Unit 4 Inflation and unemployment

4.7 The business cycle model: Aggregate demand, the supply side, and inflation

WS–PS model: Model of the aggregate economy that combines wage-setting (WS) and price-setting (PS) decisions. Where the WS and PS curves intersect is the Nash equilibrium and determines structural unemployment and the real wage. See also: wage-setting curve, price-setting curve, structural unemployment.
multiplier model: A model of aggregate demand that includes the multiplier process. See also: fiscal multiplier, multiplier process.

When we put our supply-side WS–PS model and demand-side multiplier model together, we are able to explain how the economy fluctuates around the supply-side equilibrium over the business cycle.

Figure 4.17 places the multiplier diagram beneath the WS–PS diagram. Note that in the WS–PS diagram, the horizontal axis measures the number of workers, so we can measure employment and unemployment along it. In the multiplier diagram, output is on the horizontal axis. Remember from Section 4.5 that employment and output are connected by the production function $Y=\lambda N$. To allow us to draw the demand-side model underneath the supply-side model, we simplify further, assuming $\lambda = 1$, and so $Y = N$.

This is another example of a simplifying technique in economics called a normalization. Provided that we don’t want to examine the effects of changing labour productivity, we can set the constant $\lambda = 1$. This doesn’t change the economics, because it is just a choice of units: a unit of output is the constant amount produced by one employee.

Figure 4.17 shows the economy in a situation of equilibrium at A on the supply side in the upper panel and on the demand side in the lower one. With the AD curve labelled ‘medium’, the level of aggregate demand is equal to the level of output at equilibrium employment. Unemployment is at the structural rate.

cyclical unemployment: The additional unemployment above the equilbrium level that is caused by a fall in aggregate demand associated with the business cycle. Also known as: demand-deficient unemployment. See also: equilibrium unemployment.

Changes in aggregate demand (shown by shifts in the AD curve in the multiplier panel) lead to short-term fluctuations in employment away from equilibrium. If there is a boom, the AD curve shifts up. Higher output at B in the lower panel entails higher employment at B in the upper panel, with the result that unemployment is below its equilibrium level. When there is a recession, the AD curve shifts down. Since output is at C, employment is below and unemployment is above the labour market equilibrium. The additional unemployment arising from low aggregate demand is called cyclical unemployment.

Work through Figure 4.17 to understand how the economy experiences a business cycle from equilibrium to boom and recession as a result of fluctuations in aggregate demand.

$: There are 2 diagrams. In diagram 1, the horizontal diagram shows employment and the vertical axis shows real wage. Coordinates are (employment, real wage). The vertical line at the end of the horizontal axis is labeled labour force. The horizontal lines labeled PS curve intersects with the upward-sloping, convex curve labeled WS curve. This intersection is marked by point A, representing the supply-side equilibrium. The horizontal coordinate of point A represents employment at supply-side equilibrium, where there’s no bargaining gap. The horizontal distance from Point A to the vertical labour force line captures the corresponding unemployment level of 7%, labelled as structual unemployment. In diagram 2, the horizontal axis displays Output (income) Y in billions of € ranging from 0 to 100, and the vertical axis displays Aggregate Demand AD in billions of € ranging from 0 to 100. The coordinates are (Output, Aggregate Demand). There is a 45-degree upward-sloping straight line from the origin , labelled “Y = AD”. Starting at a point above 0 on the vertical axis, there is an upward-sloping straight line with a flatter slope than the 45-degree line denoting the initial aggregate demand function labelled AD(medium). Point A replicates its position from diagram 1, denoting the intersection of the 45-degree line and the AD line. Its horizontal coordinate is marked as Y_{SEE}, representing the output level at supply-side equilibrium. In diagram 2, two additional lines labelled AD(high) and AD(low) respectively are illustrated. These lines share the same shape as AD(medium) but are positioned above to represent boom and below to represent recession. AD(high) and AD(low) intersect the 45-degree line at point B (situated above point A) and C (situated below point A) repectively. B’s vertical coordinate denotes a higher aggregate demand value while C denotes a lower level. B’s horizontal coordinate is labelled as Y_{high}, indicating an output level exceeding the supply-side equilibrium. By contrast, C’s horizontal coordinate is labelled as Y_{low}, indicating an output level lower than the supply-side equilibrium. Both points are mirrored in diagram 1, with point B placed to the right of point A and point C to the left along the PS curve. Point B is below the WS curve while point C is above. At B’s employment level, the real wage captured by WS curve is 102, exceeding the real wage of 100 captured by the PS curve, and the 2% disparity signifies the positive bargaining gap. By contrast, at C’s employment level, the real wage captured by WS curve is 99, lower than the real wage of 100 captured by the PS curve, and the −1% disparity signifies a negative bargaining gap.$

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https://www.core-econ.org/macroeconomics/04-inflation-and-employment-07-business-cycle-model-supply-side.html#figure-4-17

Figure 4.17 The supply side and the demand side of the aggregate economy.

$Supply-side and demand-side equilibrium: There are 2 diagrams. In diagram 1, the horizontal diagram shows employment and the vertical axis shows real wage. Coordinates are (employment, real wage). The vertical line at the end of the horizontal axis is labeled labour force. The horizontal lines labeled PS curve intersects with the upward-sloping, convex curve labeled WS curve. This intersection is marked by point A, representing the supply-side equilibrium. The horizontal coordinate of point A represents employment at supply-side equilibrium, where there’s no bargaining gap. The horizontal distance from Point A to the vertical labour force line captures the corresponding unemployment level of 7%, labelled as structual unemployment. In diagram 2, the horizontal axis displays Output (income) Y in billions of € ranging from 0 to 100, and the vertical axis displays Aggregate Demand AD in billions of € ranging from 0 to 100. The coordinates are (Output, Aggregate Demand). There is a 45-degree upward-sloping straight line from the origin , labelled “Y = AD”. Starting at a point above 0 on the vertical axis, there is an upward-sloping straight line with a flatter slope than the 45-degree line denoting the initial aggregate demand function labelled AD(medium). Point A replicates its position from diagram 1, denoting the intersection of the 45-degree line and the AD line. Its horizontal coordinate is marked as Y_{SEE}, representing the output level at supply-side equilibrium.$

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https://www.core-econ.org/macroeconomics/04-inflation-and-employment-07-business-cycle-model-supply-side.html#figure-4-17a

Supply-side and demand-side equilibrium

On the supply side of the economy, the labour market is in equilibrium at point A in the top panel. There is structural unemployment. With ‘medium’ aggregate demand the demand side of the economy is also in equilibrium: $Y = \text{AD}$ at point A in the bottom panel.

$A boom at B: There are 2 diagrams. In diagram 1, the horizontal diagram shows employment and the vertical axis shows real wage. Coordinates are (employment, real wage). The vertical line at the end of the horizontal axis is labeled labour force. The horizontal lines labeled PS curve intersects with the upward-sloping, convex curve labeled WS curve. This intersection is marked by point A, representing the supply-side equilibrium. The horizontal coordinate of point A represents employment at supply-side equilibrium, where there’s no bargaining gap. The horizontal distance from Point A to the vertical labour force line captures the corresponding unemployment level of 7%, labelled as structual unemployment. In diagram 2, the horizontal axis displays Output (income) Y in billions of € ranging from 0 to 100, and the vertical axis displays Aggregate Demand AD in billions of € ranging from 0 to 100. The coordinates are (Output, Aggregate Demand). There is a 45-degree upward-sloping straight line from the origin , labelled “Y = AD”. Starting at a point above 0 on the vertical axis, there is an upward-sloping straight line with a flatter slope than the 45-degree line denoting the initial aggregate demand function labelled AD(medium). Point A replicates its position from diagram 1, denoting the intersection of the 45-degree line and the AD line. Its horizontal coordinate is marked as Y_{SEE}, representing the output level at supply-side equilibrium. In diagram 2, an additional line labelled AD(high) is illustrated. This line shares the same shape as AD(medium) but is positioned above it to represent a boom. AD(high) intersects the 45-degree line at point B, situated above point A. Here, the vertical coordinate denotes a higher aggregate demand value and the horizontal coordinate is labelled as Y_{high}, indicating an output level surpassing the supply-side equilibrium. Point B is mirrored in diagram 1, placed to the right of point A along the PS curve but beneath the WS curve. At this employment level, the real wage captured by WS curve is 102, exceeding the real wage of 100 captured by the PS curve. The 2% disparity signifies a positive bargaining gap.$

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https://www.core-econ.org/macroeconomics/04-inflation-and-employment-07-business-cycle-model-supply-side.html#figure-4-17b

A boom at B

During a boom, the AD curve shifts upwards. The economy moves to higher employment where WS is above PS and the bargaining gap at B is now positive (2%).

$A recession at C: There are 2 diagrams. In diagram 1, the horizontal diagram shows employment and the vertical axis shows real wage. Coordinates are (employment, real wage). The vertical line at the end of the horizontal axis is labeled labour force. The horizontal lines labeled PS curve intersects with the upward-sloping, convex curve labeled WS curve. This intersection is marked by point A, representing the supply-side equilibrium. The horizontal coordinate of point A represents employment at supply-side equilibrium, where there’s no bargaining gap. The horizontal distance from Point A to the vertical labour force line captures the corresponding unemployment level of 7%, labelled as structual unemployment. In diagram 2, the horizontal axis displays Output (income) Y in billions of € ranging from 0 to 100, and the vertical axis displays Aggregate Demand AD in billions of € ranging from 0 to 100. The coordinates are (Output, Aggregate Demand). There is a 45-degree upward-sloping straight line from the origin , labelled “Y = AD”. Starting at a point above 0 on the vertical axis, there is an upward-sloping straight line with a flatter slope than the 45-degree line denoting the initial aggregate demand function labelled AD(medium). Point A replicates its position from diagram 1, denoting the intersection of the 45-degree line and the AD line. Its horizontal coordinate is marked as Y_{SEE}, representing the output level at supply-side equilibrium. In diagram 2, an additional line labelled AD(low) is illustrated. This line shares the same shape as AD(medium) but is positioned beneath it to represent a recession. AD(low) intersects the 45-degree line at point C, situated beneath point A. Here, the vertical coordinate denotes a lower aggregate demand value and the horizontal coordinate is labelled as Y_{low}, indicating an output level falling short of the supply-side equilibrium. Point C is mirrored in diagram 1, placed to the left of point A along the PS curve but above the WS curve. At this employment level, the real wage captured by WS curve is 99, lower than the real wage of 100 captured by the PS curve. The −1% disparity signifies a negative bargaining gap.$

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https://www.core-econ.org/macroeconomics/04-inflation-and-employment-07-business-cycle-model-supply-side.html#figure-4-17c

A recession at C

During a recession, the AD curve shifts downwards. The economy moves to lower employment at point C, where the WS is below the PS and the bargaining gap is now negative (−1%). There is cyclical as well as structural unemployment.

$Aggregate demand shocks cause business cycle fluctuations: There are 2 diagrams. In diagram 1, the horizontal diagram shows employment and the vertical axis shows real wage. Coordinates are (employment, real wage). The vertical line at the end of the horizontal axis is labeled labour force. The horizontal lines labeled PS curve intersects with the upward-sloping, convex curve labeled WS curve. This intersection is marked by point A, representing the supply-side equilibrium. The horizontal coordinate of point A represents employment at supply-side equilibrium, where there’s no bargaining gap. The horizontal distance from Point A to the vertical labour force line captures the corresponding unemployment level of 7%, labelled as structual unemployment. In diagram 2, the horizontal axis displays Output (income) Y in billions of € ranging from 0 to 100, and the vertical axis displays Aggregate Demand AD in billions of € ranging from 0 to 100. The coordinates are (Output, Aggregate Demand). There is a 45-degree upward-sloping straight line from the origin , labelled “Y = AD”. Starting at a point above 0 on the vertical axis, there is an upward-sloping straight line with a flatter slope than the 45-degree line denoting the initial aggregate demand function labelled AD(medium). Point A replicates its position from diagram 1, denoting the intersection of the 45-degree line and the AD line. Its horizontal coordinate is marked as Y_{SEE}, representing the output level at supply-side equilibrium. In diagram 2, two additional lines labelled AD(high) and AD(low) respectively are illustrated. These lines share the same shape as AD(medium) but are positioned above to represent boom and below to represent recession. AD(high) and AD(low) intersect the 45-degree line at point B (situated above point A) and C (situated below point A) repectively. B’s vertical coordinate denotes a higher aggregate demand value while C denotes a lower level. B’s horizontal coordinate is labelled as Y_{high}, indicating an output level exceeding the supply-side equilibrium. By contrast, C’s horizontal coordinate is labelled as Y_{low}, indicating an output level lower than the supply-side equilibrium. Both points are mirrored in diagram 1, with point B placed to the right of point A and point C to the left along the PS curve. Point B is below the WS curve while point C is above. At B’s employment level, the real wage captured by WS curve is 102, exceeding the real wage of 100 captured by the PS curve, and the 2% disparity signifies the positive bargaining gap. By contrast, at C’s employment level, the real wage captured by WS curve is 99, lower than the real wage of 100 captured by the PS curve, and the −1% disparity signifies a negative bargaining gap.$

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https://www.core-econ.org/macroeconomics/04-inflation-and-employment-07-business-cycle-model-supply-side.html#figure-4-17d

Aggregate demand shocks cause business cycle fluctuations

Changes in the level of aggregate demand lead to booms and recessions, in which output and unemployment fluctuate around their equilibrium levels.

To include inflation as part of the dynamics of the business cycle, we add the Phillips curve to the diagram (Figure 4.18). This highlights that:

At a higher level of aggregate demand (a boom) there is a positive bargaining gap and inflation is higher.
At a lower level of aggregate demand (a recession), there is a negative bargaining gap and inflation is lower.

Follow through Figure 4.18 to add the behaviour of inflation to the dynamics of the business cycle.

$: There are 3 diagrams. In diagram 1, the horizontal diagram shows employment and the vertical axis shows real wage. Coordinates are (employment, real wage). The vertical line at the end of the horizontal axis is labeled labour force. The horizontal lines labeled PS curve intersects with the upward-sloping, convex curve labeled WS curve. This intersection is marked by point A, representing the supply-side equilibrium. The horizontal coordinate of point A represents employment at supply-side equilibrium, where there’s no bargaining gap. The horizontal distance from Point A to the vertical labour force line captures the corresponding unemployment level of 7%, labelled as structual unemployment. Point B located on the PS curve but below the WS curve indicates a higher employment level with a positive bargaining gap of 2%. Point C located on the PS curve but above the WS curve indicates a lower employment level with a negative bargaining gap of −1%. In diagram 2, the horizontal axis displays employment and the vertical axis displays inflation rate, ranging from −2% to 8%. One upward-sloping, convex line is labeled Phillips curve at an inflation expectation level 3%. Points A, B, and C are replicated from diagram 1, all of which are lying on the Phillips curve. The vertical coordinate of A indicates an inflation rate of 3%, while B indicates a higher inflation rate of 5% equaling to the sum of the 2% bargaining gap and 3% expected inflation, and C indicates a lower inflation rate of 2% equaling to the sum of the −1% bargaining gap and 3% expected inflation. In diagram 3, the horizontal axis displays Output (income) Y in billions of € ranging from 0 to 100, and the vertical axis displays Aggregate Demand AD in billions of € ranging from 0 to 100. The coordinates are (Output, Aggregate Demand). There is a 45-degree upward-sloping straight line from the origin , labelled “Y = AD”. Starting at a point above 0 on the vertical axis, there is an upward-sloping straight line with a flatter slope than the 45-degree line denoting the initial aggregate demand function labelled AD(medium). Point A replicates its position from diagram 1 and 2, denoting the intersection of the 45-degree line and the AD line. Its horizontal coordinate is marked as Y_{SEE}, representing the output level at supply-side equilibrium. It is also noted that output level lower than Y_{SSE} and labelled Y_{low} while output level higher than Y_{SSE} and labelled Y_{high}. The output level at the end of the horizontal axis marked by 100 corresponds to the employment level maintained by the labour force line. Two more lines labelled AD(high) and AD(low) respectively are illustrated. These lines share the same shape as AD(medium) but are positioned above to represent boom and below to represent recession. AD(high) and AD(low) intersect the 45-degree line at point B (situated above point A) and C (situated below point A) repectively. B’s vertical coordinate denotes a higher aggregate demand value while C denotes a lower level. B’s horizontal coordinate is labelled as Y_{high}, indicating an output level exceeding the supply-side equilibrium. By contrast, C’s horizontal coordinate is labelled as Y_{low}, indicating an output level lower than the supply-side equilibrium.$

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https://www.core-econ.org/macroeconomics/04-inflation-and-employment-07-business-cycle-model-supply-side.html#figure-4-18

Figure 4.18 The business cycle: aggregate demand, employment, and inflation.

$Supply-side equilibrium at A: There are 3 diagrams. In diagram 1, the horizontal diagram shows employment and the vertical axis shows real wage. Coordinates are (employment, real wage). The vertical line at the end of the horizontal axis is labeled labour force. The horizontal lines labeled PS curve intersects with the upward-sloping, convex curve labeled WS curve. This intersection is marked by point A, representing the supply-side equilibrium. The horizontal coordinate of point A represents employment at supply-side equilibrium, where there’s no bargaining gap. The horizontal distance from Point A to the vertical labour force line captures the corresponding unemployment level of 7%, labelled as structual unemployment. In diagram 2, the horizontal axis displays employment and the vertical axis displays inflation rate, ranging from −2% to 8%. One upward-sloping, convex line is labeled Phillips curve at an inflation expectation level 3%. Point A, replicated from diagram 1, is depicted on the Phillips Curve, where its vertical coordinate indicates the expected inflation rate of 3%. In diagram 3, the horizontal axis displays Output (income) Y in billions of € ranging from 0 to 100, and the vertical axis displays Aggregate Demand AD in billions of € ranging from 0 to 100. The coordinates are (Output, Aggregate Demand). There is a 45-degree upward-sloping straight line from the origin , labelled “Y = AD”. Starting at a point above 0 on the vertical axis, there is an upward-sloping straight line with a flatter slope than the 45-degree line denoting the initial aggregate demand function labelled AD(medium). Point A replicates its position from diagram 1 and 2, denoting the intersection of the 45-degree line and the AD line. Its horizontal coordinate is marked as Y_{SEE}, representing the output level at supply-side equilibrium. It is also noted that output level lower than Y_{SSE} and labelled Y_{low} while output level higher than Y_{SSE} and labelled Y_{high}. The output level at the end of the horizontal axis marked by 100 corresponds to the employment level maintained by the labour force line.$

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https://www.core-econ.org/macroeconomics/04-inflation-and-employment-07-business-cycle-model-supply-side.html#figure-4-18a

Supply-side equilibrium at A

When the level of aggregate demand produces employment at supply-side equilibrium (a normal level of activity), inflation is at its expected rate.

$A boom at B: There are 3 diagrams. In diagram 1, the horizontal diagram shows employment and the vertical axis shows real wage. Coordinates are (employment, real wage). The vertical line at the end of the horizontal axis is labeled labour force. The horizontal lines labeled PS curve intersects with the upward-sloping, convex curve labeled WS curve. This intersection is marked by point A, representing the supply-side equilibrium. The horizontal coordinate of point A represents employment at supply-side equilibrium, where there’s no bargaining gap. The horizontal distance from Point A to the vertical labour force line captures the corresponding unemployment level of 7%, labelled as structual unemployment. In diagram 2, the horizontal axis displays employment and the vertical axis displays inflation rate, ranging from −2% to 8%. One upward-sloping, convex line is labeled Phillips curve at an inflation expectation level 3%. Point A, replicated from diagram 1, is depicted on the Phillips Curve, where its vertical coordinate indicates the expected inflation rate of 3%. In diagram 3, the horizontal axis displays Output (income) Y in billions of € ranging from 0 to 100, and the vertical axis displays Aggregate Demand AD in billions of € ranging from 0 to 100. The coordinates are (Output, Aggregate Demand). There is a 45-degree upward-sloping straight line from the origin , labelled “Y = AD”. Starting at a point above 0 on the vertical axis, there is an upward-sloping straight line with a flatter slope than the 45-degree line denoting the initial aggregate demand function labelled AD(medium). Point A replicates its position from diagram 1 and 2, denoting the intersection of the 45-degree line and the AD line. Its horizontal coordinate is marked as Y_{SEE}, representing the output level at supply-side equilibrium. It is also noted that output level lower than Y_{SSE} and labelled Y_{low} while output level higher than Y_{SSE} and labelled Y_{high}. The output level at the end of the horizontal axis marked by 100 corresponds to the employment level maintained by the labour force line. In diagram 3, an additional line labelled AD(high) is illustrated. This line shares the same shape as AD(medium) but is positioned above it to represent a boom. AD(high) intersects the 45-degree line at point B, situated above point A. Here, the vertical coordinate denotes a higher aggregate demand value and the horizontal coordinate is labelled as Y_{high}, indicating an output level surpassing the supply-side equilibrium. Point B is mirrored in diagram 1, placed to the right of point A along the PS curve but beneath the WS curve. At this employment level, the real wage captured by WS curve is 102, exceeding the real wage of 100 captured by the PS curve. The 2% disparity signifies a positive bargaining gap. In diagram 2, point B replicated from diagram 1 and 3 is located on the Phillips Curve above point A. B’s vertical coordinates represent a higher inflation rate of 5%, equaling to the sum of the 2% bargaining gap and the 3% expected inflation.$

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https://www.core-econ.org/macroeconomics/04-inflation-and-employment-07-business-cycle-model-supply-side.html#figure-4-18b

A boom at B

At a higher level of aggregate demand (a boom), there is a positive bargaining gap and inflation goes up from its expected rate of 3% to 5%.

$A recession at C: There are 3 diagrams. In diagram 1, the horizontal diagram shows employment and the vertical axis shows real wage. Coordinates are (employment, real wage). The vertical line at the end of the horizontal axis is labeled labour force. The horizontal lines labeled PS curve intersects with the upward-sloping, convex curve labeled WS curve. This intersection is marked by point A, representing the supply-side equilibrium. The horizontal coordinate of point A represents employment at supply-side equilibrium, where there’s no bargaining gap. The horizontal distance from Point A to the vertical labour force line captures the corresponding unemployment level of 7%, labelled as structual unemployment. In diagram 2, the horizontal axis displays employment and the vertical axis displays inflation rate, ranging from −2% to 8%. One upward-sloping, convex line is labeled Phillips curve at an inflation expectation level 3%. Point A, replicated from diagram 1, is depicted on the Phillips Curve, where its vertical coordinate indicates the expected inflation rate of 3%. In diagram 3, the horizontal axis displays Output (income) Y in billions of € ranging from 0 to 100, and the vertical axis displays Aggregate Demand AD in billions of € ranging from 0 to 100. The coordinates are (Output, Aggregate Demand). There is a 45-degree upward-sloping straight line from the origin , labelled “Y = AD”. Starting at a point above 0 on the vertical axis, there is an upward-sloping straight line with a flatter slope than the 45-degree line denoting the initial aggregate demand function labelled AD(medium). Point A replicates its position from diagram 1 and 2, denoting the intersection of the 45-degree line and the AD line. Its horizontal coordinate is marked as Y_{SEE}, representing the output level at supply-side equilibrium. It is also noted that output level lower than Y_{SSE} and labelled Y_{low} while output level higher than Y_{SSE} and labelled Y_{high}. The output level at the end of the horizontal axis marked by 100 corresponds to the employment level maintained by the labour force line. In diagram 3, an additional line labelled AD(low) is illustrated. This line shares the same shape as AD(medium) but is positioned beneath it to represent a recession. AD(low) intersects the 45-degree line at point C, situated beneath point A. Here, the vertical coordinate denotes a lower aggregate demand value and the horizontal coordinate is labelled as Y_{low}, indicating an output level falling short of the supply-side equilibrium. Point C is mirrored in diagram 1, placed to the left of point A along the PS curve but above the WS curve. At this employment level, the real wage captured by WS curve is 99, lower than the real wage of 100 captured by the PS curve. The −1% disparity signifies a negative bargaining gap. In diagram 2, point C replicated from diagram 1 and 3 is located on the Phillips Curve beneath point A. B’s vertical coordinates represent a lower inflation rate of 2%, equaling to the sum of the −1% bargaining gap and the 3% expected inflation.$

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https://www.core-econ.org/macroeconomics/04-inflation-and-employment-07-business-cycle-model-supply-side.html#figure-4-18c

A recession at C

At a lower level of aggregate demand (a recession), there is a negative bargaining gap and inflation goes down from its expected rate of 3% to 2%.

The model of the business cycle in Figure 4.18 is a snapshot. It illustrates the first stage of a boom characterized by higher aggregate demand, output, employment, and inflation, and a recession with the opposite. What happens when we allow time to roll forward? To make a prediction, we need to step into the unknown: will the initial shock to aggregate demand persist, will wage setters adjust their inflation expectations, and will a policy maker intervene to alter the economy’s trajectory? We postpone the question of the policy maker’s role until Unit 5. In the next section, we concentrate on the consequences for inflation of aggregate demand and supply-side shocks.

Question 4.6 Choose the correct answer(s)

Figure 4.18 shows diagrams of the labour market model, the Phillips curve, and the multiplier model. The unemployment rates and the bargaining gaps at different states of the economy are shown.

Based on this information, read the following statements and choose the correct option(s).

There is no inflation when the unemployment rate is zero.
In the boom shown, the upward shift in the aggregate demand curve reduces the unemployment rate, which in turn creates a bargaining gap of 2%.
In the recession shown, the downward shift in the aggregate demand curve increases the unemployment rate, which in turn creates a bargaining gap of 1%.
The resulting Phillips curve shows a positive relationship between the unemployment rate and inflation rate.

There is always a positive rate of unemployment in the supply-side model. If $U$ is below 4%, then there would be an even larger positive bargaining gap than with $U = 4\%$ and even higher inflation. Inflation is zero in the diagram only when the unemployment rate is 6%.
At point B, unemployment is below the supply-side equilibrium and creates a positive bargaining gap of 2%.
The bargaining gap created as a result of the recession is −1%, which is negative.
The Phillips curve shows a positive relationship between employment and the inflation rate, which means a negative relationship between the unemployment rate and the inflation rate.