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ECO202 Macroeconomics

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  • Course Code: ECO202
  • University: Elite Education
  • Country: Australia

Questions:

  1. Explain three types of unemployment.

  2. Explain why the supply curve for labour market slopes upward, how government determine the minimum wages and how minimum wages impact unemployment.
  1. Suppose the Reserve Bank of Australia increases the interest rate. What happens to the supply and demand for Australian dollars? Does the dollar appreciate or depreciate? Explain with words and a diagram.
 

Answers:

1.

The three main forms of unemployment are structural unemployment, frictional unemployment and cyclical unemployment. The first two represent natural unemployment while the third occurs due a decline in demand during recession.

Structural unemployment 

The labor market suffers structural unemployment due to a shift in the economic structure creating divergence between skills that workers possess and the skills that employers actually need (Goodwin et al. 2015). An example of such structural shift is replacement of manual workers with robots. It is now necessary for workers to learn how to operate these robots. Workers who are unable to learn require training for new types of job and experiencing structural unemployment. Structural unemployment often results from long recession. During long recession, people remain unemployed for a considerably long time and their existing skills are likely to become obsolete. They then take either unskilled jobs or stay unemployed until economic recovery. In such a situation, structural unemployment results in a high rate of natural unemployment.

Frictional unemployment 

Frictional unemployment in the economy occurs when workers though leave their existing but not found a new job.  Unemployment created during the transition period from one job to other is known as frictional unemployment. In most of the times worker voluntarily leave the labor market to look for a better opportunity. Students face frictional unemployment when they search for their first job after completing education (Uribe and Schmitt-Grohe 2017).  Frictional unemployment can also occur in situations where workers are laid off from their job due to some business specific reasons such as shut down of plant. Frictional unemployment is a short term problem and constitutes a part of natural job search. Frictional unemployment hence is not a serious problem for the economy.

Cyclical unemployment 

Cyclical unemployment in the economy is caused when the economy faces contraction phase of business cycle. The economy experiences a dramatic fall in demand of good and services during this time. This forces business to contract production and lay off workers in order to reduce costs (Heijdra 2017). This type of unemployment tends to aggravate the problem of unemployment as unemployed workers cut down their spending on goods and services, which further lower demand. Government intervention is necessary to recover the economy from business cycle downturn.

 

2. Upward sloping labor supply curve 

Labor supply curve represents the relationship between availability of workers and market wage. In general, there is a positive relation between wage and supply of labor. That is supply of labor increases with increase in wage and vice-versa. The main reason for an upward sloping labor supply curve is the fact that when wage increases, more workers enter the industry because of the higher rewards (Agenor and Montiel 2015). The increased labor supply arises either from increase in labor supply by the existing workers or new supply caused from new industries. The upward sloping labor supply curve can further be explained by dominance of substitution effect over income effect of increased wage.

Determination of minimum wage and its impact on unemployment 

Minimum wage is a legal minimum wage set by the government. Government determines minimum wage considering the following factors.

Need of the workers and their families: Government first determines the demand of living wage. Then government adjusts the nominal wage with respect to consume price index. The needs of workers and their families are then evaluated to determine the minimum wage requirement in the economy.

Capacity to pay: Government also evaluates the capacity of payment in terms of fair return on invested capital and productivity (Garnero, Kampelmann and Rycx 2015).

Economic and social development: The determination of minimum wage is also based on the need for investment in the country, impact of wage on generation of employment and family income and the distribution of wealth and income along with the goals of social and economic development.

An unintended consequence of minimum wage is it aggravates the problem of unemployment. Minimum wage set above the free market equilibrium wage distorts the labor market outcome. The high wage increases labor supply in the economy. Businesses on the other hand because of higher wage cost reduces labor demand (Mankiw and Kneebone 2013). As supply of labor exceeds that of the demand, there is a surplus of labor in the market. Consequently, unemployment increases in the economy.

 

Figure 1: Minimum wage and unemployment

3.

The Reserve Bank of Australia controls the overall interest rate in the economy. An increase in interest rate indicates a tight monetary policy (Johnson 2017). Such policy affects the foreign exchange market by altering demand and supply of currencies. Foreign investors invest in a country with the hope of earning a return. When rate of return in a nation is relatively high, then the country is able to attract more foreign investment. In contrast, when return is relatively low, foreign funds tend to flow out from the economy. An increase in interest rate in the Australian economy increases the return from the yielding securities. The investment in Australia thus promises a higher return to the invested fund. Consequently, more investors will demand Australian dollar in order to buy more interest bearing assets in Australia. Fewer investors now supply Australian dollar and this reduces supply of Australian dollar. The increased demand for Australian dollar increases the relative price of Australian dollar causing dollar to appreciate (Mankiw 2014). The equilibrium adjustment in foreign exchange market is illustrated below.

 

Figure 2: Increase in interest rate and effect on Australian dollar

In the above figure DD and SS represent the respective demand and supply curve in the foreign exchange market. Equilibrium in the market occurs where demand and supply of Australian dollar intersect. The equilibrium is at A. The corresponding exchange rate is given as E. Now an increase in interest rate increases demand for Australian dollar by increasing return from investment in Australia.  Expansion of demand of Australian dollar shifts the demand curve from DD to D1D1.  Supply of Australia dollar on the other hand reduces shifting the supply curve left to S1S1. The equilibrium in the foreign exchange market shifts from A to B. Accordingly, the relative price of Australian dollar increases. The relatively stronger currency implies appreciation of Australian dollar.

 

References

Agenor, P.R. and Montiel, P.J., 2015. Development macroeconomics. Princeton University Press.

Garnero, A., Kampelmann, S. and Rycx, F., 2015. Minimum wage systems and earnings inequalities: Does institutional diversity matter?. European Journal of Industrial Relations, 21(2), pp.115-130.

Goodwin, N., Harris, J.M., Nelson, J.A., Roach, B. and Torras, M., 2015. Macroeconomics in context. Routledge.

Heijdra, B.J., 2017. Foundations of modern macroeconomics. Oxford university press.

Johnson, H.G., 2017. Macroeconomics and monetary theory. Routledge.

Mankiw, G. and Kneebone, R.D., 2013. Principles of Macroeconomics, 6Ce (Vol. 6). Nelson Education.

Mankiw, N.G., 2014. Principles of macroeconomics. Cengage Learning.

Uribe, M. and Schmitt-Grohe, S., 2017. Open economy macroeconomics. Princeton University Press.

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