Question

Please answer all questions in Macroeconomics below, and answer them in detail and precisely.

Question 5 (Word limit 500 words)

The world economy, in the last few months, has started to slow down due to many factors, such as trade wars, uncertainty over Brexit, and general slowdown in other economic activity.

Assuming an economy starts initially at the full employment equilibrium, discuss (with the aid of aggregate output market and money market diagrams) the short run effect of a decrease in demand for goods due to drop in consumption. Explain what will happen output, unemployment, the general price level and interest rate.

Discuss (with the aid of aggregate output market diagram) what kind of monetary policy can be adopted to restore the economy back to the full employment equilibrium.

Suppose the president of the central bank of this economy is convinced that there is no need for any monetary policy action.

If his/her opinion is followed, then how will the problem you discussed in part (a) adjust by itself? How will the economy go back to equilibrium in the long run? Explain in under 250 words whether you think the president’s opinion is good for the citizens of this economy?

Illustrate this self-adjustment on an aggregate output market diagram.

Question 6 (Word limit 200 words)

Suppose that the economy is experiencing a high level of inflation rate and unemployment is below the natural rate. How does the economy return to the natural rate of unemployment if this higher inflation rate persists?

Answer 1

Answer:

5)

a)

The economy starts with full employment level now due to fall in consumption there is a fall in demand thus the AD curve will shift leftward thus price level will fall and the output level will also from initial full employment level. In short run we consider mainly cyclical unemployment ; it depends upon the GDP level of the economy. When GDP is near to the full employment level then unemployment level will more less ; on the other hand high unemployment rate is there when GDP is low thus in this situation as output falls from initial full employment level thus unemployment will increase. Fall in price level will decrease annual wages and interest rate of the economy.

b)

To bring back the economy to its initial full employment level the govt should use expansionary monetary policy where either the govt will lower the interest rate or they will increase the money supply of the economy.As the interest rate is lower and money supply rises the consumption or spending will increase thus AD will shift rightward, similarly lower interest rate will make big investment more attractive and saving less attractive thus people will increase their consumption level.Even a lower interest rate could lead to have a depreciation in exchange rate that will make export more attractive that import.thus AD will shift rightward and the economy will be again in the full employment level.

c) In long run self adjustment process leads to have the initial employment level eventually , in short run as price level and output level falls due to fall in AD in long run,a decrease in the price level will drive down input prices expectations about inflation which will increase the short run aggregate supply thus in long run though the price level will be lower but the employment will be at the initial level.

6)

The unemployment rate is a vital measure of economic performance. A falling unemployment rate generally occurs alongside rising gross domestic product (GDP), higher wages, and higher industrial production. The government can generally achieve a lower unemployment rate using expansionary fiscal or monetary policy, so it might be assumed that policymakers would consistently target a lower unemployment rate using these policies. Part of the reason policymakers do not revolves around the relationship between the unemployment rate and the inflation rate.

In general, economists have found that when the unemployment rate drops below a certain level, referred to as the natural rate, the inflation rate will tend to increase and continue to rise until the unemployment rate returns to its natural rate. Alternatively, when the unemployment rate rises above the natural rate, the inflation rate will tend to decelerate. The natural rate of unemployment is the level of unemployment consistent with sustainable economic growth. An unemployment rate below the natural rate suggests that the economy is growing faster than its maximum sustainable rate, which places upward pressure on wages and prices in general leading to increased inflation. The opposite is true if the unemployment rate rises above the natural rate, downward pressure is placed on wages and prices in general leading to decreased inflation. Wages make up a significant portion of the costs of goods and services, therefore upward or downward pressure on wages pushes average prices in the same direction.

Two other sources of variation in the rate of inflation are inflation expectations and unexpected changes in the supply of goods and services. Inflation expectations play a significant role in the actual level of inflation, because individuals incorporate their inflation expectations when making price-setting decisions or when bargaining for wages. A change in the availability of goods and services used as inputs in the production process (e.g., oil) generally impacts the final price of goods and services in the economy, and therefore changing the rate of inflation.

The natural rate of unemployment is not immutable and fluctuates alongside changes within the economy. For example, the natural rate of unemployment is affected by

• changes in the demographics, educational attainment, and work experience of the labor force;
• institutions (e.g., apprenticeship programs) and public policies (e.g., unemployment insurance);
• changes in productivity growth; and
• contemporaneous and previous level of long-term unemployment.

Following the 2007-2009 recession, the actual unemployment rate remained significantly elevated compared with estimates of the natural rate of unemployment for multiple years. However, the average inflation rate decreased by less than one percentage point during this period despite predictions of negative inflation rates based on the natural rate model. Likewise, inflation has recently shown no sign of accelerating as unemployment has approached the natural rate. Some economists have used this as evidence to abandon the concept of a natural rate of unemployment in favor of other alternative indicators to explain fluctuations in inflation.

Some researchers have largely upheld the natural rate model while looking at broader changes in the economy and the specific consequences of the 2007-2009 recession to explain the modest decrease in inflation after the recession. One potential explanation involves the limited supply of financing available to businesses after the breakdown of the financial sector. Another explanation cites changes in how inflation expectations are formed following changes in how the Federal Reserve responds to economic shocks and the establishment of an unofficial inflation target. Others researchers have cited the unprecedented increase in long-term unemployment that followed the recession, which significantly decreased bargaining power among workers.

Unemployment and Inflation: Implications for Policymaking

The official unemployment rate has been in decline over the past several years, peaking at 10% shortly after the 2007-2009 recession before falling to 5% in January 2016. A falling unemployment rate is generally a cause for celebration as more individuals are able to find jobs; however, the current low unemployment rate has been increasingly cited as a reason to begin rolling back expansionary monetary and fiscal policy. After citing "considerable improvement in labor market conditions," in December 2015 for the first time in seven years, the Federal Reserve increased its federal funds target rate, reducing the expansionary power of its monetary policy.¹

Labor market conditions have certainly improved since the depths of the financial crisis and 2007-2009 recession, but an unemployment rate of around 5% means that nearly 8 million people are still searching for jobs and are unable to find them. So why is the Federal Reserve reducing the amount of stimulus entering the economy when so many people are still looking for work? The answer involves the relationship between the two parts of the Federal Reserve's dual mandate—maximum employment and stable prices.

In general, economists have observed an inverse relationship between the unemployment rate and the inflation rate, i.e., the rate at which prices rise. This trade-off between unemployment and inflation become particularly pronounced (i.e., small changes in unemployment result in relatively large price swings) when the unemployment rate drops below a certain level, referred to by economists as the "natural unemployment rate." Alternatively, when the unemployment rate rises above the natural rate, inflation will tend to decelerate. In response to the financial crisis and subsequent recession, the Federal Reserve began employing expansionary monetary policy to spur economic growth and improve labor market conditions. Recently, the unemployment rate has fallen to a level consistent with many estimates of the natural rate of unemployment, between 4.6% and 5.0%.² If the unemployment rate were to continue falling, it would likely fall below the natural rate of unemployment and cause accelerating inflation, violating the Federal Reserve's mandate of stable prices.

This report discusses the relationship between unemployment and inflation, the general economic theory surrounding this topic, the relationship since the financial crisis, and its use in policymaking.

The Phillips Curve

A relationship between the unemployment rate and prices was first prominently established in the late 1950s. This early research focused on the relationship between the unemployment rate and the rate of wage inflation.³ Economist A. W. Phillips found that between 1861 and 1957, there was a negative relationship between the unemployment rate and the rate of change in wages in the United Kingdom, showing wages tended to grow faster when the unemployment rate was lower, and vice versa. ⁴ His work was then replicated using U.S. data between 1934 and 1958, discovering a similar negative relationship between unemployment and wage growth.⁵

Economists reasoned that this relationship existed due to simple supply and demand within the labor market. As the unemployment rate decreases, the supply of unemployed workers decreases, thus employers must offer higher wages to attract additional employees from other firms. This body of research was expanded, shifting the focus from wage growth to changes in the price level more generally.⁶ The negative relationship between unemployment and inflation was dubbed the Phillips curve, due to Phillips's seminal work on the issue.

What is Inflation? Inflation is a general increase in the price of goods and services across the economy, or a general decrease in the value of money. Conversely, deflation is a general decrease in the price of goods and services across the economy, or a general increase in the value of money. The inflation rate is determined by observing the price of a consistent set of goods and services over time. In general, the two alternative measures of inflation are headline inflation and core inflation. Headline inflation measures the change in prices across a very broad set of goods and services, and core inflation excludes food and energy from the set of goods and services measured. Core inflation is often used in place of headline inflation due to the volatile nature of the price of food and energy, which are particularly susceptible to supply shocks.

Many interpreted the early research around the Phillips curve to mean that a stable relationship existed between unemployment and inflation. This suggested that policymakers could choose among a schedule of unemployment and inflation rates; in other words, policymakers could achieve and maintain a lower unemployment rate if they were willing to accept a higher inflation rate and vice versa. This rationale was prominent in the 1960s, and both the Kennedy and Johnson Administrations considered this framework when designing economic policy.⁷

Rebuttal to the Phillips Curve

During the 1960s, economists began challenging the Phillips curve concept, suggesting that the model was too simplistic and the relationship would break down in the presence of persistent positive inflation. These critics claimed that the static relationship between the unemployment rate and inflation could only persist if individuals never adjusted their expectations around inflation, which would be at odds with the fundamental economic principle that individuals act rationally. But, if individuals adjusted their expectations around inflation, any effort to maintain an unemployment rate below the natural rate of unemployment would result in continually rising inflation, rather than a one-time increase in the inflation rate. This rebuttal to the original Phillips curve model is now commonly known as the natural rate model. ⁸

The natural rate model suggests that there is a certain level of unemployment that is consistent with a stable inflation rate, known as the natural rate of unemployment. The natural rate of unemployment is often referred to as the non-accelerating inflation rate of unemployment (NAIRU). When the unemployment rate falls below the natural rate of unemployment, referred to as a negative unemployment gap, the inflation rate is expected to accelerate. When the unemployment rate exceeds the natural rate of unemployment, referred to as a positive unemployment gap, inflation is expected to decelerate. The natural rate model gained support as 1970s' events showed that the stable tradeoff between unemployment and inflation as suggested by the Phillips curve appeared to break down. A series of negative oil supply shocks in the 1970s resulted in high unemployment and high inflation, known as stagflation, with core inflation and the unemployment rate both rising above 9% in 1975.

Unemployment Rate Versus NAIRU The official unemployment rate is released by the Bureau of Labor Statistics (BLS) based on a survey of individuals in the United States. For more information on how the unemployment rate is calculated, refer to CRS In Focus IF10443, Introduction to U.S. Economy: Unemployment, by [author name scrubbed]. The NAIRU, however, is an estimated figure produced by various groups; henceforth, this report uses the estimated NAIRU from the Congressional Budget Office (CBO). The CBO estimates the NAIRU based on the characteristics of jobs and workers in the economy, and the efficiency of the labor market's matching process.9

The Natural Rate Model and Inflation

The economy's ability to produce goods and services, or potential output, is dependent on three main factors in the long run: (1) the amount of capital (machines, factories, etc.), (2) the number and quality of workers, and (3) the level of technology.¹⁰ Although these factors largely govern the economy's potential output, the economy's actual output is largely governed by demand for goods and services, which can rise above or below potential output. The economy is most stable when actual output equals potential output; the economy is said to be in equilibrium because the demand for goods and services is matched by the economy's ability to supply those goods and services. In other words, certain characteristics and features of the economy (capital, labor, and technology) determine how much the economy can sustainably produce at a given time, but demand for goods and services is what actually determines how much is produced in the economy.

As actual output diverges from potential output, inflation will tend to become less stable. All else equal, when actual output exceeds the economy's potential output, a positive output gap is created, and inflation will tend to accelerate. When actual output is below potential output, a negative output gap is generated, and inflation will tend to decelerate. Within the natural rate model, the natural rate of unemployment is the level of unemployment consistent with actual output equaling potential output, and therefore stable inflation.