Chapter 23: Full Employment & a New Long-Run Equilibrium

Employment, Price Level, Inflation, Government Regulations, Changes in Competition

Full Employment

What is Full Employment?

The level of employment where there is no cyclical unemployment.

What is Full-Employment Level of Real GDP?

The level of output or real GDP at full employment.

What happens if actual employment is greater than full-employment?

The economy will begin to experience increasing rates of inflation.

Full Employment on an Aggregate Supply & Demand Curve

The second graph shows the shift left in the aggregate demand curve. Due to this shift, the economy is no longer producing at full employment & there is cyclical unemployment. The economy might be in a recession (a significant decline in production & employment; the decline is spread throughout the economy; and it lasts more than a few months).

Inflation-Unemployment Trade Off

When the cause of unemployment or inflation is change in the levels of total spending, we will see a trade off between the rates of unemployment and inflation. William Phillips first identified this relationship. This trade off does not exist when supply fluctuates, nor does it exist in the long run. In the long run, the Phillips curve will be a vertical one at the level of full-employment.

As spending rises, unemployment will fall – but part of the cost is an increasing rate of inflation. If spending falls, inflation will fall, but at the cost of rising unemployment.

What is ‘Demand-Pull’ Inflation?

When the cause of inflation is spending (aggregate demand) increasing more rapidly than aggregate supply.

However, in recent years, the Philips curve relationship has completely broken down!

What is ‘Stagflation’?

When the economy experiences rising inflation AND rising unemployment. It’s caused by changes in supply brought on by higher prices of inputs or higher costs of production. Also known as ‘cost-push’ inflation.

What are Supply Shocks?

Normally refers to a negative supply shock. Increasing prices of inputs or falling productivity will cause aggregate supply to be reduced. The result will be rising prices, falling output, and rising unemployment. For example, increases in oil prices is a negative supply shock. Falling oil prices are a positive supply shock.

Natural Adjustments - Inflation

Equilibrium in the Long Run

In the long run, equilibrium will always settle back to the point where aggregate demand & aggregate supply equal each other AT the level of full employment. In the long run, the curves will shift (thanks to inflationary pressures) back to the potential level (real GDP that can be produced in long-run equilibrium). This is also known as NAIRU (non-accelerating inflation rate of unemployment), which is a synonym for full employment. Since this shift to equilibrium in the long run is natural, full employment is something known as natural level of unemployment or natural level of output.

Natural Adjustments - Recession

This natural process of adjustment will also work in recessions. If spending falls, prices or inflation will be reduced. Output falls. Unemployment rises. Unemployed workers will offer to work for lower salaries. Employers will find it easier to attract workers even at lower wages. Wages will eventually begin to fall. As they do, costs of producing fall. As costs of producing fall, competition will force businesses to lower prices. The aggregate supply curve moves to the right. Prices fall, aggregate quantity demanded increases. The economy heads back toward the full-employment level of output.

This time, there is a difference in the natural process. It seems to take a lot longer for wages to fall than it does for wages to increase. We may not come out of a recession as quickly.

Journalists’ & Economists’ Views of Growth

To economists, economic growth is a sustainable increase in our abilities to produce more through a rise in resource endowments or an improvement in the state of technology. For that to happen, aggregate supply must increase along with aggregate demand.

In the journalist’s view, economic growth arises due to a rise in aggregate spending. Higher levels of total spending can be seen by a rightward shift in the aggregate demand curve, leading to higher output as well as inflationary conditions.

Causes of Full-Employment Rate of Unemployment

  • Rapid increases in the labor force participation mean more inexperienced workers, each one taking longer to find a job.
  • Increases in unemployment compensation lower pressures to find a job quickly and thus contribute to greater frictional unemployment.
  • Union contracts may cause wages to rise more rapidly in response to price increases (for example, by tying wage increases to CPI increases). Contracts can also prevent wages from falling.
  • More competition domestically/internationally & a willingness to lay off workers can hold down wage increases. Thus, even though unemployment may be less than the full-employment rate, inflation may not accelerate.
  • If import prices, energy prices, or food prices are rising/falling due to weather, political, or economic events in other countries, abilities of our companies to raise/lower prices will be affected.

In short, we never know exactly what the full-employment rate of unemployment is. Once the economy has gone to a lower rate of unemployment and inflation has accelerated, it is too late.


What is Hysteresis?

A phenomenon of short-term unemployment becoming long-term unemployment. An increase or decrease in short-term unemployment becomes persistent.

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