Full employment and involuntary unemployment
Full employment: all people who are able and willing to work at the current wage get work. Some unemployment still exists: people changing jobs (frictional) or who don't want to work at that wage (voluntary).
Involuntary unemployment: people are able and willing to work at the current wage but cannot find jobs. Keynes said this comes from too little aggregate demand.
Voluntary unemployment: a person does not want to work at the going wage. It is not a problem for policy.
Deficient demand and the deflationary gap
Deficient demand: AD is less than aggregate supply at the full-employment level.
Deflationary gap = AS at full employment โ AD at full employment. Example: Yf = 500, AD at 500 = 460, gap = 40.
Effects
- Unsold stocks โ firms cut output and jobs โ involuntary unemployment.
- Equilibrium settles below full employment (here at 300, as the multiplier works down: 40 ร 5 = 200 less).
- Prices tend to fall; investment falls.
Excess demand and the inflationary gap
Excess demand: AD is more than aggregate supply at the full-employment level.
Inflationary gap = AD at full employment โ AS at full employment. Example: AD at 500 = 540, gap = 40.
Effects
- All resources are already in use, so real output cannot rise.
- Buyers compete for the same goods โ general price level rises (inflation).
- Money income rises but real income does not; savers and fixed-income people lose.
Correcting through government spending and taxes (fiscal policy)
| Measure | Deficient demand | Excess demand |
|---|---|---|
| Government spending | Increase (roads, schools, jobs schemes) | Decrease |
| Taxes | Reduce, so people have more to spend | Increase, so people spend less |
| Public borrowing | Borrow less from the public | Borrow more from the public (soaks up spending) |
| Deficit financing | Can be used | Reduce |
A rise in G shifts AD up. With the multiplier, a gap of 40 needs only 40 of extra G to close (AD at Yf rises by 40); income rises by 40 ร k.
Correcting through money supply (monetary policy)
| RBI tool | Deficient demand (expand credit) | Excess demand (contract credit) |
|---|---|---|
| Repo / bank rate | Lower | Raise |
| Reverse repo | Lower | Raise |
| CRR / SLR | Lower | Raise |
| Open market operations | Buy bonds | Sell bonds |
| Margin requirement | Lower | Raise |
Cheaper, easier loans raise investment and consumption on credit โ AD up. Costlier, scarcer loans do the opposite.
Key formulas and definitions
- Deflationary gap = Yf โ AD at Yf
- Inflationary gap = AD at Yf โ Yf
- Change in equilibrium income = gap ร k, where k = 1/(1 โ MPC)
Worked examples
1. Full-employment output โน1000 cr. AD at that output โน900 cr. Name and measure the gap.
AD < AS at Yf: deficient demand. Deflationary gap = 1000 โ 900 = โน100 cr.
2. Full-employment output โน800 cr, AD at that level โน860 cr. Name and measure the gap.
Excess demand. Inflationary gap = 860 โ 800 = โน60 cr.
3. Deflationary gap is โน50 cr and MPC = 0.8. By how much is equilibrium income below full employment?
k = 5. Income shortfall = 50 ร 5 = โน250 cr.
4. C = 40 + 0.8Y, I = 60, full-employment output 600. Find AD at Yf and the gap.
AD at 600 = 40 + 480 + 60 = 580. Deflationary gap = 600 โ 580 = 20. (Equilibrium Y = 500, 100 below Yf = 20 ร 5.)
5. Prices are rising fast and there is full employment. Suggest one fiscal and two monetary measures.
Fiscal: cut government spending or raise taxes. Monetary: raise the repo rate; sell government bonds (OMO) or raise CRR.
6. Many people are willing to work at the current wage but no jobs exist. What is this and what may cause it?
Involuntary unemployment, caused by deficient demand (AD too low at full employment).
Common mistakes
- Measuring the gap at the current equilibrium instead of at full-employment output. The gap is measured at Yf.
- Saying excess demand raises real output. At full employment output cannot rise; only prices rise.
- Recommending buying bonds to fight inflation. Buying bonds adds money; to cut demand the RBI sells bonds.
- Calling someone who refuses to work at the going wage involuntarily unemployed. That is voluntary unemployment.