Question

Suppose the unemployment rate in the United States is 10% and the structural unemployment rate is 6% and the frictional unemployment rate is 5%. The actual Real GDP level is $ 30 billion and the Natural Real GDP level is $27 billion. Please answer questions 3a through 3c below.

3a. Calculate the natural unemployment rate for the United States. Then, please calculate the Cyclical Unemployment rate and then please calculate the recessionary gap or an inflationary gap using the actual Real GDP level and the Natural Real GDP level. Please show your calculations and work.

3b. Based on the information above and from the calculations you performed in 3a, is the United States in a recessionary gap or an inflationary gap? Explain why the United States is in an inflationary or a recessionary gap.

3c. As an economist, what economic fiscal policies can you suggest to President Trump to help combat the inflationary gap or the recessionary gap in the United States in this situation? Explain why the policies you suggested might help to combat the inflationary or recessionary gap that the U.S. economy is experiencing in this situation.

Answer 1

3a. Natural Rate of unemployment is that rate which exists in the economy not because of economic instability but because of natural movements in the economy. This concept was propounded by Milton Friedman and Edmund Phelps in the 1960s. Mathematically, natural rate of unemployment = (structural + frictional) rate of unemployment = 6% + 5% = 11%.

Cyclical unemployment is that unemployment caused because of change in the production cycles (business cycles). Mathematically, cyclical rate of unemployent = |(actual - natural) rate of unemployment | = |10% - 11%| = 1%

Now, actual real GDP = $30 billion. Natural real GDP (Potential GDP/ GDP at full employment) = $27 billion.

Since actual real GDP > Potential GDP, there exists an inflationary gap ?= $ (30 - 27) billion = $3 billion.

3b. Recessionary gap occurs when actual GDP < potential GDP and inflationary gap occurs when actual GDP > potential GDP. Since the latter is the case for the question given, USA is in an inflationary gap. Note that this means a general increase in price level (high inflation) and is not necessarily a good thing.

3c. Fiscal policy measures to combat this inflationary gap:

1. Increase taxes on profits so as to control over consumption which will stabilise the price level.

2. Increase in taxes on inputs so as to avoid over production in the economy.

3. Reduce subsidies given to inputs so as to control the price level.

4. It would be futile to discourage entrepreneurial activity as that would lead to a negative business environment. However, incentives given to entrepreneurs should be limited and only provided to those not earning super normal profits.

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