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.
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.
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 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.