Question

How is cyclical unemployment illustrated in an AD/AS model?

Short answer

Cyclical unemployment is illustrated in the AD/AS model by changes in aggregate demand that cause the economy to move away from or towards its full employment output. When aggregate demand decreases, the AD curve shifts left, leading to lower GDP and increased cyclical unemployment. Conversely, when aggregate demand increases, the AD curve shifts right, leading to higher GDP and reduced cyclical unemployment.

Step-by-step solution

Explain the AD/AS Model

The AD/AS model is an economic model that shows the relationship between the overall price level in an economy and the total output of goods and services (also known as real GDP). The model is made up of two curves, the Aggregate Demand (AD) curve, which shows the relationship between the price level and the quantity of goods and services demanded, and the Aggregate Supply (AS) curve, which shows the relationship between the price level and the quantity of goods and services supplied. The point where these two curves intersect represents the equilibrium in the market - that is, the point where the quantity demanded equals the quantity supplied.

Identify the Full Employment Output

In the AD/AS model, the full employment output, also known as potential GDP or long-run equilibrium, is the level of output that can be achieved when the economy is operating at full capacity, with no cyclical unemployment. This corresponds to a point on the Long-Run Aggregate Supply (LRAS) curve, which is a vertical line in the AD/AS model. When the economy is operating at this point, unemployment is at its natural rate, which includes frictional and structural unemployment but not cyclical unemployment.

Illustrate Cyclical Unemployment

Cyclical unemployment can be illustrated in the AD/AS model when the actual output of an economy is below its potential output, meaning that the AD curve intersects the short-run aggregate supply (SRAS) curve at a point below the LRAS curve. In this situation, the level of demand for goods and services is not sufficient to maintain full employment, which leads to a decrease in overall output and an increase in unemployment. This type of unemployment is cyclical because it arises due to fluctuations in the business cycle, with periods of economic growth often followed by periods of economic contraction.

Show the Effect of an Increase in Aggregate Demand

To illustrate how changes in aggregate demand can affect cyclical unemployment, we can show the effect of an increase in aggregate demand on the AD/AS model. When aggregate demand increases, the AD curve shifts to the right, leading to a higher price level and a higher level of real GDP. If this increase in demand is sufficient to push the economy back to its potential output, then cyclical unemployment will decrease, and the economy will return to full employment.

Show the Effect of a Decrease in Aggregate Demand

Conversely, a decrease in aggregate demand can lead to an increase in cyclical unemployment. When aggregate demand decreases, the AD curve shifts to the left, leading to a lower price level and a lower level of real GDP. If the decrease in demand is large enough to push the economy further below its potential output, then cyclical unemployment will increase, and the economy will move further away from full employment. In conclusion, cyclical unemployment is illustrated in the AD/AS model by changes in aggregate demand that cause the economy to move away from or towards its full employment output. An increase in aggregate demand can reduce cyclical unemployment, while a decrease in aggregate demand can increase cyclical unemployment.