Classical Unemployment and Keynesian Unemployment

To comprehend the distinction between classical and Keynesian unemployment, one must delve into the causes of unemployment and the respective analyses offered by these two economic theories. While the boundaries may sometimes appear subtle, let’s shed light on these two theories, each advocating entirely different approaches to dealing with unemployment.

Classical Unemployment

According to classical economic theory, the economic cycle revolves around investment and its financing through savings. This theory is illustrated by the following framework:

S = I, where S represents savings and I denotes investment, and the equilibrium derived from this equation determines the level of investment and the interest rate.

Read Also: Profitability Index Calculation Explained

In an economy, the capital stock is the accumulation of past investments, which, in turn, determines the number of job positions available. Employment can only exist within production units where capital has been previously allocated.

While the form of capital has evolved over time, from fields to factories to modern offices equipped with computers, one constant remains: the need for capital to create jobs. Economists calculate the capital stock, K, as the sum of all investments, which determines the amount of available labor, L. The production, Y, is a result of utilizing this capital, represented mathematically as Y = F(K, L), with F being the production function.

In simpler terms, economic equilibrium is achieved through the lens of Say’s Law. It states that income, R, equals consumption, C, savings, S, and taxes, T (R = C + S + T). Three possible scenarios arise in this economic model, based on the relationship between the active population, N, and the available labor force, L:

Read Also: Accounts Receivable Turnover Ratio: Calculation and Significance

1. N > L: This situation signifies that the active population exceeds the available labor force due to existing capital, resulting in unemployment.
2. N = L: This represents full employment.
3. N < L: In this case, there is a labor shortage, and the surplus of capital leads to increased competition among companies. As they compete for labor, wages rise, increasing costs and potentially causing inflation.

This model effectively excludes one situation when explaining unemployment, full employment, and inflation. Transitioning from unemployment to full employment, as per the classical theory, requires an increase in capital stock. Typically, this is achieved by increasing investment. A common method is to restore profitability to companies by reducing the share of wages in value-added, which ultimately means lowering wages.

This assertion has several implications:

1. It underscores the significance of entrepreneurs and business leaders in the economy. Entrepreneurs, through their investments, modernize the production apparatus and enable society to benefit from technological progress. However, these investments also create job opportunities, absorbing available labor. In the fight against unemployment, it is not the state itself but its treatment of businesses that is instrumental.
2. Lowering wages essentially means reducing labor costs, often through a decrease in social charges, without affecting the net wages received by employees.
3. Lowering labor costs can also be achieved by modifying the non-wage conditions associated with employment. In scenarios where labor contracts are challenging to terminate, companies are aware that recruitment mistakes can be costly. In such cases, the labor market is characterized by inflexibility. A highly protective labor code contributes to these costs. Greater flexibility reduces these costs and promotes a return to full employment.
4. The effectiveness of cost reduction measures depends on the location of the investments. In an increasingly globalized world, the calculation of costs for businesses extends beyond the mere need to finance capital accumulation. Cost reduction measures, primarily through fiscal policy, have become a parameter in a context of international fiscal competition. Reducing costs through taxation plays a pivotal role in public policy and must now respond to the dynamics of international tax competition.

Since the 1980s, countries worldwide have focused on policies to combat unemployment, primarily centered on cost reduction.

Read Also: Understanding CPI Calculation

Nevertheless, another perspective on short-term unemployment, known as Keynesian unemployment, exists.

Keynesian Unemployment

Keynesian unemployment is grounded in the assumption that businesses lack demand. In Chapter XXII of his “General Theory,” Keynes examines the causes of a crisis. He posits that consumption remains relatively stable over time, which challenges the often-cited principles of “demand-led recovery” and “consumption as the engine of growth.”

Keynes did not consider consumption as the driving force behind growth. In such a worldview, wage increases could only be beneficial and pose no problems. Those witnessing their purchasing power grow, newly employed individuals returning to work due to the consumption boost, and businesses expanding their markets due to increased demand would all benefit.

Read Also: Commodity Money: Unveiling the Essence of Monetary Evolution

Keynes, on the other hand, asserted that the root problem lay in investment, which was subject to severe fluctuations. Fearing uncertain demand, companies hesitated to invest and resorted to adjusting their workforce instead of prices and wages during economic crises.

Keynesian unemployment originates from a lack of private investment. Keynes suggests that public investments should be employed in place of private ones.

Keynesian economics condenses this concept into the belief that public expenditure is more effective in increasing production than private consumption. It places fiscal policy as the primary instrument for combating unemployment.

Read Also: Supply Elasticity Calculation: A Detailed Guide

One could describe this intervention’s role in economic growth in various ways, with the simplest and most comprehensive being Haavelmo’s model (Haavelmo was awarded the Nobel Prize in Economic Sciences in 1989). The model, also known as the “Haavelmo Theorem,” can be illustrated using the following equations:

1. Equality between supply and demand: Y = C + I + G (Say’s Law Y = R).
2. The equality between these two equations can be expressed as: Y = C(Y – T) + I + G.
3. Through differentiation, an increase in production can be expressed as: dY = dG – c dT / 1 – c.

The term (1 / 1 – c) in the final equation is called the Keynesian multiplier. Each increase in production requiring labor leads to a reduction in Keynesian unemployment.

This reasoning highlights four crucial elements:

1. It inverts the logic compared to classical unemployment. While classical theory increases supply-side capacity by accumulating more capital, Keynesian unemployment encourages businesses to hire to meet additional demand.
2. When state spending increases without additional public debt (dT = dG), it triggers increased production, with a multiplier effect of 1.
3. When the entire increase in public expenditure is funded by borrowing, the multiplier effect is maximal and equals 1 / (1 – c).
4. A reduction in taxes, as opposed to increased spending, also leads to a multiplier effect, which, in this case, is c / (1 – c). It is lower than the multiplier for increased spending.

The Keynesian solution to unemployment relies on an increase in demand, either directly through public expenditure or indirectly via tax cuts.

For strict Keynesians, combating unemployment requires increasing public investments without matching revenues, which implies augmenting the budget deficit and, consequently, the public debt stock.

Key Differences Between Classical Unemployment and Keynesian Unemployment

To summarize, the primary differences between classical and Keynesian unemployment are:

1. Market Flexibility vs. Demand Fluctuations: Classical unemployment is rooted in the flexibility of the labor market, while Keynesian unemployment emphasizes fluctuations in overall demand.
2. Laissez-Faire vs. Active Government Intervention: Classical theory encourages a laissez-faire approach, while Keynesian economics calls for active government intervention.
3. Temporary vs. Long-Term Unemployment: Classical theory assumes unemployment is temporary, while Keynesian economics acknowledges the potential for long-term unemployment.

In conclusion, understanding the distinctions between classical and Keynesian unemployment is crucial for shaping effective economic policies. While classical theory advocates non-interference, Keynesian theory promotes government action to stimulate overall demand. Economists and policymakers must evaluate these approaches based on the specific economic conditions of their respective countries.