In the early 1970s, the US economy experienced simultaneously rising prices AND rising unemployment — a combination that puzzled policymakers. What type of shock best explains this?
AA negative demand shock — AD shifted left, reducing both output and the price level
BA positive demand shock — AD shifted right, creating overheating and then a crash
CA negative supply shock — AS shifted left, reducing output while raising the price level
DA multiplier effect — an initial spending collapse rippled through the economy and raised costs
Stagflation (rising prices + falling output) is the signature of a negative supply shock, not a demand shock. In the AS-AD diagram, a leftward shift of the AS curve simultaneously lowers real output AND raises the price level. The 1973 oil embargo is the textbook example. A negative demand shock (AD shifts left) also reduces output but lowers the price level, not raises it — which is why policymakers trained on demand-side tools were caught off guard. Option D (multiplier) is an amplification mechanism, not the type of initiating shock that produces stagflation.
Question 2 Multiple Choice
GDP officially reached its trough in June. Based on what you know about business cycle indicators, what should you expect about the unemployment rate over the following few months?
AUnemployment has already peaked and should start declining, since it moves simultaneously with GDP
BUnemployment is likely to continue rising for several more months before it peaks
CUnemployment is a leading indicator, so it already predicted the GDP trough weeks in advance
DUnemployment is unrelated to the GDP cycle — it depends only on demographic and structural factors
Unemployment is a lagging indicator — it continues rising for months after GDP has bottomed and recovery has begun. Firms are slow to hire (they wait for sustained demand recovery before committing to new labor costs) and were slow to fire during the contraction. This means unemployment typically peaks well after the GDP trough, and can still be rising while the expansion phase has already started. Option A reflects the common misconception that unemployment and GDP move simultaneously; option C gets the direction of lag backwards.
Question 3 True / False
A recession is officially defined as two consecutive quarters of negative GDP growth.
TTrue
FFalse
Answer: False
This is the most common misconception about recessions. The NBER, which officially dates US recessions, uses a broader definition based on multiple real-economy indicators — employment, real personal income, industrial production, and wholesale-retail sales — not just GDP. A severe single-quarter contraction could be declared a recession, while two mildly negative quarters might not be, if other indicators tell a different story. The 'two consecutive quarters' rule is a media shorthand, not the official definition.
Question 4 True / False
During a recession, investment spending typically falls more sharply than consumer spending.
TTrue
FFalse
Answer: True
Investment is far more volatile than consumption across the business cycle. This is explained by the accelerator mechanism: investment is driven by expected future demand. When current demand falls, firms have excess capacity and no reason to invest in new capacity — so investment collapses disproportionately. Consumer spending is smoother because households try to maintain their standard of living (consumption smoothing), using savings or borrowing to buffer income shocks. Investment volatility exceeding consumption volatility is one of the key empirical regularities of business cycles.
Question 5 Short Answer
Why does unemployment continue rising for several months after GDP has already begun recovering from a recession?
Think about your answer, then reveal below.
Model answer: Unemployment is a lagging indicator because firms are cautious about rehiring. Even after GDP begins growing again, employers wait to see if the recovery is sustained before committing to new hires — each new employee represents a significant ongoing fixed cost. Meanwhile, some workers continue losing jobs in sectors still adjusting to the downturn. Additionally, newly confident workers re-entering the labor force during early recovery temporarily show up as unemployed before finding work, which can keep the measured rate elevated even as the economy improves.
The lag reflects asymmetric adjustment: firms cut workers slowly on the way into recession (hoping the downturn is temporary) and hire back slowly on the way out (waiting for confidence). This means unemployment is politically salient long after the worst economic damage has passed — which is why policymakers often face pressure to 'do something' about unemployment even as the GDP recovery is already well underway.