- Study Guide (Course-wide Content)
A. The Foundations of Aggregate Supply
- Aggregate supply describes the relationship between the output that businesses willingly produce and the overall price level, other things being constant. The factors underlying aggregate supply are (a) potential output, determined by the inputs of labor, capital, and natural resources available to an economy, along with the technology or efficiency with which these inputs are used, and (b) input costs, such as wages and oil prices. Changes in these underlying factors will shift the AS curve.
- A central distinction in AS analysis is between the long run and the short run. The short run, corresponding to the behavior in business cycles of a few months to a few years, involves the short-run aggregate supply schedule. In the short run, prices and wages have elements of inflexibility. As a result, higher prices are associated with increases in the production of goods and services. This is shown as an upward-sloping AS curve. The short-run AS and AD analyses are used in Keynesian analysis of the business cycle.
- The long run refers to periods associated with economic growth, after most of the elements of business cycles have damped out. In the long run, prices and wages are perfectly flexible; output is determined by potential output and is independent of the price level. The long-run aggregate supply schedule is vertical. The long-run AS and AD analyses are used in the classical analysis of economic growth.
- The government gathers monthly statistics on unemployment, employment, and the labor force in a sample survey of the population. People with jobs are categorized as employed; people without jobs who are looking for work are said to be unemployed; people without jobs who are not looking for work are considered outside the labor force.
- There is a clear connection between movements in output and the unemployment rate over the business cycle. According to Okun's Law, for every 2 percent that actual GDP declines relative to potential GDP, the unemployment rate rises 1 percentage point. This rule is useful in translating cyclical movements of GDP into their effects on unemployment.
- Economists distinguish between equilibrium and disequilibrium unemployment. Equilibrium unemployment arises when people become unemployed voluntarily as they move from job to job or into and out of the labor force. This is also called frictional unemployment.
- Disequilibrium unemployment occurs when the labor market or the macroeconomy is not functioning properly and some qualified people who are willing to work at the going wage cannot find jobs. Two examples of disequilibrium are structural and cyclical unemployment. Structural unemployment arises for workers who are in regions or industries that are in a persistent slump because of labor market imbalances or high real wages. Cyclical unemployment is a situation where workers are laid off when the overall economy suffers a downturn.
- Understanding the causes of unemployment has proved to be one of the major challenges of modern macroeconomics. The discussion here emphasizes that involuntary unemployment arises because the slow adjustment of wages produces surpluses (unemployment) and shortages (vacancies) in individual labor markets. If inflexible wages are above market-clearing levels, some workers are employed but other equally qualified workers cannot find jobs.
- Wages are inflexible because of the costs involved in administering the compensation system. Frequent changes of compensation for market conditions would command too large a share of management time, would upset workers' perceptions of fairness, and would undermine worker morale and productivity.
- A careful look at the unemployment statistics reveals several regularities:
- Recessions hit all segments of the labor force, from the unskilled to the most skilled and educated.
- A very substantial part of U.S. unemployment is short-term. The average duration of unemployment rises sharply in deep and prolonged recessions.
- In most years, a substantial amount of unemployment is due to simple turnover, or frictional causes, as people enter the labor force for the first time or reenter it. Only during recessions is the pool of unemployed composed primarily of job losers.
- The difference in unemployment rates in Europe and the United States reflects both structural policies and the effectiveness of monetary management.