REVISION OF MACROECONOMICS FINAL TEST
Chap 1: Introduction:
Definition of GDP: (Gross domestic product)
“the market value of all final goods and services produced within an economy in a given
period of time.”
Components of GDP:
C: consumption spending by households except purchases of new houses
I: investment spending by business (capitals, inventories) and households (houses)
G: government purchases of goods and services except transfer payment
NX (X –M): net export or net foreign demand for domestic goods. X is spending on
domestically produced goods by foreigners (export), M is spending on foreign goods by
domestic residents (import)
Measured by the formula:
GDP = C + I + G + (X-M)
= C + I + G + NX
Nominal and real GDP:
Nominal GDP
 Production of goods and services
 Valued at current prices
Real GDP
 Production of goods and services
 Valued at constant prices
 Designate one year as base year
 Not affected by changes in prices
Notice: For the base year
Nominal GDP = Real GDP
The GDP deflator
 Measure of the price level
 Ratio of nominal GDP to real GDP times 100
 =100 for the base year
Measures the current level of prices relative to the level of prices in the base year
Definition of CPI:
The consumer price index (CPI) is a measure of the overall cost of the goods and
services bought by a typical consumer.
Measure CPI:
1
1. Fix the basket
2. Find the prices
3. Compute the basket’s cost
4. Chose a base year and compute the CPI
Price of basket of goods & services in current year
Divided by price of basket in base year
Times 100
5. Compute the inflation rate
Percentage change in the price index from the preceding period
Inflation rate in year 2=
CPI in year 2-CPI in year 1
×100
CPI in year 1
Chap 2: AS- AD model
Aggregate Demand:
Aggregate-demand curve shows the quantity of goods and services that households, firms,
the government, and customers abroad want to buy at each price level
Aggregate demand curve is downward sloping
Why the aggregate-demand (AD) curve slopes downward
 Price level & consumption (C): wealth effect
Decrease in price level → Increase - real value of money → Consumers – wealthier →
Increase in consumer spending → Increase in quantity demanded of goods & services
 Price level & investment (I): interest-rate effect
Decrease in price level → Decrease – interest rate → Increase spending on investment
goods → Increase in quantity demanded of goods & services
 Price level & net exports (NX): exchange-rate effect
Decrease in domestic price level → Decrease – interest rate → Domestic currency –
depreciates → Stimulates net exports → Increase in quantity demanded of goods &
services
Formula of AD:
AD = C + I + G + NX
Why the AD curve might shift
Shifts Arising from Consumption
Shifts Arising from Investment
Shifts Arising from Government Purchases
Shifts Arising from Net Exports
Aggregate Supply:
2
- Aggregate-supply curve shows the quantity of goods and services that firms choose to
produce and sell at each price level
- Aggregate supply curve is Upward sloping in the short run and vertical in the long run
Why the aggregate-supply curve (LRAS) is vertical in the long run
Price level does not affect the long-run determinants of GDP:
+ Supplies of labor, capital, and natural resources
+ Available technology
In other words, GDP (output) in the long run is not determined by price level. In the long
run, when the economy adjusts itself, the output always stays at natural level of output
or potential output (Y*)
Why the LRAS curve might shift
 Changes in labor
E.g. Quantity of labor – increases → Aggregate supply – shifts right
Natural rate of unemployment – increases → Aggregate supply –shifts left
 Changes in capital
E.g. Capital stock – decrease → Aggregate supply – shifts left
 Changes in natural resources
E.g. New discovery of natural resource → Aggregate supply – shifts right
Weather keeps fine → Aggregate supply – shifts right
Availability of natural resources declines → Aggregate supply – shifts left
 Changes in technology
E.g. New technology, for given labor, capital and natural resources → Aggregate
supply – shifts right
Why the aggregate-supply (SRAS) curve slopes upward in the short-run
There are several theories to explain shape of SRAS: sticky wage theory, sticky – price
theory, misperception theory
+) Sticky-wage theory
 Nominal wages - slow to adjust to changing economic conditions due to
 Long-term contracts: workers and firms
 Slowly changing social norms
 Notions of fairness - influence wage setting
 Nominal wages - based on expected prices: don’t respond immediately
when actual price level – different from what was expected
 Sticky-wage theory
If price level < expected: Firms – incentive to produce less output
If price level > expected: Firms – incentive to produce more output
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+) Sticky-price theory
Prices of some goods & services slow to adjust to changing economic conditions due to
for example menu costs (Costs to adjusting prices) → sticky price firms besides flexible
price firms
When price level increases, flexible price firms tend to increase price. However sticky
price firms keep price unchanged → output of sticky price firms increases
+) Misperceptions theory
Changes in the overall price level Can temporarily mislead suppliers about changes in
individual markets (Changes in relative prices) or changes in all markets (changes in
common prices)
Suppliers - respond in the wisest way to changes in level of prices by Change - quantity
supplied of goods and services (price increase/decrease by output increase/decrease)
What the 3 Theories Have in Common:
In all 3 theories, Y deviates from YN when P deviates from PE.
Y = YN + a×(P – PE)
Why Might the Short-Run Aggregate-Supply Curve Shift?
Shifts Arising from Labor
Shifts Arising from Capital
Shifts Arising from Natural Resources
Shifts Arising from Technology
Shifts Arising from the Expected Price Level: A decrease in the expected price level shifts
the short-run aggregate-supply curve to the right. An increase in the expected price level
shifts the short-run aggregate-supply curve to the left.
Four steps for analyzing macroeconomic fluctuations
1. Decide whether the event shifts the aggregate demand curve or the aggregate
supply curve (or perhaps both).
2. Decide in which direction the curve shifts.
3. Use the diagram of aggregate demand and aggregate supply to determine the
impact on output and the price level in the short run.
4. Use the diagram of aggregate demand and aggregate supply to analyze how the
economy moves from its new short-run equilibrium to its long-run equilibrium.
The effects of a shift in aggregate demand: expansionary demand shock and
contractionary demand shock
AD curve
shift to
Contraction
Left
Output
Decline (short
run)
Price level
(inflation)
Fall (short run)
Fall further (long run)
Policy of
government
Shift AD to the
right
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Unchanged (long
run)
Expansion
Right
Rise (short run)
Increase (short run)
Unchanged (long
run)
Increase further (long
run)
Shift AD to the
left
The effects of a shift in aggregate supply: adverse supply shock and beneficial
supply shock
Adverse
Beneficial
(temporar
y effects)
SRAS
curve
shift to
Output
left
Decline (short
run)
Rise
Unchanged (long
run)
Unchanged
(long run)
right
Price level
(inflation)
Policy of
government
(1)
Increase AD so
that Y unchanged
but P increases
further
(2)
Decrease AD so
that P unchanged
but Y decreases
further
(1)
Increase AD so
that P unchanged
but Y increases
further
(2)
Decrease AD so
that Y unchanged
but P decreases
further
(short run)
Rise
Decline (short
run)
(short run)
Unchanged
Unchanged
(long run)
(long run)
Chap 3: AD & Fiscal Policy
The multiplier Effect: A dollar by government purchase can generate more than a dollar
by aggregate demand (it is also true with other components of GDP)
∆C
∆ Yd
consumption increases when income rises one unit)
MPC is marginal propensity to consume ( MPC=
implies how much
Yd is disposable income or after-tax income
The multiplier ¿
1
1−MPC
;
∆Y =
1
∆G
1−MPC
Furthermore:
5
Y=
1
−MPC
∗( C̄ + Ī + Ḡ)+
∗T̄
1−MPC
1−MPC
Crowding-out Effect:
Fiscal policy has another effect on AD that works in the opposite direction.
• A fiscal expansion raises r, which reduces investment, which reduces the net increase in
AD.
• So, the size of the AD shift may be smaller than the initial fiscal expansion.
• This is called the crowding-out effect.
Chap 4: Money & Monetary Policy
Fed’s Tools to control money supply
1. Open-market operations: Purchase and sale of government bonds by central bank
 To increase the money supply: central bank buys government bonds
 To reduce the money supply: central bank sells government bonds
2. Reserve requirements: Regulations on minimum amount of reserves that banks must
hold against deposits
 An increase in reserve requirement: Decrease the money supply
 A decrease in reserve requirement: Increase the money supply
3. The discount rate: Interest rate on the loans that central bank makes to commercial
banks
 Higher discount rate: Reduce the money supply
 Smaller discount rate: Increase the money supply
Money Market:
Money supply
Money demand
Controlled by central bank
Money – most liquid asset (liquidity
preference)
Quantity of money supplied fixed by
central bank therefore doesn’t vary
with interest rate
Money supply curve - vertical
Interest rate (i)– opportunity cost of
holding money. Income (Y) is the most
determinant of money demand
Money demand curve – downward sloping
MS = mM. B
MD = f(Y;i)
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 If interest rate > equilibrium: Quantity of money people want to hold less than
quantity supplied → People holding the surplus buy interest-bearing assets →
Lowers the interest rate → People - more willing to hold money until equilibrium
 If interest rate < equilibrium: Quantity of money people want to hold more than
quantity supplied → People - increase their holdings of money by selling interestbearing assets → Increase interest rates until equilibrium
Change in money supply derived from
+ monetary policy of central bank: increase or decrease money supply
+ change in price level (with real money supply)
Change in money demand derived from
+ change in national income
+ change in price level (with nominal money demand)
+ financial market stability
+ payment technology
Monetary Policy:
+ Expansionary monetary policy: central bank increases the money supply → Moneysupply curve shifts right → Interest rate falls → At any given price level increase in
quantity demanded of goods and services → Aggregate-demand curve shifts right →
output rises (unemployment rate decreases), price increases
Using expansionary monetary policy when economy is in crisis
+ Contractionary monetary policy: central bank decreases the money supply → Moneysupply curve shifts left → Interest rate increases → At any given price level decrease in
quantity demanded of goods and services → Aggregate-demand curve shifts left →
output falls (unemployment rate increases), price decreases (inflation rate falls)
Using contractionary monetary policy when economy is in boom
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Chap 5: Unemployment
Definition: People are able, available and actively seeking work – but not employed
Types of unemployed:
There are four categories of natural unemployment
+ Frictional unemployment: Results because it takes time for workers to search for the
jobs that best suit their tastes and skills
E.g. The graduate who just leave university is finding a job
+ Structural unemployment: occurs when a labor market is unable to provide jobs for
everyone who wants one because there is a mismatch between the skills of the
unemployed workers and the skills needed for the available jobs
E.g. Farmers who were reclaimed land try to be workers
+ Seasonal unemployment: occurs at seasonal jobs which require working in certain
moments of a year
E.g. Employee in water park in winter
+ Classical unemployment: occurs when real wages for a job are set above the marketclearing level, causing the number of job-seekers to exceed the number of vacancies.
E.g. Unskilled worker who only graduates from high school
Reasons for classical unemployment
-
Minimum wage law
-
Efficiency wages
-
Labor unions
Cyclical rate of unemployment:
Unemployment caused by a short-run decline of the economic activities.
 The demand for products decreases and workers get laid off.
 Results in an excess supply of workers for the remaining available jobs.
 The economy must grow at least as fast as the labor force to avoid cyclical
unemployment.
Chap 6: Inflation
Definition: (Increase in the overall level of prices)
is a sustained increase in the general price level of goods and services in
an economy over a period of time.
Or sustained reduction in the purchasing power per unit of money – a loss of real value
in the medium of exchange and unit of account within the economy (each unit
of currency buys fewer goods and services)
Cause of Inflation:
Money quantity theory – the classical theory of inflation
Velocity and the quantity equation
8
Quantity equation: M × V = P × Y
+ Quantity of money (M)
+ Velocity of money (V)
+ Dollar value of the economy’s output of goods and services (P × Y)
This quantity shows that: an increase in quantity of money must be reflected in:
+ Price level must rise
+ Quantity of output must rise
+ Velocity of money must fall
Five steps - essence of quantity theory of money
1. Velocity of money: Relatively stable over time
2. Changes in quantity of money (M) will lead to Proportionate changes in nominal value
of output (P × Y)
3. Economy’s output of goods and services (Y): in long run primarily determined by
factor supplies and available production technology. Because money is neutral then
Money does not affect output in the long run
4. Change in money supply (M): Induces proportional changes in the nominal value of
output (P × Y) and Reflected in changes in the price level (P)
5. Therefore, Central bank - increases the money supply rapidly → High rate of inflation.
→ Money quantity theory explains cause of long run inflation
“Inflation is always and everywhere a monetary phenomenon.” —Milton Friedman, 1963
Chap 7: Production and Growth
Definition:
Economic growth is the increase in the market value of the goods and services
produced by an economy over time. It is conventionally measured as the percent rate of
increase in real gross domestic product, or real GDP
To reflect more accurately about living standard of each person in country, economists
use the growth of the ratio of GDP to population (GDP per capita), which is also
called income per capita
An increase in per capita income is referred to as intensive growth. GDP growth caused
only by increases in population or territory is called extensive growth
Saving and Investment Policy: Raise future productivity
 Invest more current resources in the production of capital
 Trade-off: Devote fewer resources to produce goods and services for
current consumption
Chap 8: Saving, Investment, and the Financial System
Saving & Investment in National Income Accounts:
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Assumption: close economy: NX = 0 –Y = C + I + G
• National saving (saving), S
–Total income in the economy that remains after paying for consumption and
government purchases: Y – C – G = I; S = Y – C - G; S = I
• T = taxes minus transfer payments (S = Y – C – G); S = (Y – T – C) + (T – G)
• Private saving, Y – T – C
–Income that households have left after paying for taxes and consumption
• Public saving, T – G
–Tax revenue that the government has left after paying for its spending
• Budget surplus: T – G > 0
–Excess of tax revenue over government spending
• Budget deficit: T – G < 0
–Shortfall of tax revenue from government spending
The meaning of Saving and Investing
•S=I
• Saving = Investment
–For the economy as a whole
–One person’s savings can finance another person’s investment
What is the market for loanable funds?
It is the market for Those who want to save supply funds and those who want to borrow
to invest demand fund
Assumptions
 One interest rate that reflects Return to saving and Cost of borrowing
 Single financial market
Building the market: Supply and demand of loanable funds
 Source of the supply of loanable funds: Saving
 Source of the demand for loanable funds: Investment
 Price of a loan = real interest rate
 Borrowers pay for a loan
 Lenders receive on their saving
Policy 1: saving incentives
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E.g. Shelter some saving from taxation
 Affect supply of loanable funds
 Increase in supply
 Supply curve shifts right
 New equilibrium
 Lower interest rate
 Higher quantity of loanable funds
 Greater investment
Policy 2: investment incentives
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E.g. Investment tax credit
 Affect demand for loanable funds
 Increase in demand
 Demand curve shifts right
 New equilibrium
 Higher interest rate
 Higher quantity of loanable funds
 Greater saving
Policy 3: government budget deficits and surpluses
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 Government - budget deficit
 Interest rate rises
 Investment falls
 Crowding out effect
 Decrease in investment
 Results from government borrowing
(Analyze the situation when government runs budget surplus)
Chap 9: Macroeconomics of the Open-Economy: Basic
concepts
Flow of goods: exports, imports & net exports
• Exports
–Goods & services
–Produced domestically
–Sold abroad
• Imports
–Goods and services
–Produced abroad
–Sold domestically
•Net exports
–Value of a nation’s exports
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–Minus the value of its imports
–Also called trade balance
• Trade balance
–Value of a nation’s exports
–Minus the value of its imports
–Also called net exports
• Trade surplus
–Excess of exports over imports
• Trade deficit
–Excess of imports over exports
• Balanced trade
–Exports equal imports
Flow of financial resources: net capital outflow
• Net capital outflow
–Purchase of foreign assets by domestic residents
•Foreign direct investment
•Foreign portfolio investment
–Minus the purchase of domestic assets by foreigners
• Variables that influence net capital outflow
–Real interest rates paid on foreign assets
–Real interest rates paid on domestic assets
–Perceived economic and political risks of holding assets abroad
–Government policies that affect foreign ownership of domestic assets
Equality of net exports & net capital outflow
• Net exports (NX)
–Imbalance between: A country’s exports and its imports
• Net capital outflow (NCO)
–Imbalance between
 Amount of foreign assets bought by domestic residents
 And the amount of domestic assets bought by foreigners
• Identity: NCO = NX
• When NX > 0 (trade surplus)
–Selling more goods and services to foreigners
•
Than it is buying from them
–From net sale of goods and services
•
Receives foreign currency
14
•
Buy foreign assets
•
Capital - flowing out of the country: NCO > 0
• When NX < 0 (trade deficit)
–Buying more goods and services from foreigners
•
Than it is selling to them
–The net purchase of goods and services
•
•
•
Needs financed
Selling assets abroad
Capital - flowing into the country: NCO < 0
TABLES OF CONTENT
Chap 1: Introduction:................................................................................................1
Chap 2: AS- AD model................................................................................................2
Chap 3: AD & Fiscal Policy.......................................................................................5
Chap 4: Money & Monetary Policy........................................................................6
Chap 5: Unemployment............................................................................................8
Chap 6: Inflation.........................................................................................................8
Chap 7: Production and Growth............................................................................9
Chap 8: Saving, Investment, and the Financial System...............................10
Chap 9: Macroeconomics of the Open-Economy: Basic concepts...........13
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ESSAY
Topic 1: What is a bank run? Analyze causes and consequences of bank runs. Give an
example
Most likely all of us have never witnessed a bank run in real life, but some may have seen
one depicted in movies such as Mary Poppins or It’s a Wonderful Life. And now, we will
together answer the question in the problem: “What is a bank run?”
A bank run occurs when there is a sudden demand to withdraw money from a bank, that
the commercial bank struggles to meet. The first signs of ‘bank panic’ – another name of
bank run will encourage other depositors to also try and withdraw their savings, causing
a further ‘run on the bank.’
In a bank run, investors are trying to get back their deposits before the bank goes out of
business and depositors can no longer access their deposits.
A bank run occurs when savers become concerned about the liquidity of a bank and so
seek to withdraw their savings and put it other assets, such as cash savings. When a bank
receives multiple demands to withdraw money, it becomes unable to meet all the
demands and has to call in loans, sell assets or impose restrictions on withdrawals.
Then we will analyze the causes of a Bank Run. First of all, when savers invest money in a
bank. The bank doesn’t keep all the deposits in cash reserves. It is called fractionalreserved banking. It is more profitable for a bank to lend a high percentage of deposits
in the form of loans. It is lending money to homeowners and business, which allow the
bank to make a profit on its deposits. For instance, if a bank had deposits of $1 million, it
might lend out $0.9 million and keep only a reserve of $0.1 million (or 10% of deposits).
Secondly, if savers all demanded their cash at once, the bank wouldn’t be able to meet
the demand for cash. It would have to call in loans or sell its assets. However, the bank
relies on this not occurring. In normal circumstances, the bank can predict how much
cash savers will need to withdraw.
Nevertheless, suppose the bank lent out money to a business, but there is a recession.
Firms go out of business and its bank loans default. Also, if house prices fall and
consumers can’t meet mortgage repayments, the banks will lose on its mortgage loans.
In other words, the bank is losing money on its loan. Its balance sheet deteriorates, and
its liabilities (deposits) could become greater than its assets (loans). In other words, the
bank is in fact solvent.
If consumers hear bad economic news and news that a bank may be going out of
business, then there is an incentive for consumers to withdraw their money before the
bank go bankrupt. When news spreads that other savers “run” to the bank to withdraw
their deposits, it creates a snowball effect and encourages other savers to also want to
withdraw money.
Next, we will discuss about the consequences of Bank Run. Firstly, the bank run had dire
consequences for the economy. People lost confidence in the banking system and so
saved money in cash. Banks were starved of funds and unwilling to lend to business. As a
result, business investment dried up.
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Secondly, the collapse in confidence also discouraged any big investment or spending
plans.
Eventually, the bank collapses led to a fall in the money supply and a period of deflation.
Deflation aggravated the real burden of debt, causing a further decline in real GDP.
Bank runs complicate the control of the MS. An important example of this problem
occurred during the Great Depression in the early 1930s.
In the 1930s, the US experienced numerous bank runs. The first cause might be mention
is growth in credit during the 1920s. For instance, many consumers bought shares ‘on
the margin,’ i.e. borrowed money to buy shares.
Additionally, banks were local and focused on a particular region. When a local business
went under, everyone knew it would affect their local bank.
The Wall Street Crash of 1929 also caused stock market investors to lose money –
especially those who bought on the margin. Many ‘paper millionaires became broke –
owing more than they owed. This caused an increase in bank withdrawals. More
seriously, banks also lost money from lending people money, which they now couldn’t
pay back after the stock market fall.
Another reason is agricultural recession. Throughout the 1920s, US agriculture was in
recession with many farmers going out of business due to low prices and poor harvests.
After Great Depression, the economic panic caused consumers to cut back on spending
and firms to cut back on investment. Economic growth and GDP fell sharply, leading to
firms going bust and unemployment to rise.
Some regional banks started to struggle to meet the demand for withdrawals. This
created a loss of confidence in the local, regional banks and investors became sensitive to
news their bank would be next. Any negative news would create an incentive for people
to rush to the bank and withdraw money.
Even the smallest negative news could cause problems. In Dec 1930, the New York Times
reported a small merchant was advised by the Bank of the United States that his stock
was a good investment. However, the merchant took this as a warning that the bank was
refusing to sell his stock. The news spread like wildfire and within hours, 3,000
depositors had withdrawn $2 million.
Topic 2: What can the government do to reduce unemployment?
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All we know unemployment is a big problem in the economy. Therefore, the government
have to face up with this issue and find the suitable solutions. Depending on the types of
unemployment, there are two main strategies for policymakers to reduce
unemployment. The first one is demand side policies which reduce the unemployment
caused by recession. The other is supply side policies which reduce the natural rate of
unemployment
With the first strategy, US and UK were more successful in reducing unemployment after
9/2008 recession.
Fiscal policy can decrease unemployment by helping to increase aggregate demand and
the rate of economic growth. The government will need to pursue expansionary fiscal
policy; this involves cutting taxes and increasing government spending. Lower taxes
increase disposable income and therefore help to increase consumption, leading to
higher aggregate demand.
With an increase in AD, there will be an increase in Real GDP. If firms produce more,
there will be an increase in demand for workers and therefore lower demand-deficient
unemployment. Also, with higher aggregate demand and strong economic growth, fewer
firms will go bankrupt meaning fewer job losses.
In a recession, resources (both capital and labor) are idle. Therefore, the government
should intervene and create additional demand to reduce unemployment.
This shows an increase in AD causing higher real GDP. The increase in output leads to
firms needing more workers.
However,
1. It depends on other components of AD. e.g. if confidence is low, cutting taxes may
not increase consumer spending because people prefer to save. Also, people may
not spend tax cuts, if they will soon be reversed.
2. Fiscal policy may have time lags. E.g., a decision to increase government spending
may take a long time to affect aggregated demand (AD).
3. If the economy is close to full capacity, an increase in AD will only cause inflation.
Expansionary fiscal policy will only reduce unemployment if there is an output
gap.
4. Expansionary fiscal policy will require higher government borrowing – this may
not be possible for countries with high levels of debt, and rising bond yields.
5. In the long run, expansionary fiscal policy may cause crowding out, i.e. the
government increase spending but because they borrow from the private sector,
they have less to spend, and therefore AD doesn’t increase. However, Keynesians
argue crowding out will not occur in a liquidity trap.
Monetary policy would involve cutting interest rates. Lower rates decrease the cost of
borrowing and encourage people to spend and invest. This increases AD and should also
help to increase GDP and reduce demand deficient unemployment.
Also, lower interest rates will reduce exchange rate and make exports more competitive.
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In some cases, lower interest rates may be ineffective in boosting demand. In this case,
Central Banks may resort to Quantitative easing. This is an attempt to increase the
money supply and boost aggregate demand. However,

Similar problems to fiscal policy. e.g. it depends on other components of AD.

Lower interest rates may not help boost spending if banks are still reluctant to
lend.

Demand side policies can contribute to reducing demand deficient
unemployment e.g. in a recession. However, they cannot reduce supply side
unemployment. Therefore, their effectiveness depends on the type of
unemployment that occurs.
Supply side policies deal with more micro-economic issues. They don’t aim to boost
overall aggregate demand but seek to overcome imperfections in the labor market and
reduce unemployment caused by supply side factors. Supply side unemployment
includes: Frictional, structural and classical (real wage)
1. Education and training. The aim is to give the long-term unemployed new skills which
enable them to find jobs in developing industries, e.g. retrain unemployed steel workers
to have basic I.T. skills which help them find work in the service sector. – However,
despite providing education and training schemes, the unemployed may be unable or
unwilling to learn new skills. At best it will take several years to reduce unemployment.
2. Reduce the power of trades unions. If unions can bargain for wages above the market
clearing level, they will cause real wage unemployment. In this case reducing the
influence of trades unions (or reducing Minimum wages) will help solve this real wage
unemployment.
3. Employment subsidies. Firms could be given tax breaks or subsidies for taking on
long-term unemployed. This helps give them new confidence and on the job training.
However, it will be quite expensive, and it may encourage firms to just replace current
workers with the long-term unemployment to benefit from the tax breaks.
4. Improve labor market flexibility. It is argued that higher structural rates of
unemployment in Europe is due to restrictive labor markets which discourage firms
from employing workers in the first place. For example, abolishing maximum working
weeks and making it easier to hire and fire workers may encourage more job creation.
However, increased labor market flexibility could cause a rise in temporary employment
and greater job insecurity.
5. Stricter benefit requirements. Governments could take a more pro-active role in
making the unemployed accept a job or risk losing benefits. After a certain period, the
government could guarantee a public sector job (e.g. cleaning streets). This could
significantly reduce unemployment. However, it may mean the government end up
employing thousands of people in unproductive tasks which is very expensive. Also, if
you make it difficult to claim benefits, you may reduce the claimant count, but not the
International Labor force survey.
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6. Improved geographical mobility. Often unemployed is more concentrated in certain
regions. To overcome this geographical unemployment, the government could give tax
breaks to firms who set up in depressed areas. Alternatively, they can provide financial
assistance to unemployed workers who move to areas with high employment. (e.g. help
with renting in London)
7. Maximum working week. It has been suggested a maximum working week of (for
example 35 hours) would lead to firms needing to hire more workers and reduce
unemployment.

However, a maximum working week may increase a firm’s cost and therefore they
are not willing to hire more. Also, there is no certainty a firm will respond to a cut
in hours by employing more – they may try to increase productivity. Those with
wrong skills will still face same problem.
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Topic 3: Should policymakers use fiscal policy to control aggregate demand and
stabilize the economy? If so, when? If not, why not?
We have known how changes in aggregate demand and aggregate supply can lead to
short-run fluctuations in production and employment. We also saw how monetary and
fiscal policy can shift aggregate demand and, thereby, influence these fluctuations. But
even if policymakers can influence short-run economic fluctuations, does that mean they
should? Our first debate concerns fiscal policymakers should use the tools at their
disposal in an attempt to smooth the ups and downs of the business cycle.
Firstly, we assume that policymakers should use fiscal policy to control AD…
Policymakers Should Try to Stabilize the Economy Left on their own, economies tend to
fluctuate. When households and firms become pessimistic, for instance, they cut back on
spending, and this reduces the aggregate demand for goods and services. The fall in
aggregate demand, in turn, reduces the production of goods and services. Firms lay off
workers, and the unemployment rate rises. Real GDP and other measures of income fall.
Rising unemployment and falling income help confirm the pessimism that initially
generated the economic downturn.
Such a recession has no benefit for society-it represents a sheer waste of resources.
Workers who become unemployed because of inadequate aggregate demand would
rather be working. Business owners whose factories are left idle during a recession
would rather be producing valuable goods and services and selling them at a profit.
There is no reason for society to suffer through the booms and busts of the business
cycle. The development of macroeconomic theory has shown policymakers how to
reduce the severity of economic fluctuations. By "leaning against the wind" of economic
change, fiscal policy can stabilize aggregate demand and, thereby production and
employment. When aggregate demand is inadequate to ensure full employment,
policymakers should boost government spending and cut taxes. When aggregate demand
is excessive, risking higher inflation, policymakers should cut government spending and
raise taxes. Such policy actions put macroeconomic theory to its best use by leading to a
more stable economy, which benefits everyone.
On other side, we consider that “Policymakers Should Not Try to Stabilize the Economy”
Although fiscal policy can be used to stabilize the economy in theory, there are
substantial obstacles to the use of such policies in practice.
One problem is that fiscal policy does not affect the economy immediately but instead
work with a long lag. Fiscal policy works with a lag because of the long political process
that governs changes in spending and taxes. To make any change in fiscal policy, a bill
must go through congressional committees, pass both the House and the Senate, and be
signed by the president. It can take years to propose, pass, and implement a major
change in fiscal policy.
Because of these long lags, policymakers who want to stabilize the economy need to look
ahead to economic conditions that are likely to prevail when their actions will take
effect. Unfortunately, economic forecasting is highly imprecise, in part because
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macroeconomics is such a primitive science and in part because the shocks that cause
economic fluctuations are intrinsically unpredictable. Thus, when policymakers change
monetary or fiscal policy, they must rely on educated guesses about future economic
conditions.
All too often, policymakers trying to stabilize the economy do just the opposite.
Economic conditions can easily change between the time when a policy action begins
and when it takes effect. Because of this, policymakers can inadvertently exacerbate
rather than mitigate the magnitude of economic fluctuations. Some economists have
claimed that many of the major economic fluctuations in history, including the Great
Depression of the 1930s, can be traced to destabilizing policy actions.
In an ailing economy, it might be desirable if policymakers could eliminate all economic
fluctuations, but that is not a realistic goal given the limits of macroeconomic knowledge
and the inherent unpredictability of world events. Economic policymakers should refrain
from intervening often fiscal policy and be content if it does no harm.
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