Aggregate Supply and Unemployment - Case Study Example

?Q.a) Each point on the Aggregate Demand curve represents short run equilibrium in the economy. During recession, the output declines. This is eitherbecause any one of the components of aggregate demand (AD) including consumption (C), investment (I), government spending (G) and net exports (NX) decreases or the price level increases. Since the UK economy was severely hit by the Global Financial Crisis, it faced rising unemployment because of recession and low aggregate demand. The spending power of the people was low and a lot of people were laid off due to which AD further dropped. Also there was a bank crisis due to which consumption fell and so did the investments. This results in the shift of the AD curve to the left. Aggregate supply (AS) is the total desired output of all the nations’ producer (Chrystal, p. 666). Since there is imported inflation in UK because of the rising oil prices, the AS is shifted leftwards as shown in the diagram below. Keynesians argue that demand (AD) finds its own supply. They stress about increasing AD or implementing policies that will stimulate aggregate demand. Monetary and Fiscal policies are demand-side policies; they serve to boost Aggregate demand. Aggregate demand can be increased by implementing expansionary fiscal policy like more government spending and lower tax rates and expansionary monetary policy which is reducing interest rates and increasing money supply. Classical economists are proponents of supply-side policies. They argue that supply finds its own demand. They are in favor of boosting aggregate supply through supply side policies like training and educating workers. Classical economists argue that if AS increases due to supply-side policies, there will be less inflation. Inflation associated with production costs will be lowered. There is also lower structural and frictional unemployment as a result of increased AS. It works this way: increasing AS will require more workers so employers will start hiring. Since productivity increases as a result of increasing AS supply, a country like UK will be able to export more as a result of this. Q.b) This economic shock where the whole economy has slowed will result in workers being laid off and people who are already unemployed will find it very difficult to find a job. Cyclical unemployment or demand-deficient unemployment occurs whenever total demand is insufficient to purchase all of the economy’s potential output, causing a recessionary gap in which actual output is less than potential output (Chrystal, 2004, p. 595). It can be measured as the number of people who would be employed if the economy were at potential GDP minus the number of persons currently employed (Chrystal, 2004). Frictional unemployment results from the normal turnover of labor. Young people who enter the labor force and searching for jobs are an important source of frictional unemployment (Chrystal, 2004, p. 600). Also people who are planning to switch their present job are a source of frictional unemployment. Some people leave a job because of job-dissatisfaction and others are terminated. Structural unemployment occurs because structural adjustments can cause unemployment (Chrystal, 2004). Since the demand for labor is a derived demand, when the demand for product changes, the demand for labor also changes. If labor does not adjust as per the changing product demand, there is structural unemployment. Cyclical unemployment best describes the rising unemployment in the UK. Since UK is in the recessionary period of the business cycle, it means there is low economic activity and also there is less demand for the country’s output. Hysteresis is a Greek word which means ‘coming late’ and in economics, it means that the current equilibrium is not independent of what has gone before- it is path dependent (Chrystal, 2004, p. 601). The impact of hysteresis on NAIRU (natural rate of unemployment) is that the NAIRU will be higher after periods of high unemployment than after periods of low unemployment. Through hysteresis, the shock to aggregate unemployment as a result of economic crisis will be transferred to structural unemployment which is influenced by the path of actual unemployment (Stephanie Guichard, 2010). Workers who are consistently unemployed become unattractive (because they are out of touch from the market and their skills are not updated) to employers and they do not get jobs readily. This gives rise to further structural unemployment as predicted by hysteresis. Q.c) Monetary Policy is the policy of trying to control aggregate demand (AD) and ultimately inflation via the setting of short-term interest rates (Chrystal, 2004, p. 676). The Bank of England (BoE) is a central bank. As an initial response to the financial crisis of 2008, BoE loosened its monetary policy by making use of both conventional and non-conventional policy measures (Michael Joyce, 2011, p. 200). The BoE’s Monetary Policy Committee (MPC) decreased interest rates sharply, with cuts of 3 percentage points in Bank Rate during 2008 and a further 1? percentage points in early 2009 (Michael Joyce, 2011). However it was realized that the additional measures were necessary with reduced interest rates otherwise spending will not be able to cope up with the CPI .Quantitative Easing (QE) formed part of the non-conventional measures and consisted of asset purchases by BoE in order to inject money into the economy. This QE spanned from March 2009 till January 2010, whereby ?200 billion worth of assets such as government securities were purchased (Michael Joyce, 2011). The QE’s effect/consequence has two stages that are the impact phase and the adjustment phase. In the impact phase, the asset portfolios of the private sector change as they have more broad money after selling government securities and less government securities (or gilts). There was an imbalance in the portfolio of the private sector. To restore equilibrium there was a rise in the demand for gilts. There was more liquidity and borrowing was easy (due to decreased interest) and hence the demand for assets rose which pulled up the consumer price level (Michael Joyce, 2011, p. 202). In the adjustment phase, the aftermath of rising asset prices and consumer price level increased the demand for money balances and the supply of long term assets. This reduces the price of the assets. The main advantage of QE is that it was able to match the ideal inflation rate as a result of injecting money in to the economy and secondly the confidence of people in the economy was also restored. But a looming danger of the expansionary monetary policy is the liquidity trap. As the economy goes into deeper stagnation, BoE tries to cut interest rates further. This remedy has lowered inflation but it is feared that it will lead to negative inflation and people might be intent on holding their money and will not spend or invest it. There will be no stimulation in the economy to increase the output. Q.d) During the financial crisis, the UK government spent heavily and it faced a budget deficit (whereby government spending exceeded tax revenue). Structural deficit is when a budget deficit persists for some time and is not associated with inflation (www.lexicon.ft.com). The remaining part of the budget deficit (other than structural deficit) is cyclical. This is associated with recession phase of the business cycle when government receives less tax receipts and spends more to stimulate AD. But if the cyclical deficit does not improve with improving economic environment, then that means the budget deficit has turned into a structural one (Irvin, 2011). Much of Britain’s budget deficit is associated with structural deficit majorly as opposed to cyclical deficit. As a result of the economic crisis some portion of UK’s productive capacity is lost forever and thus tax revenue cannot be expected from that portion of the economy. Also UK’s potential output and employment are also decreased. Economists find it difficult to exactly determine how long the time lag will be to return to full employment level. There is an output gap between potential and actual output. Keynesian view of stimulating AD in the economy is to increase government spending. They favor a budget deficit in recessionary times. The logic is to put money in the hands of consumers so that they have purchasing power. When this is so demand for products would increase. Businesses would order more inventories and rehire the workers previously laid off in order to meet demand (www.chuck.hubpages.com). The workers rehired would have money spend which would in turn stimulate more activity. This cycle would continue according to Keynesians until the economy is operating at full employment and full production. Classical economists’ logical is that higher marginal tax rates discourage workers from doing work and investment is also discouraged. If tax rates are reduced during recession, people will be encouraged to seek jobs. Also people will also be encouraged to invest. Since more people work as a result of lower tax rates, the overall tax revenue will be greater than when tax rates are high. This has two advantages, firstly AD will increase as people will have more disposable income and will invest more and secondly tax revenue will increase which will in turn reduce the budget deficit. . Bibliography Chrystal, L. a. (2004). Economics 10th Edition. Ram Chand. http://www.investopedia.com. (n.d.). Retrieved from http://www.investopedia.com/terms/m/monetarypolicy.asp#axzz1aGI0FuFi Michael Joyce, R. W. (2011). The UK's quantitative easing policy: design, operation and impact. Bank of England, Macro Finance Analysis Division. London: Quarterly Bulletin (QB). Stephanie Guichard, E. R. (2010). assessing the impact of the Financial Crisis on Structural Unemployment in OECD countries. OECD Economics Department Working Papers, 6. www.chuck.hubpages.com. (n.d.). Retrieved from http://chuck.hubpages.com/hub/Democrat_vs_Republican_Tax_Cuts_ www.lexicon.ft.com. (n.d.). Retrieved from http://lexicon.ft.com/Term?term=structural-deficit Read More