Public Affairs Economics
Fall 2005
Answers to Homework 3
9/30/05
[7 points]
Campbell

Question 1:
p. 191, Q 15: “Explain what is meant by ‘deficient aggregate demand’ and ‘weak aggregate supply’ and relate them to unemployment.”

Answer Q1:

This material directly relates to the Issues book, particularly pages 310-313. It also relates to the business cycle graph from Ch. 13 and that appears in Bucking. If Aggregate Demand (total demand in the economy) is below the potential Aggregate Supply of the economy, then unemployment will result. Aggregate S is determined by a variety of things, but one of them is the amount that can be produced at full employment. If less than that is demanded, then not all workers are needed. In this sense, Ag D is deficient—insufficient for maintaining full employment.

However, unemployment can also result from weak Ag S (as shown on Fig. 11.6, Issues). Suppose that Ag S weakened. For example, suppose there is an oil price shock, leading to an increase in the cost of almost all production processes throughout the economy. This will cause Ag S to shift in (left). This new weakness in Ag S can also cause unemployment as the rise in cost of production leads to a rise in prices that reduces Quantity Demanded and therefore decreases labor demand (remember that the demand for labor is a derived demand).

Question 2:
p. 198, Q6: “Tadissa Adera recently quit his job as a construction foreman and is looking for a better job. What type of unemployment is Mr. Adera experiencing? Is this type of unemployment considered a significant economic problem? Explain.”

Answer Q2:
Frictional unemployment. This type of unemployment occurs when people voluntarily change jobs or are looking for a new job. It exists at all times in the economy. Some job seekers are temporarily left without work since matching jobs with people does not always occur swiftly. However, frictional unemployment is not long lasting and, therefore, not considered a significant economic problem.

Question 3:
p. 198, Q7: “Mitzi Morales does not expect to be called back to work on the auto assembly line after it has been modernized. Ms. Morales' work will be done by robots. What type of unemployment is created by the assembly line modernization? Is it considered a serious economic problem? Explain.”

Answer Q3:
Structural unemployment. This type of unemployment arises when changes occur that "...cause demand for specific kinds of labor to be low relative to the supply in particular markets and regions of the economy" (Issues). The decline in demand may be due to several factors: particularly, a change in technology or change in consumer preferences. In this case, a change in technology replaced the need for Ms. Morales' job skills. Changes like these can affect large numbers of workers in particular industries and regions. Retraining and/or relocation may not be an option for some. Structural unemployment is usually long-run in nature and considered a serious problem even though it is caused by efficiency in the way the economy is operating. This is because, though it is good for the economy overall, it is very hard on the affected individuals.

Question 4:
p. 198, Q8: “Yoon Chung looked for work for eight months but has not attempted to find a job during the last five weeks. Is Yoon unemployed? Is she included in the labor force? How would you classify her? What impact does her labor force status have on the unemployment rate? Explain.”

Answer Q4:
The U.S. Department of Labor defines the labor force as including "...all noninstitutionalized individuals 16 years of age and older who are either employed for pay [at least one hour per week], actively seeking employment, or awaiting recall from a temporary layoff" (Issues). When someone stops actively searching for work, regardless of the reason, he or she no longer fits this definition and is not counted as in the labor force, and therefore not counted as unemployed. In Ms. Chung's case, she is considered a discouraged worker. Since she and others like her are not counted in the unemployment rate, official measures of the unemployment rate may actually "...underestimate the problem during downturns in the business cycle due to the existence of discouraged workers" (Issues).

Additional Questions

5) Briefly explain how unemployment is measured. Briefly explain two problems with this measurement technique

Answer to Q5

In order to measure the unemployment rate, first one must compute the labor force. This is measured as described in the answer to question 4 (above). Next, those who are actively seeking employment and those who are awaiting recall from a temporary layoff are added together and divided by the total labor force. In this way, the fraction of all those in the labor force who are unemployed is computed.

There are two problems with this measurement technique. The first is also described in the answer to question 4—those who have given up (discouraged workers) are not counted as unemployed. The second is that the unemployment rate gives us no information about underemployment. Being employed for pay at least one hour per week is certainly not enough to live on.

6) Define “NAIRU.”

Answer to Q6

“NAIRU” is the Non-Accelerating Inflation Rate of Unemployment. It is also referred to as The Natural Rate of Unemployment, The Full-Employment Unemployment Rate, or “High-Employment Unemployment” (p. 199, The Illustrated Guide). It is the combination of structural and frictional unemployment, with the frictional component generally the most important. Fundamentally, NAIRU is the rate of unemployment that is “consistent with price stability” (Issues). If the unemployment rate dips below NAIRU, then inflationary pressures will build in the economy. This is because wage bidding will occur. That is, because of the shortage of workers, employers will pay workers more than the workers are actually worth [more than the Marginal Revenue Product of Labor, which we’ll discuss soon]. This will exert inflationary pressures [cost-push inflation] on the economy.

NAIRU varies across societies and across time. For one thing, the rate of frictional unemployment depends on demographic factors of the work force (what percentage of the work force is experienced job seekers) and on information flows within a society (how easy is it to for workers and employers to find each other).

7) Define demand-pull and cost-push inflation. Explain possible cures to each. Is cost-push inflation of particular interest in the US today? Why?

Answer to Q7

Demand-pull inflation can most simply be thought of as “too much money chasing too few goods.” If the economy is close to or at an efficient point then, in the short run, (aggregate) quantity supplied cannot be increased much. If (aggregate) demand increases in this situation, then prices will rise because of the increase in demand, pulling the general level of prices higher. Up to the point of full employment, the price rises can increase quantity; but after that very little increase in quantity is possible and almost pure inflation will occur.

Possible cures to demand-pull inflation include both fiscal and monetary policy. In either case, the goal would be to decrease the money supply. With monetary policy, the Fed could do this directly, through open-market operations (e.g., sales of government securities). Appropriate fiscal policies would be increasing taxes and running a Federal budget surplus. In some instances, quashing demand-pull inflation may involve an increase in unemployment.

Cost-push inflation is inflation that is caused by economy-wide rises in the cost of production. This might occur, for example, during an oil crisis (as happened in the US in the ‘70s). Because oil is such an important production input, the significant increase in the price of oil led to increases in cost of almost all production processes. Such a cost increase shifts the (aggregate) supply curve in (to the left), causing both a rise in prices AND a decrease in quantity. This used to be called “stagflation” (stagnation with inflation).

There is little that can be done about cost-push inflation except to prevent it from moving into a cost-push-demand-pull inflationary spiral. The true rise in the costs of production must be absorbed, resulting in decrease in production and, generally, unemployment. It might be possible to do something if one were in a society with large, powerful labor unions and the cost-push was due to negotiated labor costs, but this is not likely in the US at this time.

Cost-push inflation is of particular interest in the US today because of all the disruptions that have occurred in oil supplies. The world price of oil was high, and then Katrina and Rita disrupted oil refining capabilities and some oil wells. Like during the ‘70s, we can expect at least some cost-push inflation, though we can also bet the Fed will try to keep it as low as possible.

Answer to a question you were not asked

Note that between the answer to the NAIRU question and the answer to the cost-push and demand-pull inflation question, you now have a pretty good insight into the relationship between unemployment and inflation. If unemployment is too low, it can cause inflation. Also, a cost-push inflation that is not accommodated through increases in income (etc.) will cause unemployment. Quashing a demand-pull inflation will often involve unemployment.