Macropoland, a country that is a natural gas and oil importer, has a natural rate of unemployment (at the full employment level of GDP) that is about 4.5%, and the long run average rate of inflation over time has been about 2%. However, during the period 1973-1974, the country experienced an inflation rate of about 15% while simultaneously experiencing unemployment of nearly 13%.

 

At the present time, Macropoland is experiencing very sluggish consumption and investment (a result of a fall in the housing market), and unemployment has again edged up to around 9%. Inflation is very low at 0.4%.

 

Macropoland has just hired you as their economic advisor. You have a big job ahead of you. Using your knowledge of aggregate demand and aggregate supply, can you explain what happened in these two time periods?

 

Answer:

In the first time period the short run aggregate supply curve shifts leftward( the shift in aggregate supply may be due to increase in price of inputs or due to any adverse supply shock) increasing unemployment above the natural rate of unemployment and also price level above the long term trend.

In the second time period the aggregate demand curve shifts leftwards( aggregate demand in the economy has reduced) decreasing inflation below the long run trend and increasing unemployment rate above the natural rate of unemployment

Step-by-step explanation

a) The long-run aggregate supply curve shows the quantity of goods and services produced in an economy when prices and wages are fully flexible. The Long-run aggregate supply curve is vertical at the full employment level of output or in other words at that level of output when the economy is operating efficiently. The natural rate of employment is also that the level of output at which the unemployment rate is equal to the natural rate of unemployment. As shown in the below diagram the LRAS curve shows the long-run aggregate supply curve at the natural rate of unemployment. In the long run the relationship between the inflation rate and unemployment also breaks down and price level becomes equal to expected price level and long run aggregate supply curve becomes vertical.

In the AD-AS framework, the pressure for inflation to rise and fall is shown when movement from one equilibrium to another increases or decreases price level.

The short-run aggregate supply curve shifts leftwards when the price of inputs used in production rises or when the economy is hit by adverse supply shocks. When short-run aggregate supply curve shifts leftwards unemployment becomes higher than the natural rate of unemployment and inflation becomes more than the long-run trend. In this diagram below the unemployment rate at Yo is equal to 4.5% but at Y1 the unemployment rate becomes nearly 13%. As short-run aggregate supply curve shifts leftwards the price level (inflation rate) increases from 2% (P0) to 15%(P1).

B) The main two components of aggregate demand are consumption and investment. As Macropoland is experiencing very sluggish consumption and investment then we can say that their aggregate demand is falling and aggregate demand is shifting leftwards and as a result the unemployment increases from natural level (Yn) to the Y1(9%) but price level in the economy has reduced from 4.5% (P0) to 0.4%(P1).

PFA