Monday, September 15, 2008

Cyclical (Keynesian) Unemployment

Cyclical (Keynesian) unemployment is the deviation of unemployment from its natural rate. The natural rate of unemployment (5.5%) is the normal rate of unemployment around which the unemployment rate fluctuates. Cyclical (Keynesian) unemployment is caused by downturns in the economy that are part of the business cycle. The business cycle is the natural fluctuations in the economy.

The graph below illustrates how the unemployment rate has fluctuated over the last half-century.

Source: Bureau of Labor Statistics

Cyclical unemployment is also called Keynesian unemployment. John Maynard Keynes (1883-1946) was a British economist who popularized the idea that the government should play an active role in managing the economy. This is a departure from Classical economic theory, which suggests there is no role for government because the economy corrects itself. Keynes agreed that the economy might correct itself in the long run. However, he thought a natural correction might take an extremely long time. The Great Depression motivated Keynes to say “in the long run we are all dead.” Keynes’ most famous book, published in 1936, is entitled The General Theory of Employment, Interest, and Money.

The remedy for cyclical (Keynesian) unemployment is an increase in overall spending on newly produced goods and services, which economists refer to as aggregate demand. In the U.S. economy, increased demand for American products encourages U.S. businesses to produce more output. Businesses may hire additional workers to help produce the additional output needed to satisfy the increased demand. Thus, increased aggregate demand tends to reduce unemployment.

A closer look at the components of aggregate demand make it easier to develop appropriate macroeconomic strategies. Aggregate demand (AD) refers to total spending in the economy on newly produced goods and services.

AD = C + I + G + X - M or AD = C + I + G + NE

C = consumption spending (mostly by households)

I = investment spending (mostly by businesses)

G = government purchases of goods & services (It does not include transfer payments.)

X = exports of domestically produced goods & services to foreign purchasers

M = imports of foreign produced goods & services by domestic purchasers

NE = X - M = net exports

An increase in aggregate demand can be achieved using expansionary monetary or fiscal policy.

Expansionary monetary policy refers to an increase in the money supply. This reduces interest rates and encourages more consumption (C) and investment (I) spending.

Expansionary fiscal policy can be achieved by either (1) reducing taxes to encourage more spending by households and businesses (C + I); or (2) increasing government purchases (G).


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