A2 Economics 9708: The Business Cycle and Disequilibrium Unemployment

Economists in Bregmoor observe that as the economy entered a downturn phase of the business cycle, actual real GDP fell increasingly below its potential level, and the unemployment rate rose sharply. Eighteen months after real GDP growth resumed in the recovery phase, unemployment remained noticeably higher than it had been before the downturn began.

(a) Explain how a downturn in the business cycle can cause disequilibrium unemployment to emerge in the labour market. [4]

(b) Explain why disequilibrium (demand-deficient) unemployment might persist in Bregmoor even after real GDP begins growing again during the recovery phase. [3]

(c) Distinguish between disequilibrium unemployment and equilibrium unemployment, and explain why some unemployment could still be recorded in Bregmoor even at the peak of a subsequent boom. [4]

Part (a): How a downturn creates disequilibrium unemployment

A downturn phase of the business cycle is typically accompanied by falling consumer and business confidence, which reduces both consumption and investment spending, so aggregate demand falls. Because the demand for labour is a derived demand, firms want workers only in order to produce goods and services for which there is demand, a fall in aggregate demand for goods and services reduces firms’ demand for labour at any given real wage.

If real wages were perfectly flexible, they would simply fall until the labour market cleared at a new, lower equilibrium wage, with no involuntary unemployment. In practice, real wages tend to be sticky (inflexible) downward, held up by factors such as employment contracts, minimum wage legislation, or workers’ resistance to nominal wage cuts. As a result, the real wage remains above the new, lower market-clearing wage, and at that wage the quantity of labour supplied exceeds the quantity of labour demanded: this excess supply of labour is disequilibrium (demand-deficient) unemployment.

Part (b): Why unemployment can persist into the recovery

Even once real GDP starts growing again in the recovery phase, disequilibrium unemployment can persist in Bregmoor for several reasons:

Cautious rehiring: firms that cut staff during the downturn are often uncertain how durable the recovery is, so they first raise the hours or output per worker of their existing (retained) staff, rather than immediately hiring new workers.
Sticky real wages: real wages may still not have fully adjusted, so the labour market may take time to move back towards a new market-clearing position even as demand for output picks up.
Restructuring during the downturn: some firms may have permanently changed how they produce (for example, investing in more capital-intensive methods to cut costs while demand was weak) which reduces the quantity of labour they need at any given level of output, so some previously laid-off workers do not regain employment purely because output has started to grow.

Part (c): Disequilibrium unemployment vs equilibrium unemployment

Disequilibrium unemployment exists specifically because the real wage in the labour market is above the level that would equate the quantity of labour supplied and the quantity demanded (the market has not cleared. Equilibrium unemployment, by contrast, can exist even when the labour market has cleared at the market-clearing real wage (quantity of labour supplied and demanded are equal at that wage), because some unemployment persists for reasons unrelated to the wage level) for example, frictional unemployment (time taken to search for and move into a new job) or structural unemployment (a mismatch between the skills or location of the unemployed and available vacancies).

A boom raises aggregate demand for labour strongly, which can bid real wages up towards, or even above, the original market-clearing level and largely eliminate demand-deficient (disequilibrium) unemployment. However, a boom does nothing to stop school leavers or job-changers taking time to find suitable work, or to instantly re-skill or relocate structurally mismatched workers. Because this equilibrium unemployment arises from labour-market frictions and mismatches rather than from a shortfall of aggregate demand, some unemployment can still be recorded in Bregmoor even at the peak of a boom.

Final answers

(a) A fall in AD reduces firms’ derived demand for labour; sticky real wages fail to fall to the new market-clearing level, leaving an excess supply of labour, disequilibrium (demand-deficient) unemployment
(b) Cautious rehiring, sticky real wages, and permanent restructuring (e.g. towards more capital-intensive methods) during the downturn mean unemployment does not fall immediately as growth resumes
(c) Disequilibrium unemployment $=$ labour market fails to clear at the real wage; equilibrium unemployment (frictional/structural) persists even when the market has cleared, so it survives even at the peak of a boom