Workers who have been laid off but are waiting for recall to their old jobs are counted as unemployed. An individual is said to be unemployed if he/she is actively seeking employment or waiting to begin or return to a job.

Workers who have become discouraged and have given up looking for employment are not counted as unemployed. This problem accounts for the anomaly that occurs when the economy turns up and the unemployment rate jumps.

Workers looking for full-time employment but settling for part-time work are considered as being employed. Because of these measurement problems, some economists feel the proper measure of employment would be the employment/population ratio rather than the rate of unemployment.

c: Describe the three types of unemployment.

Frictional unemployment is unemployment due to constant changes in the economy that prevent qualified workers from being immediately matched with existing job openings. There are two causes of frictional unemployment:

Imperfect information.

The job search conducted by both employees and employers.

Structural unemployment is unemployment due to structural changes in the economy that eliminate some jobs while generating job openings for which unemployed workers are not qualified. Structural unemployment differs from frictional unemployment in that workers do not currently have the skills needed to perform the newly created jobs.

Cyclical unemployment is unemployment caused by a change in the general level of economic productivity. When the economy is operating at less than full capacity, positive levels of cyclical unemployment will be present. At levels above full capacity, negative cyclical unemployment will exist.

d: Define full employment.

When cyclical unemployment is zero, the economy is said to be operating at full employment. However, at full employment, both structural and frictional unemployment still exist. Therefore, there is some level of unemployment, which is expected when the economy is at full employment.

The natural rate of unemployment is that rate of unemployment present when the economy is at its full employment rate of production or output. In the recent past, the natural rate has risen due to changes in the composition of the labor force, namely, and increase in young workers entering the labor force.

This rate of unemployment can persist for an indefinite period of time and is typically associated with the economy's maximum long-rate of output.

e: Define inflation and calculate the inflation rate.

Inflation is a protracted period of rising prices. As inflation rises, the purchasing power of each dollar held declines. Inflation = (this year's price index - last year's price index) / (last year's price index).

Example: A price index is 113.5 for 2000 and 119.9 at the end of 2001. What was the inflation rate during 2001?

Answer: Inflation rate = (119.9 – 113.5)/113.5 = 5.6%

f: Discuss the effects of inflation.

Unanticipated inflation is a change in prices that was not expected by rational decision makers. When inflation is unanticipated, the purchasing power of every dollar is unexpectedly eroded. Therefore, any income which is to be received in the future is now worth less in a present-value sense. Now, let’s think for a moment about potential winners and losers from a dose of unanticipated inflation. The definite losers would be people who are currently holding long-term contracts in which they are promised to receive a fixed dollar payment. The winners would obviously be the individuals or institutions which have made the promise to pay under those same fixed-rate contracts.

Anticipated inflation is expected by decision makers. Therefore, all contracts will be written to accommodate for the inflation. With anticipated inflation, variable rate contracts will be the preferred contract by lenders, and anyone wishing to obtain a fixed-rate contract will have to pay a higher price for that contract. Once the anticipated inflation has been written into all contracts, no one will win or lose.

1.C: Preliminary Reading: Working with Our Basic Aggregate Demand/Aggregate Supply Model

a: Discuss the factors that shift aggregate demand and aggregate supply.

An increase in real wealth will cause an increased demand for goods and services at each price level.

An increase in the real rate of interest or real cost of funds will decrease AD at all price levels and shift the AD curve to the left. The increased real cost of borrowing will make it more expensive for consumers to purchase goods and for businesses to invest.

Positive business expectation, or optimism, will shift AD to the right because the expectation of improved economic conditions will increase consumption and investment.

If people expect inflation in the future, spending will occur today in order to avoid the future inflation.

If income abroad increases, then AD will increase due to heightened demand for our export goods.

If exchange rates change causing the value of the dollar to decline relative to foreign currencies, net exports will increase, causing AD to shift to the right.

b: Discuss the short- and long-run effects of unanticipated changes in aggregate demand and aggregate supply.

An unexpected shift in AD will disturb the prevailing long-run equilibrium (E) and eventually lead to a new long-run equilibrium. If consumers decide to consume less today, they necessarily have to save more (given some level of income). This reduction in consumption will temporarily shift the AD curve downward to the left (from AD1 to AD2). Inventories will accumulate on store shelves, production will be cut, and workers will be laid off. The economy will move from point E (full employment GDPf) to point A (under employment GDPu). The reduction in demand places downward pressure on wage rates and prices. As workers and suppliers begin to accept the lower wage rate, employment and output will rise due to the favorable shift in resource prices. Hence, SRAS1 will shift to the right (SRAS2) back to a point of long-run equilibrium (point B). While the long-run result is solely a reduction in prices, the short-run results are

Decline in output (higher unemployment) and

Reduction in prices.

If consumers decide to consume more, it will cause a shift to the right in AD resulting in GDP moving above full employment GDPf. In the short run both output and prices rise (reducing unemployment). In the long run, the increased resource costs (higher wages and other inputs) will reduce SRAS leading solely to higher prices. (Note: as the SRAS curve moves upward to the left, supply is falling.)

c: Discuss three self-correcting mechanisms that may help stabilize a market economy.

Three primary mechanisms are responsible for self-correcting the economy after a shock. They are:

Consumption Demand - demand is relatively stable over the business cycle.

Real Interest Rates - changes in real interest rates will help to stabilize aggregate demand and redirect economic fluctuations.

Resource Prices - changes in real resource prices will redirect economic fluctuations.

1.D: Preliminary Reading: Keynesian Foundations of Modern Macroeconomics

a: Distinguish between classical economics and Keynesian economics.