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.

Short answer

The reduction in aggregate demand or supply will cause unemployment to increase as the change in price level lead to a change in output. The price level decreases when aggregate demand decreases and increases when aggregate supply decreases.

Step-by-step solution

Unemployment caused by decrease in aggregate demand

The change in unemployment can vary with the change in magnitude, mainly decrease in aggregate demand. If the economy is at full employment level, then a decrease in aggregate demand will have an uncertain effect on unemployment but substantially impact the price level. Suppose the economy is operating on the left side of the full employment level, then the reduction in aggregate demand will increase unemployment more than the price change.

Suppose the economy was operating at point A, and after the change in aggregate demand, the economy shifts to point B. Thus, the output falls more than the price change.

Unemployment caused by decrease in aggregate supply

When the aggregate supply reduces, the price level will increase; thus, the output will fall. With the fall in production, unemployment will increase as the output is reduced.

As the aggregate supply falls, the economy moves from point C to point D, where the price level increases and the output falls; thus, it creates unemployment.