unemployment. The theory of the real business
cycle points to supply-side technological disturbances and to labor market
shifts as the clues to business-cycle fluctuations.
9. What is our appraisal of the contribution of the new classical approach to
short-run macroeconomics? The new classical approach properly insists that the
economy is populated by forward-looking consumers and investors. These economic
actors react to and often anticipate policy and can thereby change economic
behavior. This lesson is particularly important in financial markets, where
reactions and anticipations often have dramatic effects.
C. Stabilizing the Economy
10. Nations face two considerations in setting monetary and fiscal policies:
the appropriate level of aggregate demand and the best monetary-fiscal mix. The
mix of fiscal and monetary policies helps determine the composition of GDP. A
high-investment strategy would call for a budget surplus along with low real
interest rates.
11. Should governments follow fixed rules or discretion? The answer involves
both positive economics and normative values. Conservatives often espouse
rules, while liberals often advocate active fine-tuning to attain economic goals.
More basic is the question of whether active and discretionary policies
stabilize or destabilize the economy. Economists often stress the need for credible policies,
whether credibility is generated by rigid rules or by wise leadership. A recent
trend among countries is inflation targeting for monetary policy, which is a
flexible rule-based system that sets a medium-term inflation target while
allowing short-run flexibility when economic shocks make attaining a rigid
inflation target too costly.
D. Economic Growth and Human Welfare
12. Remember the dictum: "Productivity isn't everything, but in the long
run it is almost everything." A country's ability to improve its living
standards over time depends almost entirely on its ability to improve the technologies
and capital used by the workforce.
13. Promoting economic growth entails advancing technology. The major role of
government is to ensure free markets, protect strong intellectual property
rights, promote vigorous competition, and support basic science and technology.
