Question

Legislation proposes that the government should use macroeconomic policy to achieve an unemployment rate of zero percent, by increasing aggregate demand for as much and as long as necessary to accomplish this goal. From a neoclassical perspective, how will this policy affect output and the price level in the short nun and in the long run? Sketch an aggregate demand/aggregate supply diagram to illustrate your answer. Hint: revisit Figure 26.4

Short answer

In the short run, the proposed legislation to achieve a zero percent unemployment rate by increasing aggregate demand would result in an increased output and price level as AD shifts rightward. However, in the long run, the economy self-adjusts to the natural rate of unemployment, leading to higher inflation and unchanged output levels as the AS curve shifts leftward. This suggests that using macroeconomic policy alone to achieve a zero percent unemployment rate may not be effective in the long run.

Step-by-step solution

Understand the basic concepts of Aggregate Demand and Aggregate Supply

Aggregate demand (AD) represents the total demand for goods and services in an economy at a given price level; it's a measure of the purchasing power of an economy. Aggregate supply (AS) represents the total supply of goods and services produced within an economy at a given price level. The intersection of the AD and AS curves determines the equilibrium output and price level.

Draw the initial AD/AS diagram

Begin by drawing the initial aggregate demand (AD) curve and aggregate supply (AS) curves on a graph. Label the axes with "Price Level" on the vertical axis and "Real GDP" on the horizontal axis. The AD curve should slope downward from left to right, and the AS curve should slope upward from left to right. Mark the initial equilibrium point where the two curves intersect, let's call it point A.

Analyze the effects of the legislation in the short run

In the short run, the government aims to achieve a zero percent unemployment rate by increasing aggregate demand. This will cause the AD curve to shift to the right. The new AD curve (AD') represents the increase in aggregate demand due to the macroeconomic policy. The new equilibrium point will now be to the right and above point A, let's call it point B. This means that in the short run, output increases, and the price level rises due to higher demand for goods and services.

Analyze the effects of the legislation in the long run

In the long run, neoclassical economists argue that the economy will self-adjust to the natural rate of unemployment. This means that the initial increase in aggregate demand will lead to higher inflation and higher wages, which will eventually lead suppliers to decrease their production levels. This causes the AS curve to shift to the left, creating a new AS curve (AS'). The new AS'/AD' intersection will be at a higher price level and the same output level as it was at point A, let's call it point C. So, in the long run, the output remains unchanged, but the price level increases due to higher inflation.

Sketch the aggregate demand/aggregate supply diagram

Draw the aggregate demand/aggregate supply diagram with the initial AD and AS curves intersecting at point A, the new AD' curve intersecting with the initial AS curve at point B, and the new AS' curve intersecting with AD' at point C. Label points A, B, and C and their respective price levels and real GDP levels to demonstrate the effects of the legislation in both the short run and the long run. In summary, from a neoclassical perspective, the proposed legislation will initially increase output and the price level in the short run, but eventually leads to higher inflation and unchanged output in the long run. This analysis indicates that using macroeconomic policy alone to achieve a zero percent unemployment rate may not be effective in the long run.

Key concepts

Aggregate Demand

Aggregate demand (AD) refers to the total demand for goods and services in an economy at a specific price level. It's essentially the sum of all expenditures in the economy, including consumer spending, investment by businesses, government spending, and net exports.
An important aspect of AD is that it reflects the overall economic activity and purchasing power within a country.

• As the price level decreases, the purchasing power increases, leading to higher aggregate demand.
• Conversely, as the price level increases, purchasing power is eroded, and aggregate demand decreases.

The shape of the AD curve slopes downward, reflecting the inverse relationship between the price level and the quantity of goods and services demanded. In the context of trying to achieve zero unemployment, increasing AD is seen as a potential strategy to boost economic activity, although this may lead to inflationary pressures if done excessively.

Aggregate Supply

Aggregate supply (AS) signifies the total quantity of goods and services that producers in an economy are willing and able to supply at a given price level. Unlike aggregate demand, which focuses on the expenditure side, AS reflects the production capabilities and costs associated with supplying goods and services.

• The short-run aggregate supply (SRAS) curve typically slopes upwards, indicating that higher prices can incentivize producers to increase supply.
• The long-run aggregate supply (LRAS) is normally vertical, representing the natural level of output at full employment, regardless of the price level.

In the scenario where government policy boosts aggregate demand, initially, the SRAS reacts by increasing output. However, in the long run, neoclassical economics suggests that these effects are neutralized, as the economy gravitates back to its full-employment level of output, making price adjustments a crucial outcome.

Neoclassical Economics

Neoclassical economics is an approach that emphasizes the importance of rational behavior and market equilibrium. This school of thought asserts that, in the long run, the economy always returns to its natural level of output, called potential GDP. This level is determined by the factors of production: labor, capital, and technology.

• According to neoclassical theory, while policy-induced increases in aggregate demand can boost output in the short run, market forces eventually reestablish equilibrium.
• This means that, over time, the original output level (potential GDP) is restored, with most of the adjustment happening in the price level.

In the context of the proposed legislative policy aiming at zero unemployment, neoclassical economics would predict inflation in the long run without changing the long-term output, since real variables are unaffected by nominal changes.

Unemployment Rate

The unemployment rate is a critical indicator of economic health, reflecting the percentage of the labor force that is jobless but actively seeking employment. Achieving a zero percent unemployment rate, as suggested in the proposed policy, is theoretically attractive but practically challenging.

• There are different types of unemployment: cyclical, structural, and frictional. A zero unemployment rate would imply eliminating even the natural turnover inherent in labor markets.
• Neoclassical economics suggests that some level of unemployment is natural, as it allows for labor market flexibility and adjustment.

Attempting to eliminate unemployment entirely could lead to overheating the economy, resulting in inflation and inefficiency. In the long run, maintaining the natural unemployment rate is crucial for economic stability.

Price Level

The price level refers to the average of current prices across the entire spectrum of goods and services produced in the economy. It influences the purchasing power of money and is a central focus of macroeconomic policy.

• In the short run, an increase in aggregate demand can lead to higher production levels and thus temporarily increase the price level.
• Over the long run, however, if prices rise too much, it can lead to inflation without improving real output levels, as firms reach capacity limits.

From a neoclassical viewpoint, maintaining a stable price level is critical to long-term economic health. Excessive inflation, driven by sustained increases in aggregate demand, distorts spending and saving, potentially leading to an economic imbalance.