Question

Legislation proposes using macroeconomic policy to achieve 0% unemployment. How will this policy affect output and the price level in the short run and long run? Sketch an AD/AS diagram to illustrate.

a) Output will increase in short run; Price level decreases in long run
b) Output increases in short run; Price level increases in long run
c) Output decreases in short run; Price level decreases in long run
d) Output remains unchanged; Price level decreases in long run

Answer 1

Option A: Legislation proposing a 0% unemployment rate using macroeconomic policy will lead to an increase in output and decrease in price level in the short run.

Step-by-step explanation:

From a neoclassical perspective, if legislation proposes using macroeconomic policy to achieve a 0% unemployment rate, the effects on output and the price level in the short run and long run can be illustrated using an aggregate demand/aggregate supply (AD/AS) diagram.

In the short run, the policy may lead to an increase in output but a decrease in the price level. This is because an increase in aggregate demand can stimulate production and employment temporarily, but it can also lead to lower prices due to the downward stickiness of wages and costs. However, in the long run, the policy will result in a higher price level while the economy returns to potential GDP and the natural rate of unemployment.

In the long run, however, the extremely low unemployment rates caused by the policy will tend to bid up wages, shifting the short-run AS curve back to the left. This results in a higher price level, but the economy returns to its potential GDP and the natural rate of unemployment as determined by the long-run AS curve.