12-1 UnemploymentUnemployment in a Market Economy (competitive labor market): explanation of structural unemployment Employment per unit of time Wage rates D D S S e0e0 ee1e1 w w1w1 Wage rate > equil. wage rate = q.s > q.d. = surplus of labor = unemployment If labor markets competitive & wages allowed to freely rise & fall, unemployment minimized & limited to time necessary to reach equilibrium Prevention of competitive labor markets & freely adjusting prices (reasons for above-wage equilibrium)? Min. wage laws (impact on low- skill/experience) Unions (collective bargaining) Efficiency wages

12-2 Full employment Unemployment rate (natural rate of unemployment)

12-3 Annual Unemployment Rate repeating cyclical pattern relation to changes in GDP?

12-4 Circular Flow of Economic Activity ProducersHouseholds Flow of final goods and services Flow of money payments (consumption) (Aggregate Demand for goods/services) (Aggregate Supply of goods/services) Flow of productive services Flow of money payments (Aggregate Supply of resources) (Aggregate Demand for resources) Product Market Resource Market Observations: Interrelation of 2 markets: -D for goods creates D for resources to produce them -Costs of producing goods depends on prices paid/quantities of resources used to produce 2 flows (real & $) 2 incomes (real & $) Inter- dependency of variables: -income on production -production on spending -spending on income -D for resources on D for products

12-5 Long-Run Aggregate Supply “Curve” Price level (p) p0p0 q0q0 Output supplied per year (q) p1p1 S S 0 Full Employment Output/Potential Output/ Natural Rate of Output natural rate of unemployment) Economy reaches sustainable capacity at level of full employment In the long-run, a change in the price level doesn’t impact output– resources are already fully employed Can maybe temporarily move past this level by over-employing resources, but in long-run, resources force output back to natural rate

12-6 The Short-Run and Long-Run Aggregate Supply Curves Price level (p) p0p0 q0q0 Output supplied per year (q) p1p1 S1S1 S1S1 0 q1q1 S0S0 S0S0 Can temporarily move past natural rate of output level by over-employing resources (if price level turned out to be higher than expected), but in long-run, resources force output back to natural rate, at a now-higher price level

12-7 AD, LRAS, & SRAS: Long-Run Equilibrium Price Level Quantity of Output SRAS LRAS AD Equilibrium Price When the economy reaches its long-run equilibrium where AD = LRAS, the expected price level will have adjusted to equal the actual price level. As a result, the SRAS curve crosses this point as well Natural rate of output Output & price level determined in long run by intersection of AD & LRAS curve

12-8 Aggregate Demand and Aggregate Supply: AD shift Price level (p) p0p0 q0q0 Output supplied per year (q) p2p2 S1S1 S1S1 0 q1q1 S0S0 q2q2 S0S0 D0D0 D0D0 D1D1 D1D1 D2D2 D2D2 p1p1 If AD is too weak, cyclical unemployment will exist– if it persists, economy will experience recession If AD is increased, the price level increases, but so does output (to full-employment output at D 1 D 1 =LRAS) (Unemployment ↓) If AD grows beyond natural rate of output, resource overemployment may move economy beyond sustainable level of output… p3p3 Resulting in inflation (pure inflation)inflation But in long-run, output must fall back to natural level, with higher price level, at q1, p3 — how? S1S1 Expectation change of price level… expectations catch up with new reality & expected price level rises

12-9 Contraction in AD

12-10 Circular Flow of Economic Activity ProducersHouseholds Flow of final goods Consumer spending Flow of productive services Flow of money payments Investment Government Spending Exports Savings Taxes Imports LeakagesInjections Breaks in circular flow  deficient AD  part of income created by production doesn’t return to producers in form of spending  surpluses at market prices & employment levels  unemployment Leakages may be offset by injections (e.g., if rate of saving at full employment returns to CF through investment spending, AD may be sufficient to buy all goods/services produced)

12-11 Aggregate Demand & Aggregate Supply: SRAS Shift Price level (p) p0p0 q0q0 Output supplied per year (q) p1p1 0 q1q1 SRAS 0 S0S0 AD 0 SRAS 1 S1S1 Price of labor rises without productivity increase  decrease in SRAS  total output falls & price level rises (inflation) LRAS Falling output with rising prices = stagflation If firms respond to higher price level by raising expectations of price level and setting higher nominal wages, can lead to wage-price spiral SRAS 2 p2p2 In long run, low output puts downward pressure on wages, production becomes more profitable, & SRAS shifts back to natural rate

12-12 SRAS & AD shift

11-13

12-14 The Phillips Curve (a side note) Inflation rate (percent per year) Unemployment rate (percent) 0 2 6% 4%7 The Phillips curve illustrates a negative association between the inflation rate and the unemployment rate in the short-run. ● ● A B Phillips curve Inflation high & unemployment low Inflation low & unemployment high