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IB ECONOMICS EXAM ESSAYS

Question 3: What is demand deficient unemployment (cyclical), and
what can be done about it? Explain in detail the effects of fiscal and
monetary on the national GDP, use graphs. Evaluate the negative aspects
of government intervention in the economy. What is the Keynesian
Multiplier?
Answer:
As it is known, a low level of unemployment is one of the main
macroeconomic goals of every government. Unemployment essentially is
according to the International Labour Organization (ILO) “people of working
age who are without work, available for work, and actively seeking
employment”.
When we talk about demand-deficient unemployment or cyclical
unemployment we are talking about a type of disequilibrium which is
associated with the cyclical downturns in the economy. If an economy moves
into a period of slower growth or in recession, aggregate demand tends to fall
as consumers spend less on goods and services. This would lead to a fall in the
demand for labour, as firms would cut back on production. This could be
illustrated in the following graphs:

When an economy slows down, the aggregate demand is likely to fall as
shown in graph (a), from AD1 to AD2 which would cause the real output to fall
from Y1 to Y2. In the labour market this fall in the demand followed by a fall in
the real output or supply would mean a fall in the aggregate demand for
labour from ADL to ADL1 (graph (b)). In a perfect functioning labour market this
would lead to a fall in the real wages of workers from W e to W1. However this
does not occur since firms realize that paying lower real wages is likely to lead
to discontent and reduced motivation among workers therefore causing lower
workers productivity and this is not wanted. Further on, firms may not be able
to reduce wages due to labour contracts and trade union power. Consequently,
since wages are likely to remain at W e, the aggregate supply of labour will be

the solution to this type of unemployment should be the government intervention to bring about an increase in aggregate demand through the use of expansionary fiscal or monetary policies. To increase the AD the central bank might lower the base rate which would reduce the cost of borrowing and can lead to increases in both consumption and investment. Nevertheless. Direct taxes (taxes on income) can be raised or lowered to alter the amount of disposable income consumers have. Government spending and business investment are injections into the circular flow of income and any injections are multiplied through the . Both expansionary fiscal and monetary policies would lead to a raise of the national GDP as this one refers to the total of all economic activity in a country which is being increased. if consumer confidence is low then people might prefer to save and the AD might remain low. Monetary policies are defined as the set of official policies governing the supply of money in the economy and the level of interest rates in the economy. Having evaluated the possible government actions in order to intervene in the economy leading to a growth. Once again. In the long run this may lead to fiscal problems. Fiscal policies are defined as the set of a government’s policies relating to its spending and taxation rates. if consumer or business confidence is low then there is unlikely to be an increase in borrowing to finance consumption and investment. In order to use expansionary fiscal policy. The government may also encourage greater investment by lowering corporate taxes so that firms enjoy higher after-tax profits which can be used for investment. there are some concerns associated with the policies that the government may apply to intervene in the economy. a government may have to run a budget deficit spending more than it takes in revenues. Furthermore when governments reduce taxes. If governments reduce interest rates to encourage spending there is no guarantee that it will cause an increasing consumption or investment. governments may increase their spending in order to improve or increase public services which directly impacts upon AD. The main idea of this concept is that any increase in the aggregate demand will result in a proportionately larger increase in national income. As well.greater than the aggregate demand for labour and unemployment of a-b will be created. it is interesting to introduce the concept of the Keynesian multiplier. Given that the problem is due to the low level of aggregate demand. Therefore to increase the AD the government can lower income taxes increasing disposable income and encouraging greater consumption. there is no guarantee that people will spend their extra disposable income.

when all the money has been spent and re-spent ends up depending upon the marginal propensity to consume as well as upon the marginal propensity to withdraw (saving and spending on imports). saving some. who then behave in the same way paying some taxes. and spending some on imports. To conclude we may say that when talking about unemployment caused by a deficiency in the AD. the possible solutions to be applied by the government are the expansionary fiscal and monetary policies which will lead to an increase in the AD as well as an increase in the GDP. The money that is spent goes as income to a new set of recipients. leaving the rest to be spent on domestic good and services. The final addition to national income. During each “round” some income is withdrawn from the circular flow and some stays to be re-spent. However government intervention always have some negative consequences in the short and long run which should be foreseen.economy as people receive a share of the income and then spend a part of what they receive. .