Section summary
1. Who should be counted as ‘unemployed’ is a matter for some disagreement. The two most common measures of unemployment are claimant unemployment (those claiming unemployment-related benefits) and ILO/OECD standardised unemployment (those available for work and actively seeking work or waiting to take up an appointment).
2. The ‘stock’ of unemployment will grow if the inflow of people into unemployment exceeds the outflow (to jobs or out of the labour market altogether). The more rapid these flows, the shorter the average duration of unemployment.
3. In most countries, unemployment is unevenly distributed across geographical regions, between women and men, between age groups and between different ethnic groups.
4. The costs of unemployment include the financial and other personal costs to the unemployed person, the costs to relatives and friends, and the costs to society at large in terms of lost tax revenues, lost profits and lost wages to other workers, and in terms of social disruption.
5. Unemployment can be divided into disequilibrium and equilibrium unemployment.
6. Disequilibrium unemployment occurs when real wage rates are above the level that will equate the aggregate demand and supply of labour. It can be caused by unions or government pushing up wages (real-wage unemployment), by a fall in aggregate demand but a downward ‘stickiness’ in real wages (demand- deficient unemployment), or by an increase in the supply of labour with again a downward stickiness in wages.
7. In the case of demand-deficient unemployment, the disequilibrium in the labour market may correspond to a low-output equilibrium in the goods market. A fall in real wage rates may be insufficient to remove the deficiency of demand in the labour market.
8. Equilibrium unemployment occurs when there are people unable or unwilling to fill job vacancies. This may be due to poor information in the labour market and hence a time lag before people find suitable jobs (frictional unemployment), to a changing pattern of demand or supply in the economy and hence a mismatching of labour with jobs (structural unemployment – specific types being technological and regional unemployment), or to seasonal fluctuations in the demand for labour.
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higher prices – namely, firms. Thus for consumers there has been an income effectof the higher prices. The rise in prices leads to a cut in real incomes and thus people will spend less. Aggregate demand will fall. The AD curve will be downward sloping, as in Figure 15.8.
To some extent this will be offset by a rise in profits, but it is unlikely that much of the additional profits will be spent by firms on investment, especially if they see con- sumer expenditure falling; and any increase in dividends to shareholders will take a time before it is paid, and then may simply be saved rather than spent. To summarise: if prices rise more than wages, the redistribution from wages to profits is likely to lead to a fall in aggregate demand.
Clearly, this income effect will not operate if wages rise in line with prices. Real incomes of wage earners will be unaffected. In practice, as we shall see at several places in this book, in the short run wages do lag behind prices.
An income effect is also likely to occur as a result of progressive taxes. As prices and incomes rise, so people will find that they are paying a larger proportion of their incomes in taxes. As a result, they cannot afford to buy so much.
Substitution effects
In the microeconomic situation, if the price of one good rises, people will switch to alternative goods. This is the substitution effect of that price rise and helps to explain why the demand curve for a particular good will be down- ward sloping. But how can there be a substitution effect at a macroeconomic level? If prices in general go up, what can people substitute for spending? There are in fact three ways in which people can switch to alternatives.
The first, and most obvious, concerns imports and exports.
Higher prices for our country’s goods will discourage foreign residents from buying our exports (which are part of aggregate demand) and encourage domestic residents
to buy imports (which are notpart of aggregate demand).
Thus higher domestic prices will lead to a fall in aggregate demand (i.e. cause the ADcurve to be downward sloping).
The second is known as the real balance effect. If prices rise, the value (i.e. the purchasing power) of people’s balances in their bank and building society accounts will fall. But many people will be reluctant to reduce the real value of their balances (i.e. their savings) too much, and will thus probably cut back on their spending also. This desire by people to protect the real value of their savings will thus also cause aggregate demand to fall.
The third reason why people may switch away from spending concerns changes in interest rates. With higher prices to pay by consumers, and higher wages to pay by firms, there will tend to be a greater demand for money.
With a given supply of money in the economy, there will now be a shortage of money. As a result, banks will tend to raise interest rates (we examine this process in Chapter 20).
These higher rates of interest will have a dampening effect on spending: after all, the higher the interest rates people have to pay, the more expensive it is to buy things on credit. Again, aggregate demand is likely to fall.
The shape of the aggregate demand curve
We have seen that both the income and substitution effects of a rise in the general price level will cause the aggregate demand for goods and services to fall. Thus the ADcurve is downward sloping. The bigger the income and substitution effects, the more elastic will the curve be.
Shifts in the aggregate demand curve
The aggregate demand curve can shift inwards (to the right) or outwards (to the left), in exactly the same way as the demand curve for an individual good. A rightward shift represents an increase in aggregate demand, whatever the price level; a leftward shift represents a decrease in aggre- gate demand, whatever the price level.
A shift in the aggregate demand curve will occur if, for any given price level, there is a change in any of its com- ponents – consumption, investment, government expendi- ture or exports minus imports. Thus if the government decides to spend more, or if consumers spend more as a result of lower taxes, or if business confidence increases so that firms decide to invest more, the ADcurve will shift to the right.
Figure 15.8 Aggregate demand and aggregate supply
Real balance effect As the price level rises, so the value of people’s money balances will fall. They will therefore spend less in order to increase their money balances and go some way to protecting their real value.
Definition
The aggregate supply curve
The aggregate supply (AS) curve shows the amount of goods and services that firms are willing to supply at each level of prices. To keep things simple, let us focus on the short-run AS curve. When constructing this curve, we assume that various other things remain constant. These include wage rates and other input prices, technology and the total supply of factors of production (labour, land and capital).1
Why do we assume that wage rates and other input prices are constant? Wage rates are frequently determined by a process of collective bargaining and, once agreed, will typically be set for a whole year, if not two. Even if they are not determined by collective bargaining, wage rates often change relatively infrequently. So too with the price of other inputs: except in perfect, or near perfect markets (such as the market for various raw materials), firms supply- ing capital equipment and other inputs tend to change their prices relatively infrequently. They do not immedi- ately raise them when there is an increase in demand or lower them when demand falls. Thus there is a ‘stickiness’
in both wage rates and the price of many inputs.
The short-run aggregate supply curve slopes upwards, as shown in Figure 15.8. In other words, the higher the level of prices, the more will be produced. The reason is simple.
Because we are holding wages and other input prices constant, then as the prices of their products rise, firms’
profitability at each level of output will be higher than before. This will encourage them to produce more.
But what limits the increase in aggregate supply in response to an increase in prices? In other words, why is the aggregate supply curve not horizontal? There are two main reasons:
• Diminishing returns. With some factors of production fixed in supply, notably capital equipment, firms experi- ence a diminishing marginal physical product from their other factors, and hence have an upward-sloping marginal cost curve. In microeconomic analysis the upward-sloping cost curves of firms explain why the supply curves of individual goods and services slope upwards. Here in macroeconomics we are adding the supply curves of all goods and services and thus the aggregate supply curve also slopes upwards.
• Growing shortages of certain variable factors. As firms collectively produce more, even inputs that can be varied may increasingly become in short supply. Skilled labour may be harder to find, and certain raw materials may be harder to obtain.
Thus rising costs explain the upward-sloping aggregate supply curve. The more steeply costs rise as production increases, the less elastic will the aggregate supply curve be.
It is likely that, as the level of national output increases and firms reach full-capacity working, so marginal costs will rise faster. The aggregate supply curve will thus tend to get steeper (as shown in Figure 15.8).
Shifts in the aggregate supply curve
The aggregate supply curve will shift if there is a change in any of the variables that are held constant when we plot the curve. Several of these variables, notably technology, the labour force and the stock of capital, change only slowly – normally shifting the curve gradually to the right.
This represents an increase in potential output.
By contrast, wage rates and other input prices can change significantly in the short run, and are thus the major causes of shifts in the short-run supply curve. For example, a general rise in wage rates throughout the eco- nomy reduces the amount that firms wish to produce at any level of prices. The aggregate supply curve shifts to the left. A similar effect will occur if other costs, such as oil prices or indirect taxes, increase.
Equilibrium
Equilibrium in the macroeconomy occurs when aggregate demand and aggregate supply are equal. In Figure 15.8, this is at the price level Peand national output (GDP) of Qe. To demonstrate this, consider what would happen if aggregate demand exceeded aggregate supply: for example, at P2in Figure 15.8. The resulting shortages throughout the eco- nomy would drive up prices. This would encourage firms to produce more: there would be a movement up alongthe AS curve. At the same time, the increase in prices would reduce the level of aggregate demand: that is, there would also be a movement back up alongthe ADcurve. The shortage would be eliminated when price had risen to Pe.
Shifts in the AD or AS curves
If the ADor AScurve shifts, there will be a movement along the other curve to the new point of equilibrium. For ex- ample, if there is a cut in income taxes and a corresponding increase in consumer demand, the AD curve will shift to the right. This will result in a movement up along the AScurve to the new equilibrium point: in other words, to a new higher level of national output and a higher price level. The more elastic the AScurve, the more will output rise relative to prices. We will consider the shape of the AScurve in more detail in later chapters, and especially Chapter 21.
1Long-run AScurves assume that these things willchange: that they will be affected by changes in aggregate demand and the price level. We will look at long-run aggregate supply curves in later chapters.
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The rate of inflation measures the annual percentage increase in prices. The most usual measure is that of con- sumer prices. The UK government publishes a consumer prices index (CPI) each month, and the rate of inflation is the percentage increase in that index over the previous 12 months. This index is used throughout the EU, where it generally goes under its full title of the harmonised index of consumer prices (HICP). The HICP covers virtually 100 per cent of consumer spending (including cross-border spending) and uses sophisticated weights for each item (see Appendix A, page A:6–7 for an analysis of weighting in indices).
Figure 15.9 shows the rates of inflation for the USA, Japan, the UK and the 12 original members of the
eurozone. As you can see, inflation was particularly severe between 1973 and 1983, and relatively low in the mid 1980s and since the mid 1990s, but edging up in the late 2000s. Although most countries have followed a similar pattern over time, the average rates of inflation have dif- fered substantially from one country to another. These differences, however, have tended to narrow in recent years as barriers to international trade and capital move- ments have been reduced and as increasing numbers of countries have directed their macroeconomic policy towards achieving target rates of inflation of around 2 per cent (see Table 15.5).