Chapter 10 · Macroeconomic objectives I: Low unemployment, low and stable rate of inflation
Cyclical unemployment: Keynesian
Use Keynesian AS to explain how weak aggregate demand causes cyclical unemployment. Identify unused resources and the full-employment output gap.
The economic idea
Unemployment is measured among people who are without work, available for work and actively seeking it. Cyclical unemployment is unemployment created by weak aggregate demand and falling real output during the business cycle.
The Keynesian aggregate-supply curve contains a horizontal section with substantial spare capacity, a rising section as bottlenecks emerge, and a vertical section at full-employment output. The shape rejects the assumption that flexible wages always return the economy rapidly to full employment.
An underemployment equilibrium occurs where AD intersects Keynesian AS below full-employment output. Planned expenditure equals current output, so the goods market can be in equilibrium even though labour and capital remain unemployed.
Expansionary fiscal or monetary policy may raise demand and employment when spare capacity is large, but its size and inflation effect depend on the multiplier, confidence, interest sensitivity, imports and the section of the AS curve on which the economy operates.
Reading the contraction from AD₁ to AD₂
“Price level” is on the vertical axis and “Real GDP” is on the horizontal axis.
“AD₁” is the initial aggregate-demand curve and “AD₂” is the current curve. “Keynesian AS” shows the output firms are willing to produce at different price levels.
The vertical section of “Keynesian AS” marks full-employment output. An equilibrium to its left is an underemployment equilibrium.
Starting point: E₁
“E₁” represents the initial equilibrium on “AD₁”. Its coordinates are the initial price level “PL₁” and real GDP “Y₁”.
The demand change: AD₁ to AD₂
“AD₂” lies to the left of “AD₁”, so aggregate demand has decreased. Real GDP falls from “Y₁” to “Yₑ” and the price level falls from “PL₁” to “PLₑ”. Because current output is below full-employment output, the graph shows a recessionary gap and cyclical unemployment.
From the output gap to unemployment
When firms cannot sell their previous output, they cut production and demand fewer workers. The diagram does not plot employment directly; cyclical unemployment is inferred from real GDP lying below the model’s full-employment output.
Why more orders can bring idle workers back
When firms have spare capacity but too few customers, extra planned expenditure can encourage them to raise production and hire workers. The employment gain comes through increased demand for output; it is not caused by the price-level label itself.
The size of the response depends on confidence, leakages and whether idle workers have the skills firms need. A rise in AD can reduce cyclical unemployment without eliminating structural or frictional unemployment.
Demand contraction and persistent underemployment
A fall in consumption, investment, government spending or net exports moves AD from “AD₁” to “AD₂”.
At the initial price level, planned expenditure is below output; inventories accumulate and firms reduce production.
The economy moves to “E”, changing output from “Y₁” to “Yₑ” and the price level from “PL₁” to “PLₑ”.
With sticky wages, pessimistic expectations and weak autonomous spending, the economy can remain at an underemployment equilibrium unless aggregate demand recovers or policy intervenes.
Common mistakes to avoid
- The output gap is not the unemployment rate; the diagram shows the macroeconomic cause, not a direct labour-market measurement.
- Cyclical unemployment must be distinguished from structural unemployment caused by a mismatch of skills or location.
- A movement from “Y₁” to “Yₑ” does not shift productive capacity by itself.
- Equilibrium does not always mean full employment: planned expenditure can equal output while resources remain idle.
How to draw this diagram
- Title the diagram “Cyclical unemployment: Keynesian”. Label the horizontal axis “Real GDP” and the vertical axis “Price level”.
- Draw AD₁ first and label it clearly.
- Draw AD₂ next and label it clearly.
- Draw Keynesian AS next and label it clearly.
- Mark each relevant intersection and distinguish the initial, market and socially optimum or policy outcomes where applicable.
- Project important intersections to the axes with dashed guide lines and label the outcomes.
- Check that every symbol used in the explanation appears on the diagram and add arrows showing the direction of change.
Assumptions and limitations
- The diagram infers labour-market effects from output and does not calculate the unemployment rate.
- Potential or full-employment output is estimated and can change after investment losses or hysteresis.
- The aggregate model hides different employment experiences across regions, industries and demographic groups.
- Expectations, financial conditions, exchange rates and policy responses can alter the size and duration of the downturn.