Equilibrium vs. Full Employment: Keynesian and Classical Models

Posted on Sep 5, 2024 in Economy

Using the Keynesian AD/AS Diagram to Explain Equilibrium Output

Real output is the value of all final goods and services produced in an economy, adjusted for inflation. Equilibrium occurs when real output demanded equals real output supplied, represented by the intersection of the Aggregate Demand (AD) and Aggregate Supply (AS) curves.

The Keynesian AS curve has three distinct segments:

  • Horizontal (Recessionary Gap): An increase in AD only increases output, as there is significant spare capacity in the economy.
  • Upward Sloping (Resource Bottlenecks): An increase in AD increases both price level and output as resource constraints emerge.
  • Vertical (Full Employment): An increase in AD only increases inflation, as the economy is already operating at maximum capacity.

Keynesian economics assumes downward wage stickiness, meaning workers are resistant to wage cuts even during periods of high unemployment. This stickiness can lead to an economy remaining stuck in a recessionary gap.

Example: The US Economy

  • 2007 Financial Crisis: High unemployment persisted for several years, representing a recessionary gap. Even with unemployed resources, wages did not adjust downward quickly enough to clear the market.
  • 2017 Recovery: AD increased, leading to output growth and a decrease in unemployment. The economy remained below full employment, allowing for output expansion without significant inflationary pressures.

Why Economies Get Stuck in Recession: Keynesian vs. Classical Views

The Keynesian model suggests that an economy can remain in a deflationary (recessionary) gap due to downward wage stickiness. Workers are unwilling to accept lower wages, preventing the labor market from reaching equilibrium and keeping output below its full employment level.

In contrast, the Classical model assumes flexible factor costs in the long run. If wages and prices can adjust freely, the economy will naturally return to full employment. The Classical model argues that government intervention is unnecessary, as market forces will eventually restore equilibrium.

The Classical Model’s Self-Correcting Mechanism

The Classical model suggests that the economy will always return to full employment following a recession due to flexible prices and wages. Let’s illustrate this with an example:

  1. Initial Equilibrium: The economy starts at full employment (Y1) with a given price level (P1).
  2. Recession: A decrease in AD leads to a lower output level (Y2) and a decrease in the price level (P2). This situation represents a deflationary gap.
  3. Self-Correction: With lower prices, the cost of production decreases. This decrease shifts the Short-Run Aggregate Supply (SRAS) curve to the right.
  4. Return to Full Employment: The shift in SRAS continues until the economy returns to the full employment output level (Y1) at a new, lower price level (P3).

Is an Increase in Aggregate Demand Always Inflationary?

Whether an increase in AD always leads to inflation depends on the model used and the economy’s current state.

Classical View

The Classical model argues that an increase in AD will always be inflationary, at least in the short run. As AD increases, output expands beyond the full employment level, leading to competition for resources and driving up prices. This inflationary pressure continues until the economy returns to full employment at a higher price level.

Keynesian View

The Keynesian model suggests that the inflationary impact of increased AD depends on the economy’s position relative to full employment:

  • Recessionary Gap: An increase in AD primarily boosts output without significant inflation, as there is spare capacity in the economy.
  • Near Full Employment: An increase in AD leads to a mix of output growth and inflation, as resource constraints begin to bind.
  • Full Employment: An increase in AD primarily results in inflation, as the economy is already operating at maximum capacity.

Examples

  • Japan experienced prolonged periods of low inflation despite policy efforts to boost AD, suggesting the economy operated below full employment.
  • Other economies have experienced inflation due to demand-side policies when operating near or at full employment.

Key Differences Between Equilibrium and Full Employment

While often used interchangeably, equilibrium and full employment represent distinct concepts in macroeconomics.

  • Equilibrium Output: The level of output where AD intersects AS. It represents the point where planned aggregate expenditure equals the output produced.
  • Full Employment Output: The level of output achievable when all factors of production are fully employed. It represents the economy’s potential output given existing resources and technology.

In the Classical model, the long-run equilibrium output level coincides with full employment. However, in the Keynesian model, short-run equilibrium output can deviate from full employment due to factors like wage stickiness. These deviations can lead to either inflationary or deflationary gaps.

Understanding the differences between these models and the factors influencing equilibrium and full employment is crucial for policymakers to make informed decisions regarding economic stabilization and growth.