Graphing Macroeconomic Problems

Full Employment (F.E.) – There is between 5% and 5.5% unemployment in the economy There is 0% cyclical unemployment

P AS AD= C+I+G+NX ☺ F.E. RGDP

There are 3 macroeconomic Problems I. The Recessionary Gap - caused by a leftward shift in the AD curve (AD is too low)

AD shifts leftward when either C, I, G, or NX decrease ex: Consumer confidence falls causing C to fall

P AS AD= C+I+G+NX AD’ RGDP C F.E. RGDP Rec. GAP

Three things to note from the Recessionary Gap: 1. RGDP is lower than it would be at F.E. 2. Unemployment is higher than it would be at F.E.

3. The average price level is lower than normal (inflation is not a problem)

II. The Inflationary Gap - caused by a rightward shift in the AD curve (AD is too high)

AD shifts rightward when either C, I, G, or NX increase ex: The government increases military expenditures causing G to increase

P AS AD’ AD= C+I+G+NX F.E. RGDP C RGDP Infl. GAP

Three things to note from the Inflationary Gap: 1. RGDP is higher than it would be at F.E. 2. Unemployment is lower than it would be at F.E.

3. The average price level is higher than at F.E. (Inflation is getting out of control)

III. Stagflation - caused by a leftward shift in the AS curve

AS shifts leftward when the cost of production increases ex: the price of oil, a major input increases

P AS’ AS AD=C+I+G+NX RGDP C F.E. RGDP

Three things to note from Stagflation: 1. RGDP is lower than it would be at F.E. 2. Unemployment is higher than it would be at F.E.

3. The average price level is higher than at F.E. (Inflation is getting out of control)

During the Oil Crisis of the late 1970’s and early 1980’s both the inflation rate and the unemployment rate exceeded 10% Misery Index: The inflation rate + the unemployment rate

If the AS curve shifts to the right, no problem is created. RGDP increases, while neither unemployment nor inflation increase. F.E. increases due to economic growth

P AS AS’ AD=C+I+G+NX F.E. F.E.’ RGDP

If the government takes no action, the economy will naturally, over time, return to F.E. (the long run equilibrium point in the economy)

If the economy is experiencing high unemployment (rec. gap or stagflation) then there is a surplus of workers on the market

This surplus causes the price of workers (real wages) to fall That is, workers’ salaries don’t keep up with inflation

Lower wages reduce the cost of production which in turn shifts the AS curve rightward bringing the economy back to F.E.

P AS AS’ AD= C+I+G+NX AD’ RGDP C F.E. RGDP Rec. GAP

If the economy is experiencing a shortage of workers (Inflationary Gap) then real wages will be bid upwards

This causes the cost of production to increase and the AS curve to shift leftward bringing the economy back to F.E.

P AS’ AS AD’ AD= C+I+G+NX F.E. RGDP C RGDP Infl. GAP