Question

Use the aggregate demand and aggregate supply framework to show a recessionary gap. What are the costs of unemployment? Recommend policy options that the government can adopt?

Answer 1

Recessionary Gap

A recession gap occurs when the aggregate demand curve intersects the short-run aggregate supply curve at a point to the left of the long-term aggregate supply.A shift to the left side of the aggregate demand curve or a decline in quantity demanded leads to lower prices and, hence, a lower GDP. This brings economic contractions, and if such declines drive demand below the potential GDP of the economy, the economy goes into a recession. Companies will then tend to reduce their workforce hence raising the rate of unemployment.

As shown AD and SRAS curve are intersecting onnthe left side of LRAS curve. This results in recessionary gap and decline in GDP from Yp to Y1.

Costs of Unemployment

Personal Costs of Unemployment

Loss of Earnings

Unemployment leads to loss of income and earnings for the unemployed person. It may result in indebtness.

Homelessness

It results in loss of shelters and homes as unemployed person due to loss if income may find it unable to meet home costs.

Dark Future

Unemployment results in finding employment bin future. This result in dark future fir the person.

Loss of Human Capital

Unemployment results in loss of confidence chances of person getting employment in future reduces. If people are out of work, they miss out on ‘on the job training’ This is a vital component of human capital and labour skills; high rates of unemployment can reduce labour productivity.

Stress and Health problems

Unemployment results in severe financial losses. As a result the person may suffer from severe health problems like mental stress, depression and even suicide in extreme cases.

Costs to Government

Increased costs of Government Borrowing

Due to unemployment person is unable to pay taxes. As a result tax revenue received by government reduces.Also, the government expenditure increases due to higher Unemployment benefits to be paid by government.

Costs to Society

Lower GDP for the economy.

High unemployment indicates the economy is operating below full capacity and is inefficient; this will lead to lower output and incomes. The unemployed are also unable to purchase as many goods, so will contribute to lower spending and lower output. A rise in unemployment can cause a negative multiplier effect.

Increase in Social Problems

An unemployed person may resort to crime and vandalism. This results in increase in crime rate and youth may get indulge in unemployment activities.

Political Instability

The unemployment in 1930 during Great Depression led to mass social unrest. In Germany, an unemployment rate of 6 million was an important factor in the rise of Hitler and the Nazi party.

Measures to fill the Recessionary Gap

During Recessionary the main focus of the government is to boost aggregate demand. Increase in demand will result in increase Investment and production thus stimulating the economy.

Increase government spending.

Increased government spending is likely to cause a rise in aggregate demand (AD). This can lead to higher growth. Higher government spending will also have an impact on the supply-side of the economy resulting in increase in productivity.

Decrease in tax rates

By decreasing tax rates the income of people rise. As a result they are able to purchase more goods and services thus boosting aggregate demand and spending and stimulating the economy.