Monetary and fiscal policy are government attempts to smooth the business cycle,

Question

Monetary and fiscal policy are government attempts to smooth the business cycle, especially the use of expansionary policies to return to GDP growth from a recession. The goals are relatively short-term, not more than 5 years. Long-term growth, however, is arguably more important.

A) During a recession, politicians and economists often speak of returning the nation to full employment. Does this mean zero unemployment? If not, why isn’t zero unemployment desirable?

B) Relatively free trade exists between the US and Mexico as a result of the North American Free Trade Agreement (NAFTA). Should the Law of One Price prevail in major consumer goods sold in the 2 countries? Explain.

Explanation / Answer

(A)

Full employment does not mean zero unemployment. Full employment is the employment rate prevailing at the potential GDP level when an economy is operating at its highest capacity utilitizing all available resources, including technology.

Zero unemployment is undesirable. Some amount of unemployment is beneficial for the economy, there is a tade off between inflation and unemployment. To keep inflation under control, some unemployment is required, however, this has to be kept within a limit.

Also, there is frictional unemployment where people search for jobs in between two jobs. A zero frictional unemployment implies that posting a vacany by a corporate and availability of the desired employee has to be simultaneous, which is an impossibility.

(B) Law of One Price (LOOP) says that identical goods should sell for identical prices in all countries, in absence of barriers to trade and after adjusting for exchange rate differences.

But LOOP between US & Mexico cannot hold. There are still trade barriers, albeit "invisible". First, trade is not costless, since transportation cost and cost of information are still existent. Second, for LOOP to hold, demand in both countries for the same good must be identical, which is irrational. Third, it means the tastes & preferences as well as income level in both countries must be the same, which, in reality, is not.

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