What it means
Before the 1930s many economists believed that markets would clear on their own. If there were unemployed workers, wages would fall, firms would hire more, and full employment would return.
John Maynard Keynes argued that this did not always happen, because lower wages also meant lower household incomes and weaker spending. In his view, firms decide how much to produce by looking at the demand they expect.
If demand is weak, firms hire fewer workers and invest less, and the resulting low incomes keep demand weak. The economy can therefore settle at a stable position well below its potential, which is the underemployment equilibrium.
For business managers, the concept explains why a downturn can be long and why waiting for it to correct itself may be costly. Customers with no jobs or uncertain incomes do not buy, and companies that cut staff to protect profit can make the demand problem worse for each other.
This is sometimes called a fallacy of composition, where an action that is sensible for one firm is harmful when everyone does it. The standard policy response is to raise aggregate demand, which means total spending in the economy.
Governments can spend more or cut taxes, and central banks can lower interest rates to encourage borrowing and investment. The size of the effect is often described by the multiplier, because each extra dollar spent becomes income for someone else who spends part of it again.
Critics offer other explanations for long periods of high unemployment, such as rigid wages, labour market rules, high debt or poor policy. They also warn that stimulus can cause inflation when the economy is close to its limits.
The idea is therefore best used as a way of asking whether a slowdown is caused by weak demand or by something else.
In practice
Real-world examples.
Example
A country has 9% unemployment for several years and its factories run at 70% of capacity. Wages have fallen, but firms still do not hire because they cannot sell more goods. Economists describe this as an underemployment equilibrium and call for stronger public spending.
Example
A regional manufacturer sees orders drop after a local plant closes and workers lose income. The manufacturer cuts its own staff to protect margins, which further lowers local spending. The finance director models how the downturn could feed on itself.
Example
A central bank cuts its policy rate to encourage borrowing during a weak recovery. Firms with idle capacity still hold back from investing, because they see no customers for extra output. The bank concludes that lower interest rates alone are not enough and asks the government to consider fiscal support.
Formula
Calculation
Output gap = (Actual output - Potential output) / Potential output x 100%
Suppose an economy has potential output of $10,000 billion but actual output of $9,500 billion. The output gap is (9,500 - 10,000) / 10,000 x 100% = -500 / 10,000 x 100% = -5%. If households spend 80% of each extra dollar, the multiplier is 1 / (1 - 0.80) = 5. A fiscal stimulus of $100 billion could in theory raise output by 100 x 5 = $500 billion, closing the gap.Case study
Seen in the real world.
Lakeside Valley is an illustrative, fictional region whose main employer closed a large plant. Hundreds of workers lost their jobs, local shops reported lower sales, and a few years later the area still had 12% unemployment and many empty units.
A local business group asked a consultant to explain why the area did not recover on its own. The consultant showed that falling local incomes meant less spending, which gave firms little reason to hire, and that each side was waiting for the other to move first.
The illustrative remedy combined a public works programme, a training scheme and a promise to buy from local suppliers. Spending rose, shops hired again, and the region moved from the low-activity position to a healthier one within three years.
Watch out
Common mistakes.
- Assuming that falling wages always cure unemployment, when lower wages can reduce spending and deepen the problem.
- Confusing underemployment equilibrium with temporary unemployment, which is the short search period between jobs.
- Believing stimulus has no cost, when it can raise public debt and cause inflation near full capacity.
Questions
People also ask.
Who developed the idea?
It comes mainly from John Maynard Keynes, who set it out in his work on employment, interest and money in the 1930s.
How is it different from full employment?
At full employment nearly everyone who wants a job has one, whereas in an underemployment equilibrium many workers and machines remain idle.
What can move an economy out of it?
A rise in demand from government spending, lower taxes, cheaper credit, higher exports or a recovery in business confidence can do so.
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