Principles of Economics
Principles of Economics

Principles of Economics

Lead Author(s): Stephen Buckles

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N. Gregory Mankiw, Principles of Economics, 8th Edition

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Case, Fair, Oster, Principles of Economics, 12th Edition

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

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Pricing

Average price of textbook across most common format

Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Up to 40-60% more affordable

Lifetime access on any device

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

$130

Hardcover print text only

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

$175

Hardcover print text only

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

$140

Hardcover print text only

Always up-to-date content, constantly revised by community of professors

Constantly revised and updated by a community of professors with the latest content

Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

In-book Interactivity

Includes embedded multi-media files and integrated software to enhance visual presentation of concepts directly in textbook

Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

Customizable

Ability to revise, adjust and adapt content to meet needs of course and instructor

Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

All-in-one Platform

Access to additional questions, test banks, and slides available within one platform

Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

About this textbook

Lead Authors

Stephen Buckles, Ph.DVanderbilt University

Stephen Buckles is a Senior Lecturer at Vanderbilt University, where he also received his Ph.D. in Economics. Buckles has been the recipient of numerous awards, including Madison Sarratt Prize for Excellence in Undergraduate Teaching (Vanderbilt, 2008), Kenneth G. Elzinga Distinguished Teaching Award (Southern Economic Association, 2006), and the Dean’s Award for Excellence in Teaching (Vanderbilt, 2007). His course pack, which this text is based on, has been used by thousands of students and engages the concepts of active learning.

PJ Glandon, PhDKenyon College

PJ Glandon joined Kenyon College as an Associate Professor of Economics after completing his Ph.D. at Vanderbilt University.

Contributing Authors

Benjamin ComptonUniversity of Tennessee

Caleb StroupDavidson College

Chris CotterOberlin College

Cynthia BenelliUniversity of California

Daniel ZuchengoDenver University

Dave BrownPennsylvania State University

John SwintonGeorgia College

Michael MathesProvidence College

Li FengTexas State University

Mariane WanamakerUniversity of Tennessee

Rita MadarassySanta Clara University

Ralph SonenshineAmerican University

Zara LiaqatUniversity of Waterloo

Susan CarterUnited States Military Academy

Julie HeathUniversity of Cincinatti

Explore this textbook

Read the fully unlocked textbook below, and if you’re interested in learning more, get in touch to see how you can use this textbook in your course today.

Chapter 23: Full Employment and a New Long-Run Equilibrium

Figure 23.1: A Great Depression Memorial: George Segal’s Breadline sculpture stands outside the Franklin Delano Roosevelt Museum in Washington D.C. The sculpture represents a scene from the Great Depression, during which many people were in need of government assistance to survive.​ [1]


​​“Fed Has Met Jobs Mandate. On Inflation, Not So Much [1]

"The central bank may not reach its target on prices until 2018.” 

[...] “With the unemployment rate now at 4.8 percent -- well within the Fed's central tendency of 4.7 to 5.0 percent -- it's hard to argue that the jobs market isn't humming. But the inflation part of the mandate requires careful attention because the central bank continues to miss its target of 2 percent.”

                      -​Tim Duy for Bloomberg View, March 20, 2017

23.1 Objectives for Chapter 23

​ After reading this chapter, you should be able to:

  • ​Explain how output, employment, and the price level will respond to changes in spending and resources in the short and long runs.
  • Explain the tradeoff between unemployment and inflation and explain under what circumstances the tradeoff exists in the short run and why it does not in the long run.
  • Identify how demographic trends, changes in government regulations and subsidies, and changes in competition affect the level of unemployment at full employment.

The article above reports that although the Fed appears to have achieved its objective for unemployment rates, it continues to undershoot its inflation target of 2 percent and predicts that the central bank may not be able to reach its inflation target until 2018. The financial and popular press frequently report unemployment rates, wage growth, and inflation in the same article. Why and how are unemployment, wages, and inflation related? That is the focus of this chapter.

Earlier in the semester, we talked about the full-employment level of real GDP. We defined it as that level of output or real GDP at full employment. And we defined full employment as that level of employment where there is no cyclical unemployment. We also said that if actual employment becomes greater than the full-employment level of employment, the economy will begin to experience increasing rates of inflation. It means we are nearing full capacity. Understanding the concept of full employment is actually easier than actually trying to measure it. And determining the exact level, as we will see, is crucial to the welfare of our economy.

​23.2 Full Employment

Let’s add full employment to our model of aggregate supply and demand.

Graphing Question 23.01

​Graphing Question 23.02

In Figure 23.2, we begin with the aggregate supply curve we developed in the last chapter. The absolute capacity is slightly larger than the full-employment level of real GDP. The full-employment level of real GDP is shown at a level of real GDP that is slightly less than the absolute capacity for the economy. As we move out along the aggregate supply curve (increasing the aggregate quantity supplied), prices may start to rise as we approach full employment. If the economy produces even more than that level of output, prices will rise at an even faster rate.

Figure 23.2: Full-employment Level of Output and Aggregate Supply Curve​


Question 23.01

Which of the following statements is true about the full-employment level of output?

A

The absolute capacity is slightly larger than the full-employment level of real GDP.

B

The absolute capacity is slightly smaller than the full-employment level of real GDP.

C

The absolute capacity is equal to the full-employment level of real GDP.

To further refine our model, let’s add aggregate demand back into the diagram. The position of aggregate demand relative to the full-employment level of real GDP and the aggregate supply curve says a lot about current economic conditions. Figure 23.3 shows a situation where the aggregate quantity demanded is equal to the aggregate quantity supplied at the full-employment level of output. The economy is producing at a level where the price level index is about 115 and output is at the full-employment level, a level of output of about $17 trillion.

Figure 23.3: The Aggregate Supply and Aggregate Demand Curves​

​Due to lower levels of total spending, the aggregate demand falls, and we end up in a situation like the one shown in Figure 23.4, where the aggregate demand curve has shifted to the left. The level of output has fallen to $15 trillion. There is unemployment. The economy might be described as being in a recession.

Figure 23.4: Decrease in Aggregate Demand

​Graphing Question 23.03


Question 23.02

What happens to the level of unemployment because of the increased spending?

A

Unemployment rises above the full-employment rate of unemployment.

B

Unemployment is at the full-employment rate of unemployment.

C

Unemployment falls below the full-employment rate of unemployment.

D

There is no change in the rate of unemployment.

​In Figure 23.5, we show an increase in total spending. Output will begin to increase, and businesses will find themselves in positions where prices must be raised in order for them to be willing to increase production. Output ends up being higher than the full-employment level of real GDP and unemployment is very low. A situation like this, where unemployment is less than the full-employment rate of unemployment, wins the government a lot of popularity.

Figure 23.5: Increase in Aggregate Demand
Question 23.03

The position of the aggregate demand relative to the full-employment level of real GDP and the aggregate supply curve determine the state of current economic conditions. Let us assume that there is an increase in spending. Which of the following initial aggregate demand curves will result in the highest possible increase in prices due to increased spending?

Question 23.04

Let us assume that there is a decrease in spending. Which of the following initial aggregate demand curves is least likely to result in a recession due to decreased spending?


Figure 23.6: Lower levels of aggregate demand often result in a rise in unemployment. The economy might be described as being in a recession.​ [2]

Read the following article and editorial from several years ago. Discussion questions follow the editorial.

U.S. Productivity Increases, but Hints of Inflation Linger [2]

"WASHINGTON — American workers’ productivity rebounded in the second quarter, but a weak underlying trend suggested that inflation could pick up more quickly than economists have anticipated.

Nonfarm productivity increased at a 1.3 percent annual rate in the April-to-June period, the Labor Department said on Tuesday. But productivity, which measures hourly output per worker, rose only 0.3 percent from a year ago." 

                      ​​-The New York Times, REUTERS, Aug. 11, 2015

Click here to read the full article and answer the questions below. 

Question 23.05

Question 23.05

Use the aggregate supply and demand model to describe the effects of rising productivity on inflation.

Hover here to see the hint for Question 23.05.
Click here to see the answer to Question 23.05.

Question 23.06

Question 23.06

Based on the article’s discussion, how will a weaker than anticipated productivity growth set off “inflation alarms”?

Hover here to see the hint for Question 23.06.
Click here to see the answer to Question 23.06.

Question 23.07

Question 23.07

Despite the lower than predicted growth in productivity, the threat of “inflation remains benign” according to the article. How does the article explain that?

Hover here to see the hint for Question 23.07.
Click here to see the answer to Question 23.07.

Question 23.08

Question 23.08

Use the aggregate supply and demand model to describe the effects on inflation of a drop in oil prices and cheaper imports because of a strong dollar. Did you explain why a strong U.S. $ implies cheaper imports?

Hover here to see the hint for Question 23.08.
Click here to see the answer to Question 23.08.

23.3​ Inflation-Unemployment Trade-off

Figure 23.7: William Phillips, the economist who first identified the tradeoff between rates of unemployment and inflation. [3]​

One of the causes of recessions and inflationary periods is fluctuation in some component of total spending, causing an even larger fluctuation in total spending. As a result, we experience a changing price level and changing levels of output, employment, and unemployment.

​When the cause of unemployment or inflation is a change in the levels of total spending, we will see a tradeoff between the rates of unemployment and inflation. Figure 23.8 shows that typical relationship, often labeled the “Phillips curve” after the economist who first identified the relationship. As spending rises, unemployment will fall – but part of the cost is an increasing rate of inflation. If spending falls, inflation will be reduced, but at the cost of rising unemployment. This is certainly what we observed in the 1960s, the period that Figure 23.8 covers.

Figure 23.8: Phillips curve for the 1960s.​

​The cause of inflation under these circumstances is spending (aggregate demand) increasing more rapidly than aggregate supply. Often this type of inflation is called “demand-pull” inflation. The important part of that term is the demand part. Inflation is demand-driven in these situations.

23.4 Changes in Supply

ECN23_Figure23.9_updated.jpg
Figure 23.9: Phillips Curves (1960 to 2018)

Add to Figure 23.8 more recent data, and we get the results shown in Figure 23.9. The relationship seems to break down completely. In fact, for some years it seems that both unemployment and inflation are rising. There appears to be no tradeoff at all.  As a result, we notice that the Phillips curve relationship has completely broken down in recent years.

In 1973, oil prices quadrupled during the Israeli-Arab war. In 1979, following a revolution in Iran, they again doubled. What would likely happen to aggregate demand and aggregate supply if the price of a very important input in many production processes increases?

Question 23.09

What happens to aggregate demand and aggregate supply if the price of an important input increases?

A

There is no change in aggregate supply but aggregate demand increases.

B

There is no change in aggregate supply but aggregate demand decreases.

C

There is no change in aggregate demand but aggregate supply increases.

D

There is no change in aggregate demand but aggregate supply decreases.

Question 23.10

As a result of the higher cost of production, what will be the short-run effect on price and output level?

Premise
Response
1

Real GDP

A

Decrease

2

Price level

B

Increase

C

No change

​If you said that when costs rise, the aggregate supply decreases, you are correct. Producers will reduce production at each price level because they can no longer afford to produce as much. The aggregate supply curve shifts to the left. Buyers want to buy more than producers are willing to produce at the current price level and prices begin to rise. As they do, producers become more willing to expand production, and the aggregate quantity demanded begins to fall. Eventually, we end up with higher prices and less output than in the beginning. We will experience rising inflation and rising unemployment. No longer do we see a tradeoff between unemployment and inflation. News articles have often used the term “stagflation” to describe such conditions. The term “stagflation” comes from having stagnant production and inflation at the same time. This is a vestige of the 1970s. During the 1960s, it was thought that this phenomenon was not possible.

​Increases in oil prices are supply shocks. In reality, they should be labeled as “negative supply shocks,” as we could experience the opposite. Falling oil prices are a positive supply shock and will cause falling prices and falling unemployment, a rather nice alternative.

​Stagflation is very different from the demand-pull inflation caused by increasing aggregate demand. It is caused by changes in supply brought on by higher prices of inputs or higher costs of production. In fact, it is often referred to as “cost-push” inflation.

Graphing Question 23.04


Figure 23.10: Changes in oil prices are often referred to as supply shocks. Falling oil prices are a positive supply shock and will cause falling prices and falling unemployment. Rising oil prices are a negative supply shock and result in higher prices as well as greater unemployment.​ [4]
Table 23.1: Recessions in the United States

Question 23.11

Question 23.11

Describe the common causes of recessions and inflationary periods.

Hover here to see the hint for Question 23.11.
Click here to see the answer to Question 23.11.

Eurozone Slips into Deflation

The video above describes the primary causes of the deflation that has recently been witnessed in many countries across the world, including the United States and the Eurozone. A decrease in oil prices is often referred to as a positive supply shock, which causes the aggregate supply to increase. The result is falling prices. This, in turn, allows for much higher aggregate spending levels, which the video mentions.

Question 23.12

If the economy is currently at full employment, what will be the short-run effect of an increase in foreign demand for U.S. exports?

Premise
Response
1

Real GDP

A

Decrease

2

Price level

B

No change

C

Increase

D

Decrease

E

Increase

Question 23.13

Compare two economies, A and B. Everything is the same except economy A is in recession, and economy B is at full employment. Assume that consumption spending increases. Economy A’s price level will change by ______________ than economy B’s price level. Economy A’s real GDP will change by ______________ than economy B’s real GDP level.

A

More, more

B

Less, less

C

More, less

D

Less, more

Graphing Question 23.05


Question 23.14

According to the Phillips Curve, there is ______________ relationship between inflation and the employment rate.

A

A positive

B

A negative

C

No

Question 23.15

According to the "Phillips Curve" explaining the relationship between inflation and unemployment, what will happen when spending decreases?

A

Inflation decreases

B

Unemployment decreases

C

Output increases

D

The aggregate supply shifts to the right

Question 23.16

Compare the following two situations. Both have rapidly rising aggregate spending. However, economy A is experiencing rapidly rising productivity; economy B is experiencing no or little change in productivity. In economy A, we would expect ______________ inflationary pressures and ______________ output than in economy B.

A

Higher; less

B

Higher; more

C

Lower; less

D

Lower; more

Question 23.17

In our aggregate demand and supply model, an increase in wages (and nothing else changes) will cause ______________ prices and ______________ unemployment.

A

Higher; lower

B

Higher; higher

C

Lower; higher

D

Lower; lower

Graphing Question 23.06


Question 23.18

Refer to the diagram in the previous question. At the new level of output, is the economy above, below or at full employment?

A

Above full employment

B

Below full employment

C

At full employment

D

Cannot be determined

Graphing Question 23.07

Graphing ​Question 23.08

Question 23.19

Question 23.19

Now summarize the differences between the curves plotted in the last two questions.

Hover here to see the hint for Question 23.19.
Click here to see the answer to Question 23.19.​

Question 23.20

Question 23.20

Can you suggest the possible reasons for the difference between these two curves?

Hover here to see the hint for Question 23.20.
Click here to see the answer to Question 23.20.

23.5​ Natural Adjustments

Inflationary Conditions

Consider an economy that is producing where aggregate quantity demanded and aggregate quantity supplied are equal and output is at the full-employment level. Total spending increases. What will happen in our economy? You should be able to describe this process by now.

The result of that increase in total spending is shown in Figure 23.11. We end up with higher prices and slightly more output. The economy will have gone from point A to point B. We have described the equality of quantities supplied and demanded as an equilibrium and it is. However, it is only an equilibrium in the short run.

​Figure 23.11: Effects of an Increase in the Total Spending

Keep in mind that in going to point B, prices have been rising, and unemployment is falling to a very low level. What might happen under those conditions? The labor market is facing conditions where demand for workers is rising. We would eventually expect wages to begin to rise. And as they do go up, costs of producing will begin to rise. If there has been no improvement in productivity, businesses will have to raise their prices in order to pay the increased wages. Our aggregate supply function will be reduced, that is, shift to the left. And this process will continue until we are no longer producing more than the full-employment output (see Figure 23.12).

Figure 23.12: Long-run Effects of an Increase in Total Spending​

Prices have gone from a price index of about 115 (at point A) to about 130 (at point B) to almost 138 (at point C). The move from point A to point B, the initial change, was due to the increase in spending. The movement from point B to point C resulted from conditions in the labor market that caused wages to rise.

There are several observations we can make about these results.

  • ​Point B is a short-run equilibrium due to an increase in aggregate demand. It is a short-term equilibrium because there are still forces present causing the state of the economy to change. Once we are there, there is upward pressure on wages due to the low rate of unemployment. Wages eventually begin to rise, bringing us to point C. Point C is a long-run equilibrium since there are no longer forces causing the economy to change.
  • The movement from point B to point C resulted in inflation accelerating beyond the initial increase in prices. The initial increase in prices was caused by a rise in aggregate demand, while the movement from point B to point C is accompanied by inflation due to higher wages.
  • The movement back to the full-employment level of output was a “natural” one. The change in wages, and therefore the level of output, happened automatically in response to the initial change in spending.

​These three observations present us with explanations for three additional terms that are used almost interchangeably to describe the full-employment level of output. The first is that the full-employment level of output is really our potential level (in a longer-run sense). If we try to produce more, we will only return to that level eventually. So that level is our long-run potential.

The second observation is that if the economy is producing at a level where unemployment is less than the full-employment level of unemployment, the rate of inflation will accelerate. Some economists have used the very awkward expression of the “Non-Accelerating Inflation Rate of Unemployment” or NAIRU, to explain this behavior. This long-run equilibrium is stable until the macroeconomy is buffeted by another shock.

​Finally, the return to the full-employment level of output is a natural one, caused by natural forces in the labor market. Thus some use the phrase the “natural level of unemployment” or the “natural level of output.”

​None of the terms we have used are perfect. The natural level claims a great deal more than we should probably be comfortable with. NAIRU is not a term poets would use. So, we will use “potential” and “full,” despite neither one being totally accurate.

Question 23.21

Sort the following events in the order of occurrence, explaining the process of natural adjustment to full-employment level of output in response to an increase in aggregate demand.

A

Output is back at full-employment level.

B

Very low unemployment puts upward pressure on wages.

C

Higher wages lower aggregate supply.

D

Output rises above full-employment level.

Question 23.22

Assume that the U.S. economy is at the full-employment level of output, and there is a surge in aggregate demand. Click on the area that represents the short-run equilibrium for the U.S. economy.

Question 23.23

Now click on the area that represents the long-run equilibrium for the U.S. economy.

Before interpreting the various concepts associated with the definition of full employment, let us first address the true meaning of unemployment rate. The next video introduces some of the terms explained in the subsequent sections.

What is the 'Real' Unemployment Rate?

What full employment really means [4]

Why some economists worry when unemployment gets too low 

"In 1977 America's government gave the Federal Reserve what seems like a straightforward goal: maximum employment. Janet Yellen, the current chairman of the Fed, thinks America is pretty close; at 4.7%, the unemployment rate is quite low by historical standards. But firms continue to hire, and American adults, of whom only about 69% have a job, seem less than maximally employed. Most governments set themselves or their central banks a guideline of full or maximum employment. But what exactly counts as full?" ...

                            -​​The Economist, Jan 29th 2017

Read the full article here and answer the questions below.

Question 23.24

Question 23.24

What are some of the factors accounting for changes in the natural rate of unemployment as stated in the article?

Hover here to see the hint for Question 23.24.
Click here to see the answer to Question 23.24.

Question 23.25

Question 23.25

Explain what is meant by hysteresis.

Hover here to see the hint for Question 23.25.
Click here to see the answer to Question 23.25.​

Question 23.26

Which of the following expressions does not describe the natural rate of unemployment?

A

Full-employment rate of unemployment

B

Non-accelerating inflation rate of unemployment

C

Zero cyclical unemployment

D

Potential unemployment

23.6 Recessions

Figure 23.13: During the Great Depression, many people became jobless.​ [5]​

This natural process of adjustment will also work in recessions. If spending falls, prices or inflation will be reduced. Output falls. Unemployment rises. The economy goes from point A to point B in Figure 23.14. At point B, unemployment is high. Unemployed workers will offer to work for lower salaries than they expected. Employers will find it easier to attract workers even at lower wages. Wages will eventually begin to fall. As they do, costs of producing goods and services fall. As costs of producing fall, competition will force businesses to lower prices. The aggregate supply curve increases, that is, moves to the right. Prices fall, aggregate quantity demanded increases. (Remember the process of investment, net exports, and consumption rising.) The economy heads back toward the full-employment level of output at point C. So again, the same three observations can be made: an equilibrium at a level of output less than the full-employment level will be a short-run equilibrium, inflation will decrease, and the movement back to full employment is a natural one.

Point A represents the initial long-run equilibrium at full employment. The short-run equilibrium is at point B. We end up back at full employment, at point C, in a long-run equilibrium.

Figure 23.14: Long-run Effects of a Decrease in Total Spending​
Question 23.27

Sort the following events in the order of occurrence explaining the process of natural adjustment to full-employment level of output in response to a decrease in aggregate demand.

A

Lower wages increase aggregate supply.

B

High unemployment puts downward pressure on wages.

C

Output is back at full-employment level.

D

Output falls below full-employment level.

This time, there is a difference in the natural process. It seems to take a lot longer for wages to fall than it does for wages to increase. We may not come out of a recession as quickly as we come out of a situation where spending has grown to take us to a level of output greater than full-employment GDP.

​One of the conclusions we can draw from the discussion of the movement to the “natural” level of real GDP is about the tradeoffs between unemployment and inflation. We have already seen that the tradeoff exists in the short run when the cause of fluctuations is a change in spending, and it does not exist when supply fluctuates. The tradeoff also does not exist in the long run. In the long run, the economy will return to the full-employment level of real GDP. The amount of real GDP and the level of unemployment will tend toward those levels. The level of inflation, in the long run, will be increasing or decreasing depending upon what is happening to demand. The long-run Phillips curve will be a vertical one at the level of full employment.​

Figure 23.15: The financial crisis of 2008 was a period of unusually high home foreclosure rates. [6]​

Question 23.28

Question 23.28

Describe in your own words the natural adjustment process if the economy is in a recession. You may begin with a long-run equilibrium and then discuss the process to a new short-run equilibrium following a change in spending or supply conditions. Does this adjustment process work for an inflationary period?

Hover here to see the hint for Question 23.28.
Click here to see the answer to Question 23.28.

23.7​ Journalists’ and Economists’ Views of Growth

In Chapter 20, we discussed different uses of the term “economic growth.” We pointed to stories that discuss growth as though there is too much of it. Those same stories quote observers saying that economic policy should be used to slow the economy from growing so rapidly.

Compare growth in spending (the journalist’s economic growth) with growth in aggregate supply (the economist’s economic growth). What are the outcomes of each? Use the aggregate demand and supply model to show the differences.

Figure 23.16: Journalists' View of Growth.​

Your results should look like those in Figure 23.16. In the journalist’s view, economic growth arises due to a rise in aggregate spending. Higher levels of total spending can be seen by a rightward shift in the aggregate demand curve, leading to higher output as well as inflationary conditions. Proper policy would be to slow increases in spending in order to prevent inflation from becoming too high.

In Figure 23.17, in addition to aggregate demand increases, aggregate supply is also rising. As a result, the economy experiences growth in output but not necessarily inflationary conditions. This is the economist’s interpretation of economic growth. Economic policy will most likely be aimed at encouraging this type of growth. To economists, economic growth is a sustainable increase in our abilities to produce more through a rise in resource endowments or an improvement in the state of technology. For that to happen, aggregate supply also has to increase along with aggregate demand, resulting in a much larger increase in the level of full-employment output. 

Figure 23.17: Economists' View of Growth​​
Figure 23.18: According to some experts, the crisis of 2008 was the result of high-risk financial products and the failure of regulators and credit rating agencies.​ [7]

Graphing Question 23.09

Graphing Question 23.10

23.8​ Determinants of the Full-Employment Rate of Unemployment

Full-employment level of real GDP is the level of output that can be produced when we reach full employment. Full employment is that level of employment where there is no cyclical unemployment. The only unemployment is frictional and perhaps structural.

​If unemployment falls below that level, inflation will begin to accelerate. The reason is that wages will begin to increase.

A problem arises because we don’t always know what that exact rate of unemployment is at full employment. And it changes over time. We can only tell after the fact. At some point as unemployment falls, prices eventually begin to rise. In reality, it does not happen at one exact rate. It is probably more accurate to define full employment as a range, perhaps now a consensus of a 4.5 to 5.0 percent unemployment rate. As we will see, the definition causes considerable political controversy. It also creates a challenge as to how to manage economic policy.

​A number of factors can cause changes in the amounts of frictional and structural unemployment and thus in the level of unemployment that we experience at full employment. Rapid increases in the labor force participation mean more inexperienced workers, each one taking longer to find a job. Increases in unemployment compensation lower pressures to find a job quickly and thus contribute to greater frictional unemployment.

Other factors speed or slow the adjustment process. Stronger union contracts will mean that wages will begin to rise more rapidly in response to price increases. Those contracts, in fact, may tie wages increases to increases in the consumer price index. At the same time, contracts may prevent wages from falling.

More competition domestically and internationally and a willingness to lay off workers will tend to hold down wage increases. Thus, even though unemployment may be less than the full-employment rate, inflation may not accelerate.

If import prices, energy prices, or food prices are rising or falling due to weather, political, or economic events in other countries, the abilities of U.S. companies to raise or lower prices will be affected.

In short, we never know exactly what the full-employment rate of unemployment is. Once the economy has gone to a lower rate of unemployment and inflation has accelerated, it is too late.

Question 23.29

Match the following types of unemployment with the main cause explaining their occurrences:

Premise
Response
1

Cyclical unemployment

A

Unemployment caused by a mismatch of skills and job opportunities

2

Structural unemployment

B

Unemployment caused by the normal process of leaving jobs¸ getting fired¸ graduating from school¸ and searching for new jobs

3

Frictional unemployment

C

Unemployment caused by business cycles


Figure 23.19: Frictional unemployment occurs when people switch from one job to another, or when they enter the workforce, for example, after finishing university.​ [8]
Question 23.30

An increase in wages will cause a shift in the __________.

A

Aggregate demand

B

Aggregate supply

C

Both aggregate supply and demand

D

Neither aggregate supply or demand

Question 23.31

Assume the economy is currently at full employment. Now suppose there is an increase in U.S. exports. The price-level in the short run will ______________; the price-level in the long run will ______________.

A

Decrease; decrease again

B

Decrease; increase

C

Increase; increase again

D

Increase; decrease

Question 23.32

If the short-run equilibrium in the economy results in real GDP being less than potential GDP, which of the following changes will most likely occur?

A

Falling wages will cause falling prices and rising employment.

B

Falling wages will cause rising prices and falling employment.

C

Rising wages will cause falling prices and rising employment.

D

Rising wages will cause rising prices and falling employment.

Question 23.33

Why will an economy return naturally to the potential level of Gross Domestic Product more quickly from an output level greater than the full-employment level than an output level less than the full-employment level?

A

It is more difficult to encourage a positive shift in the aggregate quantity demanded than it is to encourage a negative shift.

B

Businesses feel greater pressure to decrease prices at all levels than they do to raise prices.

C

The tradeoff between unemployment and inflation only exists for returning to the full-employment level from a lower level of output.

D

It takes longer for wages to fall than it does for wages to increase.

Question 23.34

If unemployment falls below the full-employment level of GDP, inflation will begin to ______________ because wages begin to ______________.

A

Slow down; increase

B

Slow down; decrease

C

Accelerate; increase

D

Accelerate; decrease


Figure 23.20: Structural unemployment refers to those workers whose job skills do not fit the jobs available.​ [9]​

The following article was published in early 1995. The unemployment rate was 5.4 percent. Inflation had been falling and averaged 2.7 percent for the last year. Ignore references to Federal Reserve Board monetary policy or the Federal Reserve changing interest rates. We will consider those issues in the next chapter. 

​Inflation Calculus: Business and Academia Clash Over Economic Concept of
‘Natural' Jobless Rate [5]

Figure 23.21: The Federal Reserve System is the central bank of the United States.​ [10]

​"Are too many Americans at work these days for the economy's own good?

Absolutely, says Martin Feldstein, a Harvard University professor and former head of the Council of Economic Advisers under President Reagan. By Mr. Feldstein's calculations, unemployment already has fallen way below the level he believes is sure to trigger steadily rising inflation – even if the economy begins slowing soon on its own. 'We are ... into the danger zone.' he says." ...

                       ​-The Wall Street Journal, January 24, 1995

Click here to read the full article and answer the questions below. 

Question 23.35

Question 23.35

Use our aggregate demand and supply framework to show what Dana Mead may be discussing.

Hover here to see the hint for Question 23.35.
Click here to see the answer to Question 23.35.

Question 23.36

Question 23.36

Can you interpret the writer’s references to frictional and structural unemployment?

Hover here to see the hint for Question 23.36.
Click here to see the answer to Question 23.36.

Question 23.37

Question 23.37

“But before the work of Phelps and Friedman, economists thought that by speeding up economic growth they could engineer an even tradeoff between inflation and unemployment – say, a one-percentage point increase in inflation, which would yield a one percentage point drop in the unemployment rate.” Is this growth in aggregate supply or aggregate demand? Explain your answer.

Hover here to see the hint for Question 23.37.
Click here to see the answer to Question 23.37.

Question 23.38

Question 23.38

Why would the entry of women, young people, and nonwhites into the labor force cause the full-employment rate of unemployment to rise in the 1970s and then to fall in the 1980s?

Hover here to see the hint for Question 23.38.
Click here to see the answer to Question 23.38.

Question 23.39

Question 23.39

“Some economists think that a too-high minimum wage prevents employers from hiring more low-wage workers.” Use supply and demand for workers to see if this makes sense.

Hover here to see the hint for Question 23.39.
Click here to see the answer to Question 23.39.

Question 23.40

Question 23.40

Why is the exact level of unemployment at full employment so important?

Hover here to see the hint for Question 23.40.
Click here to see the answer to Question 23.40.

23.9​ Summary

  • In inflationary and recessionary periods caused by fluctuating spending, we will experience a tradeoff between unemployment and inflation. The tradeoff means that as unemployment decreases, inflation will increase and vice versa.
  • Changes in supply conditions will cause unemployment and inflation to both increase (or both decrease).
  • Full employment is the level of employment that an economy can achieve where there is no upward or downward pressure on wages and prices. Full employment is used to mean the natural level of employment and the NAIRU level of unemployment. 
  • The headlines and excerpts at the beginning of the chapter reinforce the importance of identifying where the economy is in relation to its full-employment level of real GDP. If the economy is producing more than full-employment output, unemployment is quite low and will create inflationary pressures.
  • If the economy is at a level of output that is less than the full-employment level, unemployment is high. In this case, there will be downward pressure on inflation. 
  • When we confront periods of very low unemployment, we should eventually expect inflationary pressures and a rising unemployment rate. High unemployment will eventually fall as the economy returns to the full-employment level of real GDP. 
  • The natural pressures returning the economy to full employment may take time to work their way through the macroeconomy, particularly during recessions.

23.10 Key Concepts in Chapter 23

Full employment
Recessions
Inflation
Tradeoffs between unemployment and inflation
Stagflation
Wages adjusting in response to unemployment
Natural adjustment to a long-run equilibrium

23.11 Glossary

Cyclical unemployment: Unemployment caused by recessions or slowing growth in total spending in the economy.

Economic growth: Economists use the term to refer to continual increases in aggregate supply or potential real GDP. The term is often used in the press to mean increases in total spending.

Equilibrium: See short-run and long-run equilibrium.

Fiscal policy: Policies that affect the level of government spending on goods and services, taxes, and transfers payments.

Frictional unemployment: Unemployment caused by workers entering the labor force, voluntarily changing jobs or by being temporarily laid off or fired.

Full-employment level of real GDP: The amount of output that can be produced if we are at a level of full employment. Sometimes also called the potential level of real GDP.

Full-employment rate of unemployment: Zero cyclical unemployment. The lowest unemployment can be without causing an increase in the rate of inflation.

Hysteresis: A phenomenon of short-term unemployment becoming long-term unemployment. An increase or decrease in short-term unemployment becomes persistent.

Inflation: The rate of increase in the overall level of prices of goods and services in the economy.

Long-run equilibrium: Aggregate quantity demanded equals aggregate quantity supplied at the full-employment level of output.

Monetary policy: Policies of the Federal Reserve System that affect the supply of money and credit.

NAIRU: Non-accelerating inflation rate of unemployment. Same as full-employment level of unemployment.

Natural rate of unemployment: The economy will “naturally” return to this level of unemployment, given sufficient time. Same as full-employment level of unemployment.

Negative supply shock: A negative supply shock is a reduction in aggregate supply caused by an increase in prices of inputs or a decrease in productivity.

Potential level of real GDP: The real GDP that can be produced when we are at the full-employment level of output. It is our potential in the long run.

Productivity or GDP per hour worked: The amount an average worker produces per hour, measured by dividing real GDP by hours worked in the economy.

Recession: The National Bureau of Economic Research (NBER) identifies the official beginning and ending of recessions in the U.S. The organization uses a definition of a recession that is widely accepted by economists and policy makers. A recession includes the following: a significant decline in production and employment; the decline is spread throughout the economy; and it lasts more than a few months.

Short-run equilibrium: Aggregate quantity demanded equals aggregate quantity supplied.

Spending multiplier: The ultimate change in total spending that will result from a change of a dollar of consumption, investment, government, or net export spending.

Stagflation: Conditions under which both inflation and unemployment are rising.

Structural unemployment: Unemployment resulting from workers’ skills not matching job openings.

Supply shocks: An increase in the costs of producing goods and services in the economy, resulting in increasing unemployment and rising inflation.

Trade deficit: Imports are greater than exports.

Trade surplus: Exports are greater than imports.

Unemployment rate: The percentage of the labor force that is unemployed.


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Answer Keys:

Answer to Question 23.05

As aggregate supply increases due to a rise in productivity, downward pressure will be put on prices. Thus, there will be less inflationary pressure.

Click here to return to Question 23.05.






Answer to Question 23.06

If spending in the economy grows much faster than previously thought, the output gap will close at a faster rate than anticipated. According to the article, the faster you close the output gap, the faster you get to that threshold where you begin to see inflationary pressures.

Click here to return to Question 23.06.






Answer to Question 23.07

The article states that unit labor costs rose at only a 0.5 percent rate in the second quarter compared to the downwardly revised 2.3 percent pace in the first quarter. Higher labor costs result in greater inflationary pressures. Thus, a slower pace of labor cost growth caused the threat of inflation to remain benign.

Click here to return to Question 23.07.










Answer to Question 23.08

 Prices have risen at a slower pace because both of these factors result in raising aggregate supply and putting downward pressure on the price level. Recall that cheaper inputs result in higher production, reflected in a rightward shift of the aggregate supply curve.

Click here to return to Question 23.08.






Answer to Question 23.11

Changes in aggregate demand can create recessions and inflationary periods. Increases in any portion of spending will increase total spending in the economy, and depending upon where the economy is in relation to full employment, inflationary pressures may be created. Decreases in spending will create recessionary conditions. In addition, negative supply shocks can lead to a combination of recessionary and inflationary conditions. Unemployment rises, output falls, and costs and prices increase.

Click here to return to Question 23.11.






Answer to Question 23.19

There seems to be a negative relationship between inflation and unemployment during the 1960s, as depicted by the negative slope of the Phillips curve in the first diagram. However, the Phillips curve relationship completely breaks down in the 1970s.

Click here to return to Question 23.19.






Answer to Question 23.20

When the cause of unemployment or inflation is changes in the levels of total spending, we will see a tradeoff between the rates of unemployment and inflation. The Phillips curve for the 1960s shows that typical relationship. The cause of inflation under these circumstances is spending increasing more rapidly than aggregate supply (demand-pull inflation). Due to a rise in oil prices in the 1970s, we experienced rising inflation and rising unemployment, and there was no longer a tradeoff between unemployment and inflation. Therefore, the Phillips curve relationship completely breaks down in the 1970s. The cause of inflation under these circumstances is increasing prices of inputs or falling productivity that results in aggregate supply to be lowered (cost-push inflation).

Click here to return to Question 23.20.






Answer to Question 23.24

Frictional unemployment occurs when people switch from one job to another, or when they enter the workforce. Barriers to job switching (e.g., occupational licensing) increase friction and push up the natural rate. Another factor could be more efficient hiring due to information technology; the rise of “gig economy” work may push the natural rate down.

Click here to return to Question 23.24.






Answer to Question 23.25

The boundary between long-term structural unemployment and the temporary kind is not clear. In the 1980s and 1990s, economists came up with a phenomenon known as hysteresis. As a worker’s time without a job increases, not only do his/her skills become obsolete, but his/her professional connections might also weaken. Meanwhile, the workers not laid off during a downturn might bargain for greater job security, making firms reluctant to rehire those who were laid off. Hence, the short-term unemployment becomes long-term unemployment.

Click here to return to Question 23.25.






Answer to Question 23.28

​A decrease in spending or the amount of aggregate supply results in a fall in output to below the full-employment level. In a recession, there is a significant amount of unemployment. That unemployment eventually places downward pressure on wages. As wages begin to fall, costs of production decreases, and businesses begin to expand production. Prices fall in order to sell the increased production. Spending rises. The economy starts to grow back toward the full-employment level of output.

In an inflationary period, unemployment is very low. There is upward pressure on wages. Businesses begin to raise prices in order to cover the higher costs. Spending falls. The economy begins to return to the full-employment level of output with increased inflation.

Click here to return to Question 23.28.






Answer to Question 23.35

If aggregate supply is increasing at an equivalent rate, there will not be pressures on prices. Mead has made the claim that wages are rising because of increases in productivity. This could be further explained by the idea that unemployment is not lower than the natural rate. If unemployment were so low that competition for workers would force wages up, then we might see a rise in prices. Because competition for workers may not be that intense, the inflation is not taking place as some economists have predicted.

Click here to return to Question 23.35.






Answer to Question 23.36

Structural unemployment refers to those workers whose job skills do not fit the jobs available. Frictional unemployment refers to the percentage of people who have quit or lost their job, are looking for a new one, and will find one relatively soon. ave predicted.

Click here to return to Question 23.36.






Answer to Question 23.37

An increase in spending will cause lower unemployment in the short run, but it will also cause inflation. The accuracy of the statement about a one-to-one percentage point tradeoff between inflation and unemployment is not necessarily accurate. It is certainly not accurate at all levels of unemployment and inflation.

Click here to return to Question 23.37.






Answer to Question 23.38

In the 1980s, workers with less experience than the average current worker entered the labor market in increasing numbers. It took those workers typically longer to find jobs. Frictional unemployment will increase. As the number of new workers entering decreased in the 1990s, frictional unemployment fell.

Click here to return to Question 23.38.






Answer to Question 23.39

At a very high minimum wage, the quantity supplied of workers will be much higher than the quantity demanded. A falling real minimum wage may reduce the level of unemployment at the full-employment level of output.

Click here to return to Question 23.39.






Answer to Question 23.40

If the monetary and fiscal policies we discuss in the next two chapters are used to lower unemployment below the full-employment rate, we will experience increased inflation. If we keep unemployment above that full-employment rate, we will be losing jobs and output.

Click here to return to Question 23.40.


Image Citations

[1] Image courtesy of tonythemisfit under CC BY 2.0.

[2] Image courtesy of David Shankbone under CC BY 3.0.

[3] Image courtesy of lselibrary in the Public Domain.

[4] Image courtesy of paul_lowry under CC BY 2.0.

[5] Image courtesy of notionscapital under CC BY 2.0.

[6] Image  courtesy of respres under CC BY 2.0.

[7] Image courtesy of zoonabar CC BY-SA 2.0.

[8] Image courtesy of chandl3r under CC BY 2.0.

[9] Image courtesy of jurvetson under CC BY 2.0.

[10] Image courtesy of Rdsmith4 under CC BY-SA 2.5.



The National Bureau of Economic Research (NBER) identifies the official beginning and ending of recessions in the U.S. The organization uses a definition of a recession that is widely accepted by economists and policy makers. A recession includes the following: a significant decline in production and employment; the decline is spread throughout the economy; and it lasts more than a few months.
The amount of output that can be produced if we are at a level of full employment. Sometimes also called the potential level of real GDP.
Rising productivity will cause aggregate supply to increase.
Rising productivity causes aggregate supply to rise, resulting in lower prices.
Refer to the final paragraph in the article.
A drop in oil prices and cheaper imports both raise aggregate supply by lowering the cost of production.
The Phillips curve shows a negative relationship between inflation and unemployment rates.
When the cause of inflation is spending (aggregate demand) increasing more rapidly than aggregate supply.
When the economy experiences rising inflation and rising unemployment.
Normally refers to a negative supply shock. Increasing prices of inputs or falling productivity will cause aggregate supply to be reduced. The result will be rising prices, falling output, and rising unemployment.
When inflation is caused by changes in supply brought on by higher prices of inputs or higher costs of production.
Consider the causes of changes in aggregate demand and aggregate supply.
Compare the Phillips curves for the 1960s and 1970s. Is there a negative, positive or no relationship between inflation and unemployment?
The Phillips curve shows a negative relationship between inflation and unemployment rates. For each of the two time periods, identify the causes of inflation.
The real GDP that can be produced when we are in a long-run equilibrium.
Zero cyclical unemployment. The lowest unemployment can be without causing an increase in the rate of inflation.
Non-accelerating inflation rate of unemployment. Same as full employment.
The economy will “naturally” return to this level of unemployment, given sufficient time. Same as full employment.
The natural rate of unemployment depends on frictional unemployment and on structural unemployment.
“Hysteresis” is a phenomenon of short-term unemployment becoming longer-term unemployment.
The long-run Phillips curve is a vertical line at the level of full-employment because the tradeoff between unemployment and inflation does not exist in the long run.
In both scenarios, think about the effect of high or low unemployment on wages and prices.
Unemployment caused by business cycles.
Unemployment caused by the normal process of leaving jobs, getting fired, graduating from school, and searching for new jobs.
Unemployment caused by a mismatch of skills and job opportunities.
Dana Mead is suggesting that continued growth in spending will not lead to inflation.
Recall the definitions of structural and frictional unemployment.
Speeding up economic growth in such a way that there would be tradeoff between inflation and unemployment is growth in aggregate demand.
Think of the definition of full-employment rate of unemployment in terms of frictional unemployment.
If the minimum wage is “too high,” then the quantity supplied of workers will be much higher than the quantity demanded.
Think of the possible use of policies to lower unemployment.