Question

QUESTION 3 (15marks) There are three possible states of an economy a. Describe the relationship between Real GDP and Natural Real GDP in the three states of an economy by using graph. (8 marks b. Describe the relationship between the unemployment rate and the natural unemployment rate in the three states of an economy. (7 mark

Answer 1

a) Relationship between real GDP and natural real GDP in three states of economy

1) Real GDP is less than natural real GDP

The diagram below shows the Ad curve and short and long run AS curves. The vertical line is the long run supply curve. We can see that when Q which is the short run equilibrium is at Q whereas the long run or natural real GDP is at Qn which is higher than the short run real GDP. This is the recessionary gap. It means that the economy is producing at a level loweLthan the natural real GDP.

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2) When real GDP is greatet than natural real gdp

This happens when the short run equilibrium is more than the long run equilibrium ie the short run real gdp is more than Qn ie natural real gdp as in the figure.

Such a situation is called inflationary gap.

3) Real GDP is equal to natural real GDP

Here the long run and the short run equilibrium are the same ie the real gdp is equal to natural real gdp (at Qn). So here the economy is at long run equilibrium.

b) Relationship between unemployment rate and natural unemployment rate

In recessionary gap , the unemployment rate is more than natural level of unemployment. This means that more people than the natural level are unemployed. This implies that there exists surplus in labour market.

In inflationary gap , the unemployment rate is less than the natural level of unemployment. This means that more people are employed than natural level. So there would be shortage of labour in labour market.

When the economy is in long run equilibrium, the natural rate of unemployment is equal to unemployment. So there is neither a surplus nor a shortage but an equilibrium in labour market.

(You can comment for doubts)