Macroeconomics Principles - Problems - and Policies

Question: Discuss about the Macroeconomics for Principles, Problems, and Policies. Answer: Introduction: For an economy to achieve its maximum output, it is imperative that the nation must use the various resources available in the most efficient manner. One of the critical input factors which impact the output is the amount of labour that is employed. For achieving the potential output, it is desirable that the natural rate of employment must be attained. However, the employment generated is impacted by the level of wages. The economic conditions tend to vary but the prices and wages do not adjust to these economic conditions in the short run. This is referred to as price or wage stickiness and tends to avoid the adjustment required for attaining stable equilibrium (Mankiw, 2012). This leads to a situation where there is either surplus or shortage of labour which prevents the employment to reach the natural level for the economy. The net result is that the economy is not able to reach its maximum potential level (Dombusch, Fischer Startz, 2012). For natural employment level to be achieved, it is essential that adjustment in real wages takes place to ensure that the demand and supply of labour remained balanced. A critical role in the achievement of the stable equilibrium is played by the Long Run Aggregate Supply (LRAS). It tends to denote the relationship between price and output level in the long run. It is imperative to differentiate between the long run and short run as in the long run, the price and wages are assumed to be flexible. This is in sharp contrast with the situation in the short run where stickiness is observed which inhibits adjustment as explained above (Koutsoyiannis, 2013). In order to understand the concept of LRAS, the following figures are helpful. The panel (a) tends to indicate the real wage we at which the natural employment could be achieved. It is noteworthy that to achieve this level Le, there could be a host of nominal wage and price combination possible. However, in LRAS, the maximum potential Yp could be achieved at any particular price as apparent from panel (b). Typically for higher price levels, a corresponding higher nominal wage would be required so that the real wage remains at we, but this can be achieved in the long run. This is because the nominal wages are flexible in the long run unlike in the short run. Hence the shape of the LRAS is vertical unlike SRAS which tends to be sloping (Krugman Wells, 2012). Also, in the long run, through changes in price level, the economy can achieve the equilibrium output level to various alterations in the aggregate demand. For instance, if the aggregate demand would increase, the price level would increase as the AD curve shifts to the right but the output retains the same level. Similarly, a decrease in the aggregate demand would respond by lowering of the price level since the AD curve would shift to the left. However, the output would still be retained (Mankiw, 2012). The short run curves depicting AD and SRAS tend to drive the equilibrium in the short run. The relevant diagram to understand the phenomenon of stable economic equilibrium is shown below (Koutsoyiannis, 2013). It is apparent that the LRAS indicates the maximum potential output or GDP at $ 12,000 billion. Consider the initial situation where the aggregate demand curve is denoted by AD1. The equilibrium point is where the AD and SRAS tend to intersect each other. Coincidently at this point the LRAS is also intersected and the output is $ 12,000 billion. However, now consider that there is an increase in the aggregate demand which may be caused due to higher trade surplus or lower trade deficit (Dombusch, Fischer Startz, 2012). This is graphically represented by a rightward shift in the AD curve as indicated above. The new demand curve is AD2. Correspondingly, there is a temporary increase in the output to $ 12,100 billion and also the price level. But it is noteworthy that this output level is not stable and thus would not stay in the long run. The main reason for the same is the shortage of labour since the level of employment would be above the natural rate of employment. However, due to price stickiness, price could not adjust and hence there would be a temporary mismatch which could have been avoided if the price increased to $ 1.18. However, the actual price has increased only to $ 1.16 which causes a shortage of labour. As a result of thus, in the long run there would be a tendency to move towards point B from point A as the price becomes more flexible (McConnell, Brue Flynn, 2014). Now assume that from the base case denoted by AD1, there is a reduction in aggregate demand which would lead to by a leftward shift in the AD curve as indicated above. The new demand curve is AD3. Correspondingly, there is a temporary decrease in the output to $ 11,900 billion and also the price level. But it is noteworthy that this output level is not stable and thus would not stay in the long run. The main reason for the same is the excess of labour since the level of employment would be below the natural rate of employment (Mankiw, 2012). However, due to price stickiness, price could not adjust and hence there would be a temporary mismatch which could have been avoided if the price decreased to $ 1.10. However, the actual price has reduced only to $ 1.12 which causes a surplus of labour. As a result of thus, in the long run there would be a tendency to move towards point B from point C as the price becomes more flexible (Krugman Wells, 2012). Thus, from the above discussion, it is apparent that stable economic equilibrium can only be achieved at point A or where the aggregate demand curve, SRAS and LRAS tend to intersect each. Any other economic equilibrium is essentially shortlived and in the long run eventually the optimal economic equilibrium would be achieved as the wages and price become flexible. References Dombusch, R., Fischer, S. Startz, R. (2012).Macroeconomics, New York, NY: McGraw Hill Publications Koutsoyiannis, A. (2013). Modern Macroeconomics, New York, NY: Palgrave McMillan Krugman, P. Wells, R. (2012), Macroeconomics, London, LDN: Worth Publishers Mankiw, G. (2012), Principles of Macroeconomics, London, LDN: Cengage Learning McConnell, C., Brue, S. Flynn, S. (2014), Macroeconomics: Principles, Problems, Policies, New York, NY: McGraw Hill/Irwin Publications