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

greater than the aggregate demand for labour and unemployment of a-b will
be created.
Given that the problem is due to the low level of aggregate demand, 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.
Fiscal policies are defined as the set of a governments policies relating to its
spending and taxation rates. Direct taxes (taxes on income) can be raised or
lowered to alter the amount of disposable income consumers have. Therefore
to increase the AD the government can lower income taxes increasing
disposable income and encouraging greater consumption. 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. As well,
governments may increase their spending in order to improve or increase
public services which directly impacts upon AD.
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. 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.
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.
Nevertheless, there are some concerns associated with the policies that the
government may apply to intervene in the economy. In order to use
expansionary fiscal policy, a government may have to run a budget deficit
spending more than it takes in revenues. In the long run this may lead to fiscal
problems. Furthermore when governments reduce taxes, there is no guarantee
that people will spend their extra disposable income; if consumer confidence is
low then people might prefer to save and the AD might remain low. If
governments reduce interest rates to encourage spending there is no
guarantee that it will cause an increasing consumption or investment. Once
again, if consumer or business confidence is low then there is unlikely to be an
increase in borrowing to finance consumption and investment.
Having evaluated the possible government actions in order to intervene in
the economy leading to a growth, it is interesting to introduce the concept of
the Keynesian multiplier. The main idea of this concept is that any increase in
the aggregate demand will result in a proportionately larger increase in
national income. Government spending and business investment are injections
into the circular flow of income and any injections are multiplied through the

economy as people receive a share of the income and then spend a part of
what they receive. The money that is spent goes as income to a new set of
recipients, who then behave in the same way paying some taxes, saving
some, and spending some on imports, leaving the rest to be spent on
domestic good and services. During each round some income is withdrawn
from the circular flow and some stays to be re-spent. The final addition to
national 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).
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. However government
intervention always have some negative consequences in the short and long
run which should be foreseen.