Question

Explain: "Unemployment can be caused by a decrease of aggregate demand or a decrease of aggregate supply." In each case, specify the price-level outcomes. LO12.6

Short answer

Decreased aggregate demand lowers prices and raises unemployment; decreased supply raises prices and also raises unemployment.

Step-by-step solution

Understanding Aggregate Demand and Aggregate Supply

Aggregate demand refers to the total quantity of goods and services demanded across all levels of an economy at a particular price level and in a given time period. Aggregate supply, on the other hand, refers to the total supply of goods and services that firms in an economy plan to sell during a specific time period at a given price level.

Decrease in Aggregate Demand

When aggregate demand decreases, it means that consumption, investment, government spending, or net exports have declined. This leads to a reduction in the total output and employment as firms see less need for production, potentially causing unemployment. Price levels tend to fall or increase at a slower rate when demand decreases because there is less competition for goods and services.

Decrease in Aggregate Supply

A decrease in aggregate supply might occur due to higher production costs or disruptions. This decreases the economy's ability to produce goods and services, leading to unemployment as businesses scale back operations. Unlike demand-side issues, a supply shortage typically causes price levels to rise because the same or reduced quantity of goods is met with ongoing demand, potentially intensifying inflation.

Analyzing the Impact on Unemployment and Price Levels

Both a decrease in aggregate demand and a decrease in aggregate supply can lead to higher unemployment levels, but their impact on price levels is different. A demand decrease generally results in lower price levels, while a supply decrease leads to higher price levels.

Key concepts

Aggregate Demand

Aggregate demand is a crucial idea in economics that represents the total amount of goods and services that households, businesses, the government, and foreign buyers are ready to purchase at a specific price level in an economy. Think of it like everyone in a country's shopping list at a given time. It includes spending by:

• Consumers (buying everyday goods and services).
• Businesses (investing in machinery or buildings).
• Government (spending on public services).
• Foreign buyers (purchasing exports).

When any of these categories spend less, aggregate demand goes down. This decrease can lead to firms reducing their production because there's less need for their products. As a result, they might not need as many employees, which can cause unemployment to rise. This drop in demand often makes price levels fall or grow at a slower pace because there isn't as much pressure on goods and services prices.

Aggregate Supply

Aggregate supply is the total supply of goods and services that businesses in an economy plan to produce and sell at a given overall price level during a certain time frame. Picture it as the collective amount of products and services made in a country. The supply can decrease due to various factors:

• Increase in production costs.
• Natural disasters disrupting production.
• Labor strikes or shortages of materials.

When aggregate supply declines, businesses are often forced to reduce their output, leading to fewer job opportunities and therefore, higher unemployment. However, because there is still the same demand from consumers, prices usually go up. This effect is quite like when fewer goods are available, but buyers still want to buy them, leading to price hikes.

Price Levels

Price levels indicate the average of current prices across the entire spectrum of goods and services produced in the economy. They respond differently to shifts in aggregate demand and aggregate supply:

• When aggregate demand decreases, price levels generally decrease or rise more slowly. This is because, with less demand for products, there isn't a strong push to bid up prices.
• Conversely, when aggregate supply decreases, price levels tend to increase. The scarcity of goods and services drives prices up as consumers and businesses compete to buy the limited products available.

Understanding these dynamics helps explain why inflation or deflation happens in an economy, as both are strongly tied to the movement of price levels.

Economic Fluctuations

Economic fluctuations, often described as the ups and downs in an economy, are closely linked to changes in aggregate demand and supply. These fluctuations can be thought of as "economic waves" that affect various aspects of economic life such as:

• Employment rates
• Investment levels
• Consumer confidence and spending

When aggregate demand decreases, the economy tends to slow down, leading to what we call a recession with higher unemployment and lower price levels. On the other hand, a decrease in aggregate supply can lead to a stagflation scenario, characterized by slow economic growth, high unemployment, and high inflation due to rising price levels. Understanding economic fluctuations helps policymakers devise strategies to stabilize the economy by addressing either supply or demand factors effectively.