1 Econ 1250 HW A5– Ch 12 Q1. Assume economy is operating at potential level of Real GDP and unemployment equals its natural rate. Use an appropriate diagram to depict the impact of the following events. For each case also indicate the effect on Price level, Real GDP, Unemployment and the government budget balance. a. Government reduces the minimum nominal wage b. Firms expect future growth in Real GDP and increase their purchases of physical capital 2 Q2. a. Draw the AD- AS diagram depicting an economy for which unemployment rate is lower than the natural rate. Is this economy facing an inflationary gap or recessionary gap. b. If the government does not intervene to close this gap, what would be the effect on Real GDP and Price level in the long run? Show the effect on your diagram. [Hint: In the Long run the economy self corrects itself] Q3. a. Draw an economy facing a recessionary gap in the short run. b. What discretionary stabilization policies can the government implement that might bring the economy to long-run macroeconomic equilibrium? Illustrate with the help of diagram. c. Assume the government used discretionary fiscal policies to close the gap. State the effect of these policies on Price level, Real GDP, unemployment and budget balance. 3 Ch 10 Q4. Using the Loanable Funds Market Model show what happens to nominal interest rates if inflation falls below what it was expected to be.
Principles of Macroeconomics
- An economy operating at a point where unemployment equals its natural rate means that it is at full employment. Government reduction of nominal wages in such an economy can encourage businesses to hire more low-skilled workers, raising the demand for labor, as shown in figure 1. Similarly, a reduction in the minimum nominal wages by the government can lead to a decline in price levels as firms incur fewer operational costs in terms of wages, an increase in real GDP, a reduction in unemployment, and a lower budget balance.
As shown, a decrease in minimum nominal wage, from W0 to W1, causes an increase in the demand for low-skilled labor from E0 to E1.
- If firms expect future growth in real GDP and increase their purchases of physical capital, the aggregate demand for labor is likely to shift to the right, as entities seek additional human capital to boost productivity, as shown in figure 2. Also, the highlighted event may cause an increase in price levels due to the high operational costs associated with the additional workforce, a reduction in unemployment, and government budget balance, as more revenue would be collected compared to the amount of money the government spends on the economy.
As seen in figure 2, when firms expect future growth in real GDP, aggregate demand for labor shifts from AD0 to AD1, as entities seek additional labor to boost productivity.
- An unemployment rate lower than the natural rate means that an economy is operating above full employment. The aggregate demand (AD) and short-run aggregate supply curve (SRAS) in such a scenario intersect to the right of the long-run aggregate supply curve (LRAS), as shown in figure 3. An economy whose unemployment rate is lower than the natural rate faces an inflationary gap, whereby the actual GDP surpasses the potential full-employment GDP in the economy.
- If the government does not intervene to close an inflationary gap, a scenario known as non-intervention, the real wages ultimately adjust in the long run to the equilibrium point, and the unemployment level moves back to its natural level. Similarly, the real GDP of the economy moves to the potential level, and the price level increases from P1 to P2 in the long run, as shown in figure 3. This phenomenon is mainly caused by changes in nominal wages relative to labor. Most notably, when the unemployment rate is lower than the natural rate, it means that there are fewer job seekers compared to job openings in the market. Therefore, in the long run, firms adjust wages in response to the labor shortage, which in turn causes the short-run aggregate curve to shift, bringing the economy back to its initial potential output, as shown in figure 3.
- A recessionary gap occurs when the real GDP of a country is lower than the potential real GDP. The gap can also occur when a country’s unemployment rate is greater than the natural rate of unemployment. In the short run, the recessionary gap appears as shown in figure 4.
Figure 4: Illustration of Recessionary Gap
- The government can implement expansionary policies to bring the economy to long-run macroeconomic equilibrium in a scenario where there exists a recessionary gap. Among policies that can be implemented include tax cuts. Most notably, tax cuts can enhance the after-tax income available to households, thus increase their consumption level. In turn, increased consumption can trigger a rise in the aggregate demand for employment, which would bring the economy back to equilibrium, as shown in figure 5.
- A discretionary fiscal policy used to close a recessionary gap would involve either a tax cut or increased government spending to boost aggregate demand. Therefore, these policies would cause an increase in price level because the level of disposable income among households increases, causing a significant rise in the level of inflation in the economy. Also, fiscal policy would cause a surge in real GDP as it shifts close to the potential GDP. Furthermore, the level of unemployment in a country would decline after implementing fiscal policies in closing a recessionary gap as firms would demand more labor to fulfill the increased consumption among households. Additionally, the government’s budget balance would increase because more government purchases would be made to close the recessionary gap.
The nominal interest rate is a sum of real interest rates and the expected level of inflation. Therefore, when inflation falls below what is expected, the nominal rate also declines significantly. The change in inflation may have a significant impact on the loanable funds market model. Most notably, when inflation falls below what is expected, the real interest rates rise significantly, which in turn discourages borrowing in the market, as shown in figure 6.
Figure 6: Loanable Funds Market Model
As seen in figure 6, when the inflation rate falls below the expected level, the real interest rate rises significantly from R0 to R1, which, in turn, lowers the demand for loanable funds from Q0 to Q1.