Chapter 31 Summary

A. The Foundations of Aggregate Supply 1. Aggregate supply describes the relationship between the output that businesses willingly produce and the overall price level, other things being constant. The factors underlying aggregate supply are (a) potential output, determined by the inputs of labor, capital, and natural resources available to an economy, along with the technology or efficiency with which these inputs are used, and (b) input costs, such as wages, energy prices, and import prices. Changes in these underlying factors will shift the AS curve. 2. Two major approaches to output determination are the classical and Keynesian views. The classical view holds that prices and wages are flexible; any excess supply or demand is quickly extinguished and full employment is established after AD or AS shocks. The classical view is represented by a vertical AS curve. The Keynesian view holds that prices and wages are sticky in the short run due to contractual rigidities such as labor-union agreements. In this kind of economy, output responds positively to higher levels of aggregate demand because the AS curve is relatively flat, particularly at low levels of output. In a Keynesian variant, the economy can experience long periods of persistent unemployment because wages and prices adjust slowly to shocks and equilibration toward full employment is slow. 3. A synthesis of classical and Keynesian views distinguishes the long run from the short run. In the short term, because wages and prices do not have time to adjust fully, the AS curve is upward-sloping, showing that businesses will supply more output at a higher price level. By contrast, in the long run, wages and prices have time to adjust fully to shocks, so we treat the long-run AS curve as vertical or classical. Hence, in the long run, output will be determined by a nation's potential output, and the evolution of aggregate demand will affect prices rather than output. B. Unemployment 4. The government gathers monthly statistics on unemployment, employment, and the labor force in a sample survey of the population. People with jobs are categorized as employed; people without jobs who are looking for work are said to be unemployed; people without jobs who are not looking for work are considered outside the labor force. Over the last decade, 66 percent of the population over 16 was in the labor force, while 6 percent of the labor force was unemployed. 5. There is a clear connection between movements in output and the unemployment rate over the business cycle. According to Okun's Law, for every 2 percent that actual GDP declines relative to potential GDP, the unemployment rate rises 1 percentage point. This rule is useful in translating cyclical movements of GDP into their effects on unemployment. 6. Recessions and the associated high unemployment are extremely costly to the economy. Major periods of slack like the 1970s and early 1980s cost the nation hundreds of billions of dollars and have great social costs as well. Yet, even though unemployment has plagued capitalism since the Industrial Revolution, understanding its causes and costs has been possible only with the rise of modern macroeconomic theory. 7. Economists divide unemployment into three groups: (a) frictional unemployment, in which workers are between jobs or moving in and out of the labor force; (b) structural unemployment, consisting of workers who are in regions or industries that are in a persistent slump because of labor market imbalances or high real wages; and (c) cyclical unemployment, pertaining to workers laid off when the overall economy suffers a downturn. 8. Understanding the causes of unemployment has proved to be one of the major challenges of modern macroeconomics. Some unemployment (often called voluntary) would occur in a flexible-wage, perfectly competitive economy when qualified people chose not to work at the going wage rate. Voluntary unemployment might be the efficient outcome of competitive markets. 9. The theory of sticky wages and involuntary unemployment holds that the slow adjustment of wages produces surpluses and shortages in individual labor markets. This theory holds that the cyclical unemployment occurs because wages are inflexible, failing to adjust quickly to labor surpluses or shortages. If wages are above market-clearing levels, some workers are employed but other qualified workers cannot find jobs. Such unemployment is involuntary and also inefficient in that both workers and firms could benefit from an appropriate use of monetary and fiscal policies. 10. Labor markets fail to clear partly because of costs involved in administering the compensation system. Frequent adjustment of compensation for market conditions would command too large a share of management time, would upset workers' perceptions of fairness, and would undermine worker morale and productivity. In the long run, wages tend to adjust and remove abnormal levels of unemployment or job vacancies. But the slow pace of wage adjustment means that societies may suffer prolonged periods of unemployment. 11. A careful look at the unemployment statistics reveals several regularities: a. Recessions hit all groups in roughly proportional fashion - that is, all groups see their unemployment rates go up and down in proportion to the overall unemployment rate. b. A very substantial part of U.S. unemployment is short-term. In low-unemployment years (such as 1999) about 85 percent of unemployed workers are unemployed less than 26 weeks. The average duration of unemployment rises sharply in deep and prolonged recessions. c. In most years, a substantial amount of unemployment is due to simple turnover, or frictional causes, as people enter the labor force for the first time or reenter it. Only during recessions is the pool of unemployed composed primarily of job losers. d. The persistent unemployment in Europe appears to arise from a combination of weak aggregate demand and inflexible labor market institutions.