Economic Policy: Unemployment, Inflation, and Aggregate Demand

Posted on Mar 9, 2025 in Economy

Economic Policy Objectives

Item 9 focuses on key economic policy objectives: low unemployment, low inflation, and a low deficit.

Aggregate Demand

Aggregate demand (D) represents the total demand for goods and services in an economy at a given price level. We can distinguish three levels of demand:

  • Aggregate Demand (D): The total demand across all markets.
  • Market Demand: Demand within a specific market.
  • Individual Demand: Demand from a single consumer.

Components of Aggregate Demand

Aggregate demand is composed of:

  • Consumption (C): Depends on autonomous consumption (independent of income) and disposable income (positively correlated).
  • Investment (I): Depends on autonomous investment (expectations) and is inversely related to interest rates.
  • Public Expenses (G): Government spending, including automatic stabilizers like unemployment benefits.
  • Net Exports (NX): Exports (X) depend on other countries’ income, while imports (M) depend on the country’s income.

Aggregate Supply

Aggregate supply depends on production costs, technology, the country’s population, and the activity rate (the proportion of the population willing to work). Product potential refers to the maximum production capacity. As production approaches this potential, the price level tends to rise.

[Model Supply – Aggregate Demand (drawing)]

Unemployment

Types of Unemployment

  • Seasonal: Depends on the time of year (e.g., coastal areas in winter).
  • Cyclical: Depends on the economic cycle.
  • Structural: Arises from a mismatch between available jobs and workers’ skills.
  • Frictional: Inherent in the labor market as people transition between jobs.

Causes of Unemployment

Two main explanations exist:

  1. Neoclassical: Advocates for no intervention in the labor market, suggesting that suppressing wages (e.g., minimum wage) reduces demand. Lower wages and costs shift the aggregate supply curve to the right.
  2. Keynesian: Attributes unemployment to a lack of aggregate demand, proposing increased public spending as a solution.

Stagflation

Stagflation occurs when there is both unemployment and inflation. This is problematic when inflation is driven by costs rather than demand (e.g., oil crises).

[Type inflation costs ex1: oil crises (drawing)]

Economic Cycles

Economic cycles have a duration of more than one year. Two types exist:

  1. Short Cycles (20-40 months): Caused by weak demand, leading to increased inventories and lower income. Recovery can be initiated by renewing machinery.
  2. Long Cycles (20-40 years): Related to technological change. New technologies require new skills and production methods.

Phases of Economic Cycles

  • Expansion: Typically causes an increase in prices (Y).
  • Recession: Characterized by a decrease in Y (defined as two consecutive terms of negative growth).