Applying AD-AS analysis to growth and unemployment

Overview

Cyclical unemployment and structural unemployment using AD-AS analysis and use of demand-side policy to reduce unemployment.

What you need to know

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Questions from this subtopic

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1. 1

   Using aggregate demand and aggregate supply analysis, explain the difference between actual and potential economic growth.

   Model answer

   Actual growth is an increase in real national output achieved by moving the equilibrium to the right along or up an existing aggregate supply curve, usually because aggregate demand has shifted right and idle resources have been brought into use. Potential growth is an increase in what the economy is capable of producing, shown by a rightward shift of the long-run aggregate supply curve. On a diagram with the general price level on the vertical axis and real national output on the horizontal axis, actual growth closes an output gap, while potential growth moves the vertical long-run curve itself.

2. 2

   Apply AD-AS analysis to show why growth driven only by rising aggregate demand cannot be sustained indefinitely.

   Model answer

   Each rightward shift of aggregate demand moves the equilibrium up the aggregate supply curve, raising both the general price level and real national output. As output approaches the long-run aggregate supply position the curve steepens and eventually becomes vertical, so further shifts deliver progressively less output and progressively more inflation. Once output is above potential, rising wages and input costs shift short-run aggregate supply left and pull output back. Lasting growth therefore requires the long-run aggregate supply curve to move right, which demand policy cannot achieve.

3. 3

   Real national output rises from 2,000 billion pounds to 2,060 billion pounds in a year. Calculate the growth rate and explain what further information is needed to judge whether it is sustainable.

   Model answer

   Growth = (2,060 - 2,000) / 2,000 = 60 / 2,000 = 0.03, or 3.0 per cent. To judge sustainability we need to know where potential output lies: if the long-run aggregate supply curve has also moved right by 3 per cent, the expansion is sustainable and non-inflationary, whereas if capacity is unchanged the economy has simply moved up a steepening short-run aggregate supply curve and inflationary pressure will build. The behaviour of the general price level over the same period is the practical indicator.

4. 4

   Use AD-AS analysis to explain how a fall in aggregate demand causes unemployment.

   Model answer

   A leftward shift of aggregate demand means less planned spending on domestic output at every general price level. On a diagram with the general price level on the vertical axis and real national output on the horizontal axis, the equilibrium moves down along the short-run aggregate supply curve, so real national output falls and the general price level falls. Producing less output requires fewer workers, so firms cut hours and shed labour, and cyclical unemployment rises. The size of the job loss depends on how steep the aggregate supply curve is, since a flat curve means the whole adjustment falls on output.

5. 5

   An economy has a negative output gap of 60 billion pounds and output per worker of 60,000 pounds a year. Estimate the number of jobs the gap represents.

   Model answer

   Dividing the shortfall in output by output per worker gives 60,000,000,000 / 60,000 = 1,000,000 jobs. Closing the gap would therefore create roughly a million jobs, on the assumption that output per worker stays the same as output expands. In practice firms often hold on to staff during a downturn, so measured productivity falls and the job loss is smaller than the output loss implies.

6. 6

   Distinguish between cyclical unemployment and structural unemployment using AD-AS analysis.

   Model answer

   Cyclical unemployment arises when aggregate demand is too low, so the equilibrium sits to the left of the long-run aggregate supply curve and firms do not need all the available workers; it is shown as a negative output gap and can in principle be removed by raising aggregate demand. Structural unemployment arises when workers' skills or locations do not match the jobs available, so it persists even when the economy is at its long-run aggregate supply position; it appears as a long-run aggregate supply curve that lies further left than it need be. Demand policy addresses the first; training, mobility and other supply-side measures address the second.

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