Demand deficient unemployment

Unemployment is defined as a situation where workers are willing and able to work but are not occupied in gainful employment.

Unemployment can be caused by various factors including a mismatch of skills on offer by workers and those currently required by firms, changes in the structure of an economy, and insufficient demand for goods and services.

Given that the demand for labour is derived from the demand for goods and services, a fall in aggregate means that fewer goods and services are in demand and less labour is required - causing demand deficient unemployment.

Diagrammatically, a fall in aggregate demand (AD) can result in less output (at Y1 in the diagram below) and higher unemployment (at U1).

Assuming the output in the economy is initially at Y, a sustained fall in AD will result in less output - at a lower level of output fewer workers are required.

demand deficiecy diagram

The result is ‘demand deficient’ unemployment, which is also known as Keynesian unemployment and 'cyclical' unemployment.

Cycles

The 'business' or 'trade' cycle is a permanent feature of market economies, where period of growth are followed by lower growth and possibly negative growth in the form of a recession or 'depression'. Long wave cycles, called supercycles, can also be extended over many decades,

Demand deficiency typically causes the highest levels of unemployment, compared with other types.

Changes in unemployment and employment tend to lag behind changes in GDP. Studies1 have shown that unemployment can continue falling after a recession has ended, and demand for labour may well not recover for around 18 months2.

Factors affecting demand deficient unemployment

The extent of demand deficient unemployment depends upon the extent of the decline in aggregate demand as well as the elasticity of aggregate supply.



A fall in AD could result from a decline in any component, including a fall in consumption, investment, government spending or net exports.

Even a small fall is likely to be amplified by a downward multiplier effect as those workers initially unemployed spend less, which reduces income for others leading to even further unemployment.

Finding the demand-deficient level of unemployment

There are several ways to estimate the extent of demand-deficient/cyclical unemployment. Perhaps the simplest is to subtract the rate at the worst point on the cycle from the rate at the best point.

If we apply this to the recession associated with the financial crash, unemployment was at 4.5% in 2007 (the peak of economic activity) and rose to 9.5% in 2010 (the trough).

As a guideline, rates above 5% (for both the UK and the USA) are an indication that some cyclical unemployment has occurred. Another method is to subtract rates for frictional and structural unemployment from the headline rate.

Demand deficient unemployment in the UK

Like many advanced economies, the UK has experienced periods of demand deficient unemployment - notably the 1920s and 1930s, the recessions of the early 1980s and 1990s, and again during the financial crash of 2008 to 2010.

As yet, the effects of the Covid-19 pandemic remain unknown, but estimates put the unemployment rate for 2020 at 9% then falling back to 6% in 2021.

These estimates would have been much higher were it not for the UK's furlough scheme, which is set to run until at least the summer of 2021.

demand deficiency diagram

Demand deficient unemployment in the US

Unemployment for the US follows a similar, though less volatile path to that of the UK. The impact of Covid-19, however, may prove to be more significant to the US than the UK.

demand deficiency diagram
Aggregate demand

More on aggregate demand and the AD curve.

Aggregate demand
Structural unemployment

What determines structural unemployment?

Structural problems
Monetary policy

Is monetary policy effective at controlling inflation?

Monetary policy

Endnotes

1.As reported in Forbes - https://www.forbes.com/sites/sageworks/2011/06/29/why-unemployment-lags-behind-gdp-growth/?sh=145685063842
2.Data provided by Sageworks - https://www.abrigo.com/people/sageworks/
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