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Say you have a Keynesian diagram showing a recessionary gap where actual output is less than potential output, and aggregate demand is on the left of the full employment level of output (Yfe). If AD increases and shifts to the right, but does not reach the full employment level of output, and the price level (PL) increases, and the new AD curve is still on the left side of Yfe, would the increase in PL be called 'inflation'?

How do you know whether there is spare capacity in an economy?

When reading an article, how do you know whether aggregate demand is in the spare capacity section?

Can AD be somewhere in the middle - in between completely spare capacity and full capacity? What are the characteristics of this section?

Why are prices and wages sticky/inflexible? Can they be upwardly sticky/inflexible?

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OK so a lot of questions but here goes [Just FYI, I don't have time to sketch a graph so I'm hoping I interpreted your questions right]:


a) You now that because you're not at the Long Run level of output. Therefore you can have more production. The way I think of this generally think of it is like this: I have a factory that can produce 10 goods. At present, I'm just producing 6. So I can produce 4 more and therefore, my Long Run level is 10.


b) You really can't know for certain from most articles, but a good way is to see what's driving the inflation/deflation. So, for example, lets say the US raises government spending. This drives AD out (assuming it was in the LREQ). So essentially make a judgement call.


c) Yes it can be in the middle. The characteristics are that inflation > previous inflation and output>previous output (assuming AD to the left). Opposite if AD to right. An easy way to get this is make a rough sketch, and see where inflation and output are relative to where they were previously.

d) Wages are sticky because if I lower wages, my employees go to work in another place. So they can only go upwards. Generally this is in oligopolies. Generally can't be upward sticky because you can't really lower wages, so they have to rise.


Hope this helps. Please let me know if any of the things I said don't answer your question/I misunderstood it.

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Here are my answers:

  1. Inflation is a persistent increase in the average price level. If your price level has increased, then yes, it can be considered inflation (compared to the previous macroeconomic equilibrium).
  2. How to know if there is spare capacity: you look at hard data like real GDP and unemployment in the past years to have an idea about what figures you should see at the potential output of the country. For example, looking at the Swiss unemployment rate of the past 10 years (see pic below), it's pretty obvious that the natural rate of unemployment is somewhere between 3-3.5%, which means that this is the full employment of the country, so their GDP is equal to the full employment output (potential output) when the economy is operating at this unemployment rate. If unemployment goes substantially above this rate, you can assume that there is demand-deficient (cyclical) unemployment, which also indicates that there is spare capacity in the country. Spare capacity refers to the fact that there are unemployed resources (land, labour, capital) which could be put to production to reach the level of output that a country is potentially capable of producing.
    Switzerland Unemployment Rate 
    Also, if you really want to know how to calculate potential GDP, here is the formula (but this is beyond the IB Economics syllabus, so it is not required from IB students to know it): image.png.f04757251c2973ab1f9f96b2c7b53645.png
  3. Again, you check it against the data from the past and use the formula above.
  4. Any actual output which is below the full employment output means that there is spare capacity. When actual output is not that far from potential output, spare capacity is low. The characteristics of this section is that further boosts in AD will have larger and larger effects on inflation and lower and lower effects on real output. So if the economy is operating close to the full employment output, an increase in AD will have more of an inflationary effect while real GDP will increase less significantly.
  5. Wages are sticky downwards because when firms need to cut costs (e.g. because of lower AD in the country, leading to lower revenues of all firms), then one option would be to cut wages. However, wages are determined in employee contracts, and if a firm would decrease the wages of workers, these employees could go to court as the firms would be breaking their agreements. Also, many workers work for the minimum wage, and hence it is not legally allowed to give them less. Furthermore, labour unions could also start large-scale protests if companies would plan to lower wages. So for all these reasons (workers' contracts, minimum wage laws and labour unions), firms find it difficult to cut wages, and easier to cut jobs (i.e. fire workers) - and this is true for all types of firms and market structures. Hence wages tend not to decrease much even if there is a recession, while the unemployment rate increases as workers get fired and companies go bankrput. On the other hand, wages are rarely sticky/inflexible upward, as most workers are happy to accept higher wages.

Hope this helps, let me know if you have questions.

IB Economics teacher, examiner and tutor


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