Studyledge

The Multiplier, Growth and Money and Banking: Question 6

Syllabus 9.3.1

Multiple choice A2 1 mark

In the labour market, disequilibrium unemployment exists when the real wage rate is above the level that would clear the market, so that the quantity of labour supplied exceeds the quantity of labour demanded. Equilibrium unemployment, by contrast, can exist even when the labour market has cleared (real wage = market-clearing wage), because it takes time for some workers to move between jobs or find suitable work.

Which of the following is the best example of disequilibrium unemployment caused by a fall in aggregate demand for labour (demand-deficient / cyclical unemployment)?

Choose an answer to check it, then compare with the worked solution below.
Show worked solution Hide worked solution

Worked solution

Step 1: Recall the equilibrium/disequilibrium distinction

Disequilibrium unemployment exists because the real wage in the labour market is stuck above the level that would equate the quantity of labour supplied and demanded, so the market does not clear. Two causes are commonly distinguished:

  • Real-wage (classical) unemployment: wages are held above equilibrium by institutions (e.g. minimum wage laws, trade union bargaining), regardless of the state of aggregate demand.
  • Demand-deficient (cyclical) unemployment: a fall in aggregate demand reduces firms’ demand for labour, and real wages fail to fall in response, leaving an excess supply of labour.

Equilibrium unemployment, by contrast, can exist even when the labour market has cleared at the market-clearing wage, for example, frictional unemployment (time spent searching between jobs) or seasonal unemployment (workers between seasonal contracts).

Step 2: Check option B

Option B describes a recession reducing firms’ demand for labour, with real wages failing to fall enough to restore market-clearing. This is exactly demand-deficient (cyclical) disequilibrium unemployment, driven by a fall in aggregate demand.

Step 3: Rule out options A, C and D

  • Option A: a minimum wage held above equilibrium is disequilibrium unemployment, but it is real-wage (classical) unemployment caused by a wage-setting institution, not by a fall in aggregate demand.
  • Option C: a worker taking six weeks to find a comparable job is frictional unemployment. This persists even when the labour market as a whole is at its market-clearing wage, so it is a form of equilibrium unemployment, not disequilibrium unemployment.
  • Option D: seasonal lay-offs between contracts are seasonal unemployment, another form of equilibrium unemployment that recurs regardless of the strength of aggregate demand.

Final answer

Option B. A fall in aggregate demand reducing firms’ demand for labour, with real wages failing to fall to the new market-clearing level, is the defining example of demand-deficient (cyclical) disequilibrium unemployment, distinct from real-wage unemployment (A) and from frictional/seasonal equilibrium unemployment (C and D).