Rosalind Levačić

Unemployment and the Labour Market

Unemployment is an emotive issue and this is reflected in the terminology adopted in the economic analysis of unemployment. The Keynesian concept of full employment has already been used in the previous chapters but without any careful consideration of what it means. The social objective of achieving ‘full employment’ has had a powerful appeal in this century and, following the adoption of Keynesian economics, its maintenance has been treated as a prime responsibility of government. Only in the last decade has it become increasingly apparent that government policies are unable to produce the low rates of unemployment experienced in the 1950s and early 1960s. Consequently more attention is now being given to analysing the supply side of the economy. It is to this topic that we now turn, this chapter outlining Keynesian and neoclassical ideas on the determination of the level of unemployment. In doing so we consider whether full employment has a satisfactory theoretical definition and, if given such a definition, it is possible in practice to measure its appropriate level.

Introduction to Macroeconomics

Macroeconomics is the study of the behaviour of the whole economy. It is concerned with the determination of the broad aggregates in the economy, in particular the national output, unemployment, inflation and the balance-of-payments position. The main body of macroeconomic theory applies to a developed, capitalist economy. A capitalist economy is one where productive assets are owned either directly by individuals or by individuals through the medium of firms. These employ others to work with the productive assets in order to produce output. In such an economy, economic decisions are taken by individuals and firms acting independently of one another and co-ordinated via the market mechanism. All these decisions then interact to determine the values of variables such as output and prices. Economies that are nowadays classified as ‘capitalist’ all have important state sectors which in various and differing ways intervene in the operation of market forces to redirect or suppress them.

The Phillips Relation

The previous two chapters have considered two contrasting hypotheses about price adjustment. In neoclassical analysis prices adjust fully to bring about market-clearing equilibrium. A distinctive feature of the neoclassical model is that the equilibrium values of the real variables are invariant with respect to changes in the equilibrium value of the price level brought about by changes in stock of money. In Keynesian analysis prices either fail to adjust at all or only do so slowly so that markets remain uncleared. So from both perspectives interest focuses on how the price level varies over the trade cycle and how such variations relate, if at all, to fluctuations in real output and employment.

One-Sector Neoclassical and Keynesian Models

This chapter outlines the simplest one-sector versions of the neoclassical and Keynesian models. Even in their rudimentary form they exhibit the essential difference in the two schools of thought, which centres on the role of the price mechanism.

The ISLM Model

The one-sector Keynesian model of the economy, which was reviewed in Chapter 2, deals only with the demand for output in the real sector or, as it is alternatively named, the goods market. This sector is concerned with the receipts of the national product by factors of production and the expenditure of this income by households and firms. The model can easily be extended to include a government sector and a foreign trade sector, but it does not concern itself with how expenditure is financed. In other words, there is no explicit consideration of the role of money. The one-sector model was developed by Keynes’s disciples as a simple exposition of the distinctive Keynesian view that the supply of national output is demand determined. The General Theory of Employment, Interest and Money, as its title indicates, did include an explicit consideration of the monetary sector.

The Monetary Approach to the Balance of Payments

The monetary approach to the balance of payments and exchange-rate determination is a currently popular version of the asset market approach. This analyses changes in the exchange rate and the BOF in terms of stock adjustment in the money market in which the supply and demand for money adjust so that all domestic money balances are eventually willingly held. In this approach changes in economic variables will affect the BOF and the exchange rate through their impact on the demand for and supply of money balances. This stock-adjustment approach springs from the fact that a necessary condition for a non-zero BOF is some initial difference between the public’s actual money stock and the public’s desired money stock.

The Trade Cycle: Keynesian and Monetarist Interpretations

The long-run expansion of industrialised market economies has been accompanied by cyclical fluctuations in economic activity. This type of fluctuation is known as the business or trade cycle. The general feature of the cycle is that an expansion of economic activity is followed by a contraction, which is in turn succeeded by a further expansion. Explaining the occurrence of trade cycles has been a major preoccupation of macroeconomics for a long time.

The Demand for Money

The choice of how much money to hold is an example of a portfolio decision as it concerns allocating one’s wealth over a number of different assets. Money is a unique type of asset: not only does it perform the store of value function common to all assets but it also serves as a medium of exchange. A preliminary account of the theory of the demand for money was given in Chapter 2 (p. 15) and Chapter 3 (pp. 25, 32), where it was deduced that the demand for real money balances depends positively on income and inversely on the rate of interest. In this chapter we shall examine the microeconomic basis of the demand for money function a little more thoroughly and review some of the empirical work in this field. (For a detailed and more rigorous review of the literature, students can consult any one of references [1]–[4] or read some of the classic articles such as [5]–[8].)

Policy Analysis When Asset Stocks Adjust

The analysis of monetary and fiscal policies which we carried out in Chapter 4 and subsequent chapters did not allow for the fact that such policies imply changes in the size and composition of the private sector’s wealth. These in turn will change the private sector’s demand for goods and financial assets. This must be taken account of if there is to be a complete and consistent analysis of policy.1

The Balance of Payments and Keynesian Analysis

The analysis of macroeconomic behaviour in section I was conducted in the context of a closed economy. The introduction of trade with other economies widens the choices available to consumers, producers and investors. In an open economy consumers are no longer restricted to domestically produced goods, while producers are no longer confined to the domestic market. Therefore, a change in total domestic expenditure on final goods and services no longer implies an equal change in the expenditure on domestic output, as part of domestic expenditure falls on foreign-produced goods and services, while part of the expenditure on domestic production is due to foreign purchases of domestic output.