Question

As output increases along the short-run aggregate supply curve, briefly explain what happens to the natural rate of unemployment and to the cyclical rate of unemployment.

Short answer

As the output increases along the short-run aggregate supply curve, the natural rate of unemployment remains unchanged as it is determined by structural and institutional factors. The cyclical rate of unemployment, however, decreases as the economy operates closer to full employment.

Step-by-step solution

Understanding SRAS, Natural Unemployment Rate and Cyclical Unemployment

To commence, it's important to grasp the meaning of the key terms. The SRAS curve represents the total quantity of goods and services produced by firms for given overall price levels at a particular time period. The Natural Rate of Unemployment is the unemployment rate when the economy is at full employment - meaning that cyclical unemployment is zero. It consists of frictional and structural unemployment. The Cyclical Unemployment refers to the deviation of the actual unemployment rate from the natural rate due to business cycles, that is, the extent to which actual unemployment is greater or lesser than the natural rate.

Understanding Output and Natural Rate of Unemployment

The natural rate of unemployment is not affected by the increase in output along the SRAS, because it is determined by structural factors, such as technology and demographics, not by actual economic conditions. It would remain the same, irrespective of the productive output.

Understanding Output and Cyclical Unemployment

Cyclical unemployment, however, decreases when output increases along the SRAS curve. In recessionary conditions, when the output is low, the cyclical unemployment is high because firms lay off workers in response to lower demand for goods and services. Conversely, in an expanding economy, where output is increasing, the demand for labor also rises which leads to a decrease in cyclical unemployment.

Key concepts

Natural Rate of Unemployment

The natural rate of unemployment is an essential concept in understanding how economies function at full capacity. It is the unemployment rate that prevails when the economy is producing at its maximum potential output. This does not mean everyone is employed; rather, it includes those people who are between jobs or are unemployed due to factors like mismatched skills or relocation.

These factors are known as frictional and structural unemployment. Frictional unemployment occurs because it takes time for people to find a job that suits them and their skills. Structural unemployment happens when there is a long-term mismatch between the skills people have and the jobs available.

Importantly, the natural rate of unemployment is unaffected by changes in actual economic output. Instead, it remains stable unless there are changes in these underlying structural factors. So even if the economy is growing and producing more goods and services, the natural rate does not change accordingly. It is shaped more by technology, demographics, and education than by the business cycle itself.

Cyclical Unemployment

Cyclical unemployment is closely tied to the health of the economy and is a key indicator of economic fluctuations. It reflects the difference between the natural rate of unemployment and the actual unemployment rate.

During economic downturns or recessions, cyclical unemployment rises because there is a reduction in demand for goods and services. Companies respond by cutting back production and laying off workers. As a result, the actual unemployment rate temporarily exceeds the natural rate.

Conversely, when the economy is booming and output is increasing along the short-run aggregate supply curve, cyclical unemployment tends to decrease. More goods and services are being produced, leading to a higher demand for workers. As businesses hire more employees to meet this demand, the extra unemployment that characterizes the cyclical component diminishes.

Economic Output

Economic output is the total value of all goods and services produced in an economy at any given time. It represents the actual production capacity utilized by an economy and is a critical indicator of economic health.

On the short-run aggregate supply curve, output can increase due to short-term factors such as increased demand, better utilization of existing resources, or temporary improvements in productivity. However, this increase doesn't always lead to changes in the natural rate of unemployment, as these are determined by permanent factors.

When output increases, cyclical unemployment typically decreases, thereby aligning unemployment more closely with the natural rate. This is because an expanding economy creates more jobs, leading to greater employment opportunities. Thus, observing changes in economic output can provide insights into employment trends, especially how they relate to cyclical changes in the unemployment rate.