Using graphical analysis, examine the view that unemployment is essentially a Keynesian problem

University Degree Business and Administrative studies

Student Number: 2011432859

Using graphical analysis, examine the view that unemployment is essentially a Keynesian problem.

Assignment 2

Business Environments

Module: 26301

Tutor: Leigh Davison

Student Number: 2011432859

John Maynard Keynes was an economist and political philosopher who was remarkably made famous overnight with his 1919 book, “Economic Consequences of the Peace” where he predicted that Germany would escalate the Second World War because of hyperinflation. (Baumol et al, 1997, p530). He is well known for his masterpiece published in 1936, “The General Theory of Employment, Interest and Money” on which most of modern macroeconomics is based upon. In this book, he argues that full employment was not a natural phenomenon, and that employment levels are determined by the spending of money and not by the price of labor as suggested by neoclassical economists.

The matter of unemployment is a macroeconomic problem that has the most severe impact on individuals. Most people rely on their income from labor to maintain or even increase their living standards but also a sense of their personal achievements. The loss of a job would mean lower living standards and often a fall in their self-esteem. Moreover, involuntary unemployment also harms the whole economy, as they are not contributing to the economy’s production and potential output is wasted; they are viewed as the burden of the economy and adversely affect the growth of the country (Lipsey et al, 2007). As a result, unemployment is a recurring debated matter of governments.

There are two main types of unemployment, equilibrium and disequilibrium unemployment. Keynesian unemployment is often referred as demand deficient or cyclical unemployment and is categorized to being in disequilibrium; this is where “real wage rates in the economy are above the equilibrium level” (Sloman et al, 2010).

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Cyclical unemployment is strongly linked with the business cycle where it can start to develop during a downturn and increase significantly during a recession because of the closure of businesses and staff being laid off. This particular type of unemployment generally occurs when there is insufficient demand in the economy to maintain the full employment levels thereby causing a recessionary gap. This is illustrated in Figure 1 when an economy is below full capacity and demand subsequently falls and shifts to the left because firms will demand less labor as demand for goods and services decrease thus reducing production levels. If there is resistance to the wage cuts, assuming that wages remain fixed, there will now be disequilibrium unemployment of b-a.

Figure 1

During the recession in 1990-1992, the demand levels for goods and services inevitably fell as unemployment rose. Figure 2 shows that unemployment peaked in 1993 at 3 million. UK unemployment was relatively low from the end of the 1990s to 2008, and then during the 2009 recession, it had risen dramatically to just over 2.5 million. This demonstrates that there is a trend and that unemployment is highly cyclical. Unemployment levels have typically increased to 3 million when the economy enters a recession. If the suspected double dip recession is to occur, the unemployment rate can be expected to reach 3 million.

Figure 2

Keynesian unemployment can be reduced by the use of demand side policies and implementing loose monetary and expansionary fiscal policies to boost effective aggregate demand. Measures in pursuing expansionary fiscal would involve increasing government spending and cutting taxes (e.g. VAT cut from 17.5% to 15% in 2008). A cut in taxes would increase consumer disposable income, resulting more goods and services demanded. If there is spare capacity in the economy, an increase in aggregate demand will favorably increase Real GDP. A higher production rate amongst organizations will mean higher demand for workers and therefore lower cyclical unemployment (Grant et al, 2005). The effectiveness of implementing fiscal measures depends on other components of aggregate demand, for example reducing taxes may not see an immediate increase on consumer spending if consumer confidence is low. The fiscal policy may also have time lags where a decision to increase government spending may take a long time to have the desired effects on increasing aggregate demand.

A measure of implementing a loose monetary policy would incorporate cutting interest rates where it would decrease the cost of borrowing and increase the spending and encourage people to spend. This increases aggregate demand and should again aid the growth of the economy and reduce demand deficient unemployment. In some cases, the lowering of interest rates may not be effective in boosting demand if banks are tentative about lending. If this is the case, then the Central Banks could use quantitative easing to increase money supply, thus increasing demand.

Sloman et al (2010) explains that there are two functions of wage rates. One is to balance the traditional demand and supply of labor and the other is to motivate workers. If wage rates were to be reduced, then there would be a surplus of labor yet the current employees would become demotivated and be less productive. On the other hand, increasing wage rates would motivate staff, reduce labor turnover and will find it easier to attract more experienced and qualified applicants and may experience a reduction of costs, therefore maintaining a higher real wage would be more beneficial to the employer. The efficiency wage rate is therefore more than likely to be above the market wage rate and Keynesian unemployment is still likely to continue.

In the event that real wages had decreased, it still may not resolve the issue of demand deficient unemployment. There is a possibility that it may be harmful, as a reduction in an individual’s income will lead to a reduction on their consumption of goods and services. The decrease in aggregate demand may have a knock on effect on the demand for labor and consequently, a reduction in wages shown by a shift of the aggregate demand for labor curve on Figure 1 from D1 to D2. Demand deficient unemployment will still exist, since a fall in wages would be falling towards the equilibrium wage, yet equilibrium is also decreasing and equilibrium will never be reached.

This Keynesian view on unemployment contrasts with the classical view on unemployment. The Keynesian view focuses on the demand side policies to reduce the demand deficient unemployment, which will occur during a recession. On the other hand, the classical view focuses on supply side policies to reduce real wage unemployment. Classical unemployment “exists when the real wages are kept at such a high level that demand for labor is greater than the supply of labor” (Anderton, 2006). Both cases of unemployment occurs when the market is in disequilibrium, yet classical economists put emphasis on supply side factors as the main cause of unemployment such as the power of trade unions, the quality of education and training etc. They also argue that cyclical unemployment only exists in the short run and that market forces will automatically restore the issue. Yet in practice, this rarely occurs and with aid of government intervention, the recession period can be shortened thus reducing unemployment at an earlier stage.

Bibliography

Sloman, J., Hinde, K. and Garratt, D. (2010) ‘Essentials of Economics’, Chapter 11.3 – Unemployment, 5th Edition, Harlow: Pearson Education Ltd, p353-360

Baumol, W. and Blinder, A. (1997) ‘Economics Principle and Policy’, Chapter 25 – Demand Side Equilibrium: Unemployment and Inflation, 7th Edition, Texas: The Dryden Press, P587-608

Anderton, A. (2006) ‘Economics’, Types of Unemployment, 4th Edition, Harlow: Pearson Education Ltd, p575-578

Grant, S., Vilder, C. and Smith, C. (2005) ‘Heinemann Economics A2 for AQA’, Chapter 6.6 – The causes of unemployment, Oxford: Hardlines Ltd, p167-169

Lipsey, R. and Chrystal, K. (2007) ‘Economics’, Chapter 26 – Unemployment, 11th Edition, Oxford: Hardlines Ltd, p576-587

Nordhaus, S. (2005) ‘Economics’, Chapter 13B – Labour Market Issues and Policies, 18th Edition, New York: McGraw Hill, P253-263