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Economic Instability

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Economic Instability

You open the news, and you find out that Coinbase, one of the largest cryptocurrency exchanges in the world, is laying off 18% of its staff due to deteriorating economic conditions. You see that a couple of days later, Tesla, one of the largest EV makers, decided to cut some of its workforce, again due to economic conditions. What happens during times of economic instabilities? Why do people lose their jobs during such periods? What causes economic fluctuations, and what can the government do about them?

Economic instabilities can be quite severe and often result in many people being unemployed in the economy. Keep reading and get to the bottom of this article to find out all there is about economic instabilities!

Economic Instability Definition and Examples

What exactly is economic instability? We will go through economic instability and its examples in just a bit, but let us start with the definition. Although the economy might be pretty stable for the majority of the time, there are periods in which it may experience economic instability.

Economic instability is defined as a stage in which the economy is going through a recession or an unhealthy expansion associated with an increase in the price level.

We all know that a recession is bad, but why would an expansion become a problem? Think about it, an expansion might be driven by a massive increase in demand, and the supply can't keep up with demand. As a result, prices increase. But when prices rise, most people will lose their purchasing power. They won't be able to afford the same amount of goods and services as before as they need to have more money to pay for them.

A robust economy experiences expansion, maintains price stability, has a high employment rate, and enjoys consumer confidence. Businesses can be competitive, consumers are not adversely affected by the impacts of large monopolies, and the earnings of typical households are sufficient to satisfy their daily needs. The majority of individuals are even able to spend money on a few leisure activities.

On the other hand, instability in the economy causes a rise in prices, a loss of confidence among consumers, and an increase in the amount of effort that must be expended just to survive.

Instability in the economic system results when the elements that impact an economy are not in a state of equilibrium. Inflation is characterized by a decline in the value of money and occurs whenever an economy experiences periods of instability.

This results in higher pricing, increased unemployment rates, and overall anxiety among consumers and companies struggling to maintain their financial stability. To put it another way, people do not seem to be happy. They no longer invest and cannot purchase much due to their limited financial resources. This contributes to an even worse slowdown in the economy.

There are many examples of economic instability. The most recent example was in 2020 when COVID-19 hit the economy. Businesses were shutting down due to lockdowns, and there were many layoffs from work, causing unemployment to increase to record levels.

Consumer confidence dropped, and people started saving as they didn't know what the future would hold. Panic in the market also caused the stock prices to drop. This continued until the Fed intervened and promised to support the economy during that time.

Macroeconomic Instability

Macroeconomic instability occurs when the price level fluctuates, unemployment increases, and the economy produces less output. Macroeconomic instability comes with a deviation in the economy from its equilibrium level, often causing distortions in the market.

These distortions in the market then harm individuals, businesses, multinational companies, etc. Macroeconomic instability is concerned with deviations in macroeconomic variables such as the aggregate price level, aggregate output, and the level of unemployment.

Causes of Economic Instability

There could be several causes of economic instability; however, the main ones include fluctuations in the stock market, changes in the interest rate, fall in home prices, and black swan events.

Fluctuations in the stock market

The stock market provides one of the primary sources of saving for individuals. Many people invest their retirement money in the stock market to enjoy future benefits. Additionally, their trading stock price significantly influences multinational companies in the stock market.

If the prices were to fall, the company would incur losses, pushing them to lay off the workers they support with income. Considering these fluctuations in the stock market, such as the value of stocks dropping down significantly, can be pretty harmful to the economy.

Interest Rate Changes

Changes in the interest rate often cause the economy to experience a period of instability. Dropping the interest rate down to significantly low levels would inject a lot of money into the economy, causing the price of everything to go up. This is what the U.S. economy is currently experiencing in 2022.

However, to counter inflation, the Federal Reserve may decide to increase the interest rate. But as you might have heard, it fears that a recession might be coming along the way. The reason for that is that when the interest rate is high, borrowing becomes expensive, causing less investment and consumption.

Fall in home prices

The real estate market is one of the most important markets for the U.S. economy and economies around the world. A fall in home prices would send shocking waves around the economy, causing a period of instability. Think about it, people who have mortgage loans may find that the value of their houses has decreased to the point where they owe more on the loan than the property is now worth if home prices continue to decline.

They could stop making their payments on the loans, and they might also cut down on their expenditures. If they stop making payments on loans, it brings trouble to the bank, as it has to pay back depositors. This then has a spillover effect, and as a result, the economy becomes unstable, and the institutions suffer financial losses.

Black Swan Events

Black Swan Events include events that are unexpected but have a significant impact on the economy. Such events could be considered natural catastrophes, such as a hurricane hitting one of the states in the U.S. It also includes pandemics such as COVID-19.

Economic Instability Effects

Effects of economic instability could occur in many ways. The three main impacts of economic instability include: business cycle, inflation, and unemployment.

  • Business cycle: The business cycle could be expansionary or recessionary. An expansionary business cycle occurs when the total output produced in the economy is growing, and more people can find jobs. On the other hand, a recessionary business cycle occurs when the economy has less output, which results in higher unemployment. Both could be affected and triggered by economic instability.
  • Unemployment: Unemployment refers to the number of people who are looking for a job but cannot find one. As a result of economic instability, the number of unemployed people could grow significantly. This is indeed harmful and has other negative effects on the economy. The reason for this is when there are many unemployed people, consumption drops in the economy, which then causes losses to businesses. Subsequently, businesses end up laying off even more workers.
  • Inflation: Periods of economic instability could also cause the price level of goods and services to increase. When an event causes problems with the shipment of goods and services, which would harm the supply chain, it will make production more expensive and challenging. As a result, businesses would end up producing less output, and as you might know, less supply means higher prices.

Economic Instability Unemployment rate in the U.S. StudySmarterFigure 1. Unemployment rate in the U.S., StudySmarter Originals. Source: Federal Reserve Economic Data1

Figure 1 shows the unemployment rate in the United States from 2000 to 2021. In periods of economic instabilities such as the 2008-2009 Financial Crisis, the number of unemployed increased to almost 10% of the U.S. workforce. The unemployment rate went down until 2020 when it increased to slightly over 8%. The economic instability during this time resulted from the COVID-19 pandemic.

Economic Instability Solution

Fortunately, there are many solutions to economic instability. We've seen that several factors could lead to economic instability. Identifying those causes and designing policies that address them is a way to stabilize the economy again.

Some of the solutions to economic instability include: monetary policy, fiscal policy, and supply-side policy.

Monetary policies

Monetary policies are fundamental when it comes to combating the economic crisis. Monetary policy is conducted by the Federal Reserve. It controls the money supply in the economy, which impacts the interest rate and the price level. When the economy is experiencing a significant increase in the price level, the Fed increases the interest rate to bring down inflation. On the other hand, when the economy is down and less output is produced, the Fed decreases the interest rate, making it cheaper to borrow money thereby increasing investment spending.

Fiscal policies

Fiscal policies refer to the government's use of tax and government spending to affect aggregate demand. When there are recessionary periods, where you have low consumer confidence and lower output produced, the government may decide to increase spending or decrease taxes. This helps boost aggregate demand and raises the output produced in the economy.

The government may decide to invest $30 billion in building schools across the country. This will increase the number of teachers hired in schools and people working in construction. From the income that is generated through these jobs, there will be more consumption taking place. These types of policies are known as demand-side policies.

We have an entire article that covers demand-side policies in detail.

Feel free to check it out by clicking here: Demand-side Policies

Supply-side policies

Often, the economy is troubled by a decrease in output. Businesses need the necessary incentive to keep producing or increase their production rate. Increasing production leads to lower prices while everyone enjoys more goods consumed. Supply-side policies aim to do just that.

As a legacy of COVID-19, there are supply chain problems in the U.S. economy. Many businesses are finding it hard to find the raw materials they need in their production process. This increased the price of outputs, causing the general level of prices to go up. Less output is being produced.

In such cases, the government should incentivize businesses to produce more by either lowering taxes or aiming to solve the supply chain issues that caused the problem in the first place.

Economic Instability - Key takeaways

  • Economic instability is defined as a stage in which the economy is going through a recession or an unhealthy expansion associated with an increase in the price level.
  • Causes of economic instability include fluctuations in the stock market, changes in the interest rate, fall in home prices, and black swan events.
  • The three main impacts of economic instability include: business cycle, inflation, and unemployment.
  • Some of the solutions to economic instability include: monetary policy, fiscal policy, and supply-side policy.

References

  1. Federal Reserve Economic Data (FRED), https://fred.stlouisfed.org/series/UNRATE

Frequently Asked Questions about Economic Instability

Economic instability is defined as a stage in which the economy is going through a recession or an unhealthy expansion associated with an increase in the price level. 

The three main impacts of economic instability include business cycle, inflation, and unemployment.

Causes of economic instability include fluctuations in the stock market, changes in the interest rate, fall in home prices, and black swan events. 

There are many examples of economic instability; you have the most recent example in 2020 when COVID hit the economy. Businesses were shutting down due to lockdowns, and there were many layoffs from work, causing unemployment to increase to record levels. 

Some of the solutions to economic instability include monetary policy, fiscal policy, and supply-side policy.

Final Economic Instability Quiz

Question

What causes inflation in the economy?

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Answer

Many factors could contribute to an increase in inflation; here are some of the main ones: 

  • Demand-Pull Inflation
  • Cost-Push Inflation 
  • Wage-Price Spiral
  • Excessive Monetary Growth


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Question

What is inflation?

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Answer

Inflation captures the increase in the prices of goods and services that most people, including you, consume daily.  

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What are some of the categories included in measuring inflation?

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Answer

  • Food grains, metals, and fuel
  • Utility services such as electricity or transportation
  • Entertainment, health care, and labor services.

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Question

What is considered when calculating inflation?

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Answer

Price increases across a wide range of goods and services are considered when calculating inflation, which yields a single figure that may indicate the overall rise in the price level of goods and services over a given period.

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Question

Explain Demand-Pull Inflation

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Answer

Demand-Pull Inflation happens when all individuals in the economy try to buy more goods and services than the economy can produce. Hence, raising the price level.

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Question

Explain Cost-Push Inflation

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Answer

This type of inflation is driven by a rise in input prices that firms use to produce goods such as energy or wages. 

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Question

Explain wage-spiral inflation

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Answer

Occurs when an increase in the price level causes wages also to increase, adding more fuel to inflation and making it hard to stop.

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Question

Explain how excessive money growth causes inflation.

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Answer

When there is more money in the economy, it will be followed by an increase in the price level. 

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Question

What are the causes of demand-pull inflation?

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Answer

Causes of demand-pull inflation include a growing economy, increasing export demand, government spending, etc.

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Question

When does demand-pull inflation kicks in?

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Answer

Demand-pull inflation kicks in when consumer demand for many kinds of consumer products exceeds the available supply, which increases the cost of living overall. 

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Question

What are the main causes of cost-push inflation?


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Answer

The most prevalent reason for cost-push inflation is a rise in the cost of manufacturing, which may be anticipated or unanticipated depending on the circumstances.


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Question

What are the control measures of inflation?

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Answer

Price control imposed by the government on specific products or industries to control inflation is one common measure used. 

In addition, contractionary monetary policy is one of the most common and preferred measures to combat inflation in today's economy.

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Question

Name 5 causes of inflation.

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Answer

  • An expanding economy
  • Demand for increased exports
  • An increase in government spending
  • Money Supply
  • cost of manufacturing

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Question

Can natural catastrophes causes inflation?

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Answer

Natural catastrophes, including floods, earthquakes, fires, and tornadoes, are also a source of cost-push inflation.

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Question

What are the 3 tools the Fed uses to control inflation?

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Answer

  1. Reserve requirement ratio
  2. Federal Funds Rate
  3. Open market operations

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Question

What is a demand-side policy?

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Answer

demand-side policy is an economic policy focused on increasing or decreasing aggregate demand to influence unemployment, real output and the price level in the economy.

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Question

What are the two types of demand-side policies?

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Answer

Types of demand side policies include fiscal policy and monetary policy.

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Question

What are the four components of aggregate demand?

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Answer

There are four components of aggregate demand: Consumption spending (C), gross private domestic investment (IG), government expenditures (G), and net exports (XN). 

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Question

Give an example how a tax cut injects money in the economy, leading to a growth in GDP.

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Answer

A tax cut leaves businesses and consumers with extra cash, which they are encouraged to spend to stimulate the economy during a recession (two or more consecutive quarters - three-month periods - of reduced GDP). By increasing spending, the government has increased aggregate demand and can reduce unemployment by stimulating the economy.

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What are demand-side policies sometimes called?

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Answer

Keynesian economics.

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What did John Maynard Keynes say about using fiscal policies to stimulate aggregate demand?

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Answer

John Maynard Keynes argued that the government should use fiscal policies to lower unemployment numbers and stimulate total spending in the economy (aggregate demand). Keynes theory suggests that any change in the components of aggregate demand would also change the GDP. 

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Question

Explain monetary policy.

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Answer

Monetary policies are also known as demand-side policies. Monetary policies are designed by the Federal Reserve, the United States's central bank. Monetary policy directly impacts the interest rate, which then influences the amount of investment and consumer spending in the economy, both essential components of aggregate demand.

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Question

What happens if there is a lower interest rate in the economy?

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Answer

Suppose monetary policies favor low-interest rates. In that case, there will be more investment spending as it is cheap to borrow. Therefore, this will lead to an increase in aggregate demand.

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What happens to the economy when there is an increase in government spending?

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Answer

Total output produced and the price level increases.

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Question

Why monetary policy is demand side policy?


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Answer

Monetary policy is a demand side policy because it impacts the level of investment spending and consumer spending, which are some of the main components of aggregate demand.

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What is an example of a demand-side policy?


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The government investing $20 billion in building infrastructure across the country.

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What are the advantages of demand-side policies?


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A major benefit of demand-side policies is speed. 

A second significant benefit of demand-side policies is the ability to direct government spending where needed more. 

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What are the disadvantages of demand-side policies?


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Answer

A downside of demand-side policies is inflation. Rapid government spending may be too effective and result in rising prices. 

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What's the difference between supply-side and demand-side policies?

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Answer

When it comes to supply-side vs. demand-side policies, the main difference between the two is that the supply side aims to increase the long-run aggregate supply. In contrast, demand-side policies aim to increase aggregate demand in the short run. 

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Question

Name two types of supply-side policies.

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Answer

Lower taxes, lower interest rates, and better regulations that encourage firms to invest in their productive capacities and efficiencies and thus increase the long-run aggregate supply.

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Question

How does unemployment affect the economy?


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Answer

Uncertainty is one of the main consequences of unemployment. In an uncertain economy, workers start to decrease their consumption because they might be afraid that they will be laid off shortly.

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What are the causes of unemployment?


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Answer

Economists identify several main causes of unemployment such as frictional unemployment, structural changes in the economy or consumer preferences, outsourcing, swings in the business cycle, and seasonal changes.


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What are the examples for the consequences of unemployment?

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Uncertainty, decreases in consumption, high crime rates, and poverty are some consequences of unemployment.

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How does unemployment affect the government?


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Answer

The consequences of unemployment on the government are uncertainty and instability. In an unstable economy with high unemployment rates, governments should prioritize their work to create more jobs to decrease unemployment instead of working on public goods or the development of technology.


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How does unemployment affect an individual or a family?


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Answer

Among the consequences of unemployment, we can see the mental and material hardship unemployed workers face on an individual level.



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Question

What leads to long-term unemployment?

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Answer

Unemployment leads to instability in the economy which decreases consumption on average. Since this leads to further unemployment, the unemployed people would face even harder times finding a job. 


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What is frictional unemployment?


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It is one of the causes of unemployment and happens when workers switch between jobs for some reason. Generally, this leads to short-term unemployment and the resulting financial hardship is not so significant. 


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What is structural unemployment?


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Answer

Structural Unemployment is another cause of unemployment and happens when there is a fundamental change in the economy or consumer preferences. 


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What is outsourcing?

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Answer

Outsourcing is another reason for unemployment which means hiring people from outside to do specific jobs.

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What is the intention behind outsourcing?

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The intention is usually to decrease the operating costs by hiring people with lower wages from outside countries (or firms).

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What causes cyclical unemployment?


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The swings in the business cycle are the reason for cyclical unemployment. 

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What is long-term unemployment?

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Answer

Long-term unemployment refers to the unemployed workers who have not worked for at least 27 weeks and have actively looked for work for the past four weeks.


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What is the long-term unemployment rate?

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Answer

The long-term unemployment rate stands for the share of long-term unemployed workers among all unemployed workers

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What does it mean that the long-term unemployment rate is high?

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Answer

If the long-term unemployment rate is high then it means that the cause of the unemployment is persistent and probably due to structural causes, not a seasonal effect. 

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Question

What is the GDP gap?

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Answer

The GDP gap is the difference between the actual GDP and the potential GDP. The potential GDP shows the GDP that could be reached if all resources were used efficiently.

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Question

What is economic instability?

Show answer

Answer

Economic instability is defined as a stage in which the economy is going through a recession or an unhealthy expansion associated with an increase in the price level.

Show question

Question

What is an example of economic instability?

Show answer

Answer

There are many examples of economic instability; you have the most recent example in 2020 when COVID hit the economy. Businesses were shutting down due to lockdowns, and there were many layoffs from work, causing unemployment to increase to record levels. 

Show question

Question

What is macroeconomic instability?

Show answer

Answer

Macroeconomic instability occurs when the price level fluctuates, unemployment increases, and the economy produces less output. Macroeconomic instability comes with a deviation in the economy from its equilibrium level, often causing distortions in the market. 


Show question

Question

What causes economic instability?

Show answer

Answer

Causes of economic instability include fluctuations in the stock market, changes in the interest rate, fall in home prices, and black swan events. 

Show question

Question

Explain how fluctuations in the stock market may cause economic instability.

Show answer

Answer

The stock market provides one of the primary sources of saving for individuals. Many people invest their retirement money in the stock market to enjoy future benefits. Additionally, their trading stock price significantly influences multinational companies in the stock market. 


If the price were to fall, the company would incur losses, pushing them to lay off the workers they support with income. Considering these fluctuations in the stock market, such as the value of stocks dropping down significantly, can be pretty harmful to the economy. 

Show question

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