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representatives, employer representatives and sometimes others, negotiate wages for periods of one year, two years and sometimes longer. Some negotiations take place at a national level, others take place locally. There appears to be support for the view that the more coordinated are wage-bargaining negotiations – i.e. the more trades unions are involved collectively – the better the outcome for the unemployment rate. If unions negotiated unilaterally for wage rates for only their workers, each union would try to negotiate the highest wage possible.

If all unions have to negotiate together with all employers and the government then it is clear to all that excessively high wages for all unions’ workers would just lead to higher unemployment.

More modest wage negotiations are more likely, as is lower unemployment.

8.2.2ANALYSING UNEMPLOYMENT: MACRO AND MICRO

The macroeconomic aggregate demand and supply framework can also be used when analysing unemployment. Beginning with the long-run case, where an economy faces a downward sloping aggregate demand function and a vertical aggregate supply function, unemployment occurs if the level of equilibrium national income is below potential output. In such circumstances the challenge for business and government is to get the economy to its long-run equilibrium position at or at least closer to potential output, so that a minimum of economic resources are unemployed. Such analyses follow in later sections.

Classical approach

One school of thought in economics, known as the classical school, maintains that labour markets would operate to ensure that unemployment did not exist and that in the long run economies would tend towards their full employment level of output. In a labour market with flexible wages and no intervention by governments, wages would adjust to clear the market and, therefore, any unemployment would necessarily be voluntary, i.e. only frictional or equilibrium unemployment would exist. Wages would fall in times of low demand for labour (relative to its supply) so that unemployed resources could be put to work. If demand for labour was high (relative to its supply) wages would rise to bring the labour market and eventually the economy back to equilibrium.

Supporters of the classical view see unemployment as a possibility in the short run where distortions exist that do not allow wages to change (perhaps due to a minimum wage policy, or to negotiations with trades unions or due to generous

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unemployment benefits). Solving such unemployment problems would be possible by allowing wages to be more flexible. With wages free to move up or down, unemployment would not be a feature of the long-run performance of an economy.

Classical vs. Keynesian approach

An alternative view was put forward by John Maynard Keynes (in 1936), who believed that unemployment and slow growth in economic activity could persist over the short run and maybe even for long periods and become ingrained in an economy. Such unemployment is also called demand-deficient unemployment since firms do not demand labour because consumers demand too few goods. Keynes argued that reducing wages to deal with such an unemployment problem would be inappropriate because wage cuts would lead to lower incomes which in turn lead to lower planned expenditure, lowering aggregate demand and further lowering employment and raising unemployment.

In the Keynesian approach to the economy, unemployment could be involuntary due to problems faced by economic agents who, for whatever reasons, do not have the capacity to boost aggregate demand to the degree required to cause firms to hire more workers. Accordingly, a possible solution for an unemployment problem would be for governments to increase their expenditure, increasing aggregate demand, recirculating more income so that demand for unemployed labour will increase. Keynes acknowledged, however, the potential for problems of persistent budget deficits that might be generated by such a strategy.

A comparison of the classical and Keynesian views on unemployment is presented in Figure 8.3 using microeconomic analysis of the labour market. In panel A the classical position is sketched where the prevailing real wage is w1 and is higher than the level required to clear the labour market. There is involuntary unemployment, which could be reduced in the short run and ultimately eliminated by a fall in real wages towards w . In the classical approach, such involuntary unemployment would not prevail very long because real wages are assumed to adjust down to clear the labour market.

In Figure 8.3 panel B the differences between classical and Keynesian views can be highlighted. In panel B, involuntary unemployment exists at the wage rate w1. In the Keynesian explanation of unemployment real wages do not simply fall to eliminate unemployment as real wages are essentially fixed or ‘sticky’ – workers are unwilling to accept cuts in wages required to bring the labour market into equilibrium. This could be a feature of an economy where nominal wages were set through a centralized bargaining approach regarding what level of wages and wage

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A Classical unemployment

B Keynesian unemployment

P		P	involuntary
	LD	LS	LD unemployment LS
	involuntary
	unemployment
w1		w1
w*
	Q*	Q	Q**	Q
F I G U R E 8 . 3 U N E M P L O Y M E N T : C L A S S I C A L A N D
K E Y N E S I A N A P P R O A C H E S

inflation is acceptable. With such agreements there is no scope for cutting wages, or indeed for increasing them beyond agreed levels.

In Figure 8.3 panel B the unemployment problem could be remedied if labour demand increased to the dotted demand line indicated in panel B. Hence, unemployment here is caused by demand deficiency. A reduction in wages to below w1 would lead the market to clear but the labour demand curve drawn represents demand for labour in an economy where demand for firms’ output is below the full employment level. This means that an equilibrium position could prevail in the short run and persist as long as demand is less than the full employment level of output. Also, if wages are below w1, workers may reduce their planned expenditures, making the demand deficiency even worse.

So which model is correct – the classical or Keynesian? There is disagreement among economists on that issue in the sense that many believe that there is a self-correcting mechanism operating in the economy that brings the economy back towards equilibrium over time. However, the speed of this correction is what gives rise to the disagreement. Those who believe that the speed is rather quick consider that no action is required to induce the economy to move more quickly to equilibrium. Those following the Keynesian view support a more activist approach since the speed of economic adjustment is considered to be slow.

8.2.3UNEMPLOYMENT AND THE RECESSIONARY GAP

The macroeconomic aggregate demand and supply model illustrates the problem of unemployment from both classical and Keynesian perspectives. In Figure 8.4 we have an economy in short-run equilibrium at a level of output below its long-run

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P	LRAS
	AD	SRAS
P*		recessionary gap
P*LR
	SRY*	Y
		Y*
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potential level. Since the economy is not operating at its potential level, this implies the economy has some unemployed resources and the level of unemployment is above the natural rate. The economy is in recession.

Note in Figure 8.4 that both long-run and short-run aggregate supply curves are included. We do not treat the SRAS as a ‘combination’ aggregate supply curve. Over the (almost) vertical portion of the SRAS lying to the right of the LRAS, the economy is producing at its maximum but unsustainable level of output. Many workers are working overtime, capital is being utilized over several shifts, for example, but the level of output could not be retained at such high levels without pressure on prices and wages. At any point on the LRAS, the prices of all outputs and inputs have fully adjusted to clear all markets in the long run.

In a recession, the difference between the level of potential output and the lower actual output is described as the recessionary gap.

This recessionary gap is shown as the difference between short run output SRY and potential output Y , indicating that actual output falls short of its potential level. In comparing short-run to long-run equilibrium we also see that the price level differs in both cases. The short-run price level P lies above the long run level of P LR.

Following a classical theory of adjustment, wages, as one of the prices prevailing in the economy, are too high and must fall to bring the economy to long-run equilibrium. Hence the economy’s price level would fall as the economy adjusts over time from its short-run to its long-run equilibrium, from SRY and P to Y and P LR. Firms would hire more workers at lower wage rates and output could expand. At a lower price level of P LR, aggregate demand would increase.

According to a Keynesian theory of adjustment, wages are fixed or sticky in the short run and what is required is government intervention to increase injections into the economy (increase government expenditure) or reduce withdrawals (taxes) to