Principles of Macroeconomics and Unemployment - Essay Example

? Principles of Macroeconomics Principles of Macroeconomics Unemployment is considered to be one of the biggest macro economical problems. Unemployment can be expressed either as a number or as a percentage of labor force. The most common definition that economists use for the number of unemployed are those between the ages of 18 and 60 who are without work but who are available for work at current wage rate. If the figure is to be expressed as a percentage, then it is a percentage of the total labor force, labor force is defined as those between the working age who are willing and able to work. Unemployment can be measured by the claimant count or the standardized ILO unemployment measure. (Abel, 2010) Unemployment can be classified into two broad categories: Equilibrium unemployment and Disequilibrium unemployment. When Aggregate Demand for Labor (ADL) equals Aggregate Supply of Labor (ASL) at market wage rate, the labor market is said to be in equilibrium. The difference between the ASL and the labor force is known as equilibrium unemployment or the natural rate of unemployment. This represents the excess of people looking for work over those actually willing to accept jobs. This can be seen in the graph shown below. (Dornbusch, 2006) As shown in the diagram above, distance AB is the equilibrium unemployment. This type of unemployment may occur due to frictional (irreducible minimum level of unemployment in a dynamic and growing economy), structural (resulting from the mismatch of skills and job opportunities), regional (associated with specific regions often due to the concentration of industries in a region) or seasonal (associated with industries or regions where demand for labor is lower at certain times) causes. (Dornbusch, 2006) Disequilibrium unemployment occurs when real wages in the economy are above equilibrium level. This means either the ASL exceeds the ADL or that stickiness in wages prevents wages falling to equilibrium level. The labor market is in a state of disequilibrium, it may be due to real wage (unemployment created when labor wages are deliberately maintained above market clearing level) or demand deficient unemployment (associated with cyclical downturn or recession). (Dornbusch, 2006) Now let us take the consider interest rate. Interest is a rate at which the interest has to be paid by the borrower to the lender apart from the principle amount. Interest rate is a tool of the monetary policy which the government uses in order affect the money supply of the economy in order to achieve macroeconomic objectives. Interest rates are of two types: real and nominal. Real interest rates are interest rates that are formed in accordance with the rate of inflation. On the other hand nominal interest rate refers to the amount, in money term of interest payable. (Dornbusch, 2006) There are many reasons that may lead to a change in the interest rates. Firstly, it may lead to short-term political gains. Politicians do this in order attain public support; however, it may later lead to problems later on. Deferred consumption may also lead to changes in interest rates. Speculation may lead to changes in the interest rates as well, for instance if consumers think that interest rates are going to rise, the consumers would demand more bonds and thus increase demand for bonds, this would lead to an even higher increase in interest rates. (McEachern, 2008) High levels of unemployment means that the economy is not functioning at its production possibility function, that is, it is underachieving and that it can produce more goods but that would require the economy to function more efficiently than it is doing right now. Unemployment imposes private, economic as well as social costs. In that not only does it represent a was of valuable resources but also causes suffering in terms of increased poverty, falling living standards and psychological disorders. Naturally, the costs of unemployment depend on its severity and duration. The costs of unemployment include: Private costs- when people are involuntarily unemployed, the private costs of unemployment are high. There are the direct financial costs in terms of lost earnings measured as the difference between the previous wage earned and any unemployment benefits received. They also suffer from a process of deskilling making it more difficult to reenter the work force. Additionally, there exists the loss of self esteem, depression and other psychological disorders. (McEachern, 2008) Economic costs- economic costs or the broader costs to the society including the lost output that could have been produced had full employment had existed. When unemployment goes up the economy is effectively throwing away the goods and services that the unemployed could have produced. Such economic losses are the greatest documented economical loses to a modern economy. They are many times larger than the estimated inefficiencies from microeconomic waste due to monopolies, tariffs and quotas. Economic costs also include reduced tax revenue (both direct and indirect) and increased public expenditure in terms of transfer payments. This can have a significant impact on the government’s budget as resources are allocated towards the problem. Social Costs- the total costs to society are greater than the pricate costs because of the spillover because of crime, vandalism and increased demand not only dor transfer payments but also increased healthcare. (Dornbusch, 2006) Keynes explained the concept of hysteresis in terms of unemployment. Hysteresis is essentially any phenomenon whereby the effect persists even when the original cause has been removed. This process of hysteresis in terms of unemployment means lingering unemployment even when demand deficiency has been removed. The can be explained by firm’s caution about future developments, deskilling of labor and greater emphasis by firms on rebuilding neglected capital rather than hiring labor. Policies that the government should take to correct high levels of unemployment will depend on whether the economy is attempting to reduce disequilibrium (involuntarily) or equilibrium (voluntary) unemployment. Disequilibrium unemployment basically requires AD to increase. This type of unemployment links AD in the product market with demand for labor in the labor market. Expansionary, monetary and fiscal policies that impact output and employment are recommended. Equilibrium unemployment (natural rate of unemployment) requires supply side policies which are essentially microeconomic incentives that alter the level of full employment, potential output and the natural rate of unemployment. Supply side policies that aim to reduce the natural rate of unemployment include: a) Policies directed towards improving the mobility of labor such as reduced trade union power, training and retraining and better information. b) A cut in marginal income tax rates that reduces voluntary unemployment by increasing the opportunity cost of not working in the first place. c) Policies aimed at increasing the demand for labor such as higher productivity through improved capital to labor ratio, higher investment, research and development. Since the economy is not operating at Production Possibility Frontier, that means that there is a gap between the potential GDP of and economy and is actual GDP, with Actual being lower than potential. This can be explained from the equation: AD= C+I+G+(X-M) Where C is consumption, I is investment, g is government spending and (X-M) is net exports. Consumption is the most major part of the economy, and disposable income plays a major part in this as well. People’s Marginal propensity to consume has increased; however, as people are unemployed, then over all consumption is lower. Thus AD is low causing lower standard of living. The government should decrease real interest rate so that consume more and at the same time can borrow money at lower cost (interest rates) this would then cause investment to increase and injections into the economy would be higher than leakages thus increasing AD. Government should also try to avoid speculations to affect the interest rates because that would then cause irregularities in the economy. The government has a very significant effect upon investment, both directly as the largest investor in the economy in the form of government spending and indirectly through its policies. Investment decisions ae influenced by government taxation policies and by monetary policy which influences the availability and price of borrowing finance. (Dornbusch, 2006) One thing that must be taking into account when considering investment is the net effect an investment causes on the economy. Every investment (even if it is government spending) has a multiplied effect which can be explained through the multiplier. Thus each investment has a multiplied effect with the multiplier to show net change. Government spending thus plays a vital part of the economy. For example, US president Roosevelt invested ample amounts of government spending into the economy and that actually paid off as USA was able to recover from the depression due to the injections from the government and then its net increased effect on the economy. (Mankiw, Macroeconomics, 2010) Now we can see that a government’s fiscal policy can cause an effect on the state of the economy. Whether that being through the course of government spending or in the form of taxation. I believe that progressive taxation should be implemented in accordance to respective income brackets that would charge rich with higher tax and poor people with lower rates of tax. It can cause a trickledown effect as it would cause more even distribution of income. Also, if government taxes consumers then the government would poses larger reserves which can enable them to make greater government spending (investment) mainly on merit goods that provide utility to the whole economy, again this would also cause a magnified effect due to the multipliers effect. (Farmer, 2011) Interest rates again cause an effect on to the economy. If interest rates rise, then people of the economy would be willing to save more that consume since they are able to make more money out of saving; therefore, MPS would rise and MPC to fall causing the AD to fall and this would further worsen the situation of the unemployment issue. There will be an added damage since the multiplier will cause the negative consumption effect to be magnified as well. On the other hand, if the interest rates fall, then there would be less incentive to save and more incentive to invest and consume causing the aggregate demand of the economy to rise. (Hall, 2010) In the conclusion I would like to say that everything has a domino effect. The government should insure that consumptions levels are kept high so that the aggregate demand of the economy remains high, because after all, is I the biggest chunk of aggregate demand. Consumption can be kept at high levels through innovation and invention as more people are intrigued to consume the product. Government should insure that interest levels are low so that saving are not given preference and that people invest more because that would come back into the economy through investment which would then have a magnified effect because of the multiplier. This thus acts like an injection into the economy. However, the government should also take care of the fact that high inflation again is not good for the economy because might burst the bubble as it is. Government should also consider the net exports. A positive net export balance is always good signs for the economy because more goods can be sold to other countries and fewer goods are being imported meaning net flow of capital into the economy. And a negative balance of trade would act like a leakage which would eat into the aggregate demand causing a fall in the net consumption in the economy. Everything needs to be checked when making decisions, and most of all it is very important to take into consideration the fact that it is not necessary that nominal and real interest rates are always the same. There might be variance and decisions must be taken be keeping in mid which tool is actually being used. (Mankiw, Macroeconomics, 2010) Bibliography: Abel, A. (2008). Macroeconomics. Prentice Hall. Abel, B. (2010). Macroeconomics. Boston: Cengage Learning. Arnold, R. A. (2010). Macroeconomics. McGraw-Hill Companies. Basu, C. (2011, January 12). The Link Between Interest Rates & Unemployment Rates. Retrieved November 16, 2011, from eHow: http://www.ehow.com/info_7766050_between-interest-rates-unemployment-rates.html Baumol, W. J. (2005). Macroeconomics: Principles and Policies. Cengage Learning. Blanchard, O. (2003, March). Monetary Policy and Unemployment. Retrieved November 16, 2011, from MIT: http://econ-www.mit.edu/files/731 Dornbusch, R. (2006). Macroeconomics. McGraw-Hill Companies. Farmer, R. E. (2011, April 10). How to Raise Interest Rates ant lower unemployment at the same time. Retrieved November 16, 2011, from Economists Forum: http://blogs.ft.com/economistsforum/2011/04/how-to-raise-interest-rates-and-lower-unemployment-at-the-same-time/#axzz1dt3P1AfW Hall, R. E. (2010). Macroeconomics: Principles and Applications. Cengage Learning. Jones, C. I. (2009). Macroeconomics. Norton, W.W. & Company, Inc. Mankiw, N. G. (2010). Macroeconomics. Chicago: Cengage Learning. McConnell, C. (2009). Macroeconomics. McGraw-Hill Companies. McEachern, W. A. (2008). Macroeconomics. 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