The economy of Budopia is going through a recession. How will a counte

The economy of Budopia is going through a recession. How will a countercyclical policy affect the labor market in Budopia if wages are flexible? Explain with a diagram.

What will be an ideal response?

ANSWER

Starting from a pre-recession equilibrium labeled as point E1 in the diagram below, the labor demand curve of Budopia will shift to the left during a recession, reducing employment and GDP. This will take the economy to the point marked E2, where employment and wages are lower. If wages are flexible, a successful countercyclical policy will shield the economy from the full impact of the recession by shifting the labor demand curve back to the right, taking the economy to the point labeled E3. Therefore, a successful countercyclical policy will lead to a partial increase in equilibrium employment and wage.