Model Answer
0 min readIntroduction
The Great Depression of the 1930s challenged classical economic thought, leading John Maynard Keynes to develop a revolutionary macroeconomic framework. A central tenet of this framework is the concept of ‘underemployment equilibrium’ – a situation where the economy settles at a level of output below full employment. This differs significantly from classical views which posited automatic adjustment mechanisms towards full employment. Understanding this concept is crucial for comprehending the rationale behind Keynesian policy prescriptions, particularly the active role of government in stabilizing the economy. This answer will explain underemployment equilibrium with a graphical illustration and analyze why full employment isn’t automatically achieved in Keynes’ approach.
Understanding Underemployment Equilibrium
Underemployment equilibrium refers to a situation where the aggregate demand (AD) is insufficient to support full employment of resources. This means that the economy can be in equilibrium at a level of output where there is involuntary unemployment – individuals are willing to work at the prevailing wage rate but cannot find jobs. This is a departure from classical economics, which assumes that unemployment is voluntary and arises from individuals choosing not to work at the market wage.
Graphical Illustration
The concept can be best understood through the Aggregate Demand-Aggregate Supply (AD-AS) model.
Explanation of the Graph:
- X-axis: Real GDP (Output)
- Y-axis: Price Level
- AD: Aggregate Demand curve
- AS: Aggregate Supply curve (relatively flat at lower levels of output, reflecting underutilized capacity)
- E: Equilibrium point where AD = AS
- Y1: Equilibrium level of output (less than potential output Y*)
- U: Level of involuntary unemployment
The graph shows that at the equilibrium point E, the economy is producing Y1, which is below the potential output Y*. This implies the existence of involuntary unemployment (U). The AS curve is relatively elastic at this point because there is significant spare capacity in the economy.
Why Full Employment Isn’t Automatically Reached
Keynes argued that several factors prevent the automatic attainment of full employment:
1. Insufficient Aggregate Demand
The primary reason is a deficiency in aggregate demand. Keynes believed that AD is determined by the sum of Consumption (C), Investment (I), Government Spending (G), and Net Exports (X-M): AD = C + I + G + (X-M). He argued that private investment is often volatile and influenced by ‘animal spirits’ – psychological factors that can lead to pessimistic expectations and reduced investment even when interest rates are low. Furthermore, consumption is influenced by the Marginal Propensity to Consume (MPC), which is the proportion of an increase in disposable income that is spent on consumption. If MPC is low, the multiplier effect is weak, limiting the impact of increased income on AD.
2. The Multiplier Effect & Its Limitations
Keynes introduced the concept of the multiplier. An initial increase in spending (e.g., government spending) leads to a larger increase in national income due to the ripple effect through the economy. The multiplier (k) is calculated as k = 1/(1-MPC). However, the multiplier effect can be limited by leakages such as savings, taxes, and imports. If a significant portion of income is saved or paid as taxes, the multiplier will be smaller, reducing the impact on AD.
3. Sticky Wages and Prices
Unlike classical economists who assumed flexible wages and prices, Keynes argued that wages and prices are ‘sticky’ – they don’t adjust quickly to changes in demand. This is due to factors like labor contracts, menu costs (the cost of changing prices), and psychological resistance to wage cuts. Because wages and prices don’t fall easily, a decrease in AD doesn’t lead to a corresponding decrease in real wages, preventing the economy from automatically returning to full employment.
4. Role of Expectations
Pessimistic expectations about future economic conditions can depress investment and consumption, leading to a fall in AD. If businesses expect low demand, they will postpone investment plans, and consumers may delay purchases, further exacerbating the problem. This creates a self-fulfilling prophecy where negative expectations lead to negative outcomes.
Government Intervention
Because of these factors, Keynes advocated for active government intervention to stabilize the economy. He proposed using fiscal policy (government spending and taxation) to boost aggregate demand during recessions. For example, increasing government spending on infrastructure projects or reducing taxes can increase AD and move the economy towards full employment. Monetary policy (controlling interest rates and money supply) can also be used, but Keynes believed it was less effective during deep recessions due to the liquidity trap – a situation where interest rates are already very low, and further reductions have little impact on investment.
Conclusion
In conclusion, the concept of underemployment equilibrium highlights a fundamental departure from classical economic thought. Keynes demonstrated that an economy can get stuck in a state of less-than-full employment due to insufficient aggregate demand, sticky wages and prices, and pessimistic expectations. Automatic adjustment mechanisms are insufficient to restore full employment, necessitating active government intervention through fiscal and monetary policies. The Keynesian framework remains highly relevant today, informing macroeconomic policy responses to economic downturns and emphasizing the importance of demand management in achieving economic stability.
Answer Length
This is a comprehensive model answer for learning purposes and may exceed the word limit. In the exam, always adhere to the prescribed word count.