Question

In the country of Cardonia, the natural rate of unemployment is 3.5% according to the Ministry of Economics. Last year there was an economic slow down where the actual rate of unemployment increased to 4.5%. Assuming that the unemployment percentages are accurate for Cardonia, what is the likely outcome for the economy of Cardonia?

Cardonia’s economy will grow until real GDP is equal to potential real GDP and the unemployment rate equals 3.5%.

Calculations from the Ministry of Economics are incorrect since by definition the actual rate of unemployment cannot rise above the natural unemployment rate.

The structural rate of unemployment will increase until the natural rate of unemployment equals the current unemployment rate of 4.5%.

Answer 1

Increase in the level of unemployment from 3.5 per cent to 4.5 per cent in the economy due to economic slowdown will reduce the level of employment in the economy. As the level of employment reduces, the production level in the economy will reduce. Thus, the aggregate supply curve of the economy will shift leftwards due to decline in production level in the economy. Also the income of the workers will reduce because people will become unemployed and aggregate demand in the economy will also reduce. Thus, economy will be operating below its potential level and overall growth rate of output will decrease in the economy.