What causes unemployment?
We will honor tradition and begin with a discussion of Say’s law
an old and simple idea
that still stirs strong passions. Conservatives often claim Say as one of their own and defend him
The most authoritative source on virtuall
y any dead economist is at
We will let Say speak for himself:
"It is worth while to remark, that a product is no sooner created, than it, from that instant,
affords a market for other products to the full extent of its own value. When the producer has put
the finishing hand to his product, he is most anxious to sell it immediately, lest its value should
diminish in his hands. Nor is he less anxious to dispose
of the money he may get for it; for the
value of money is also perishable. But the only way of getting rid of money is in the purchase of
some product or other. Thus the mere circumstance of creation of one product immediately
opens a vent for other produ
(J.B. Say, 1803: p.138
Lets consider the statement a bit. Production is said to create demand equal in value. The
$20,000 you pay for a car is divided up in payments to autoworkers, steelworkers, rent on land,
machinery and profits. All funds g
o to a person who then decides to go to the movies, buy
books, travel, buy stocks, bonds, deposit the funds in a bank or start their own company. While if
all these possibilities are considered demand, it is clear supply and demand must be the same but
supply and demand for autos certainly need not be the same. Even the supply and demand for
goods need not be the same once goods are separated out from financial instruments. All
recognize this distinction between the identity of aggregate demand and sup
ply and the
components of supply and demand.
The tricky part is in the unstated corollary of Say. If supply creates its own demand then the
absence of supply must also create the absence of demand. If producers simply choose not to
produce then demand
will be low and the underproduction is justified. This is the core idea
behind the multiple equilibrium theories of employment that we are about to study.
Or, as Say put it:
In a community, city, province, or nation, that produces abundantly, and
ds every moment to the sum of its products, almost all the branches of
commerce, manufacture, and generally of industry, yield handsome profits,
because the demand is great, and because there is always a large quantity of
products in the market, ready to b
id for new productive services. And,
, wherever, by reason of the blunders of the nation or its government,
production is stationary, or does not keep pace with consumption, the
demand gradually declines, the value of the product is less than the
of its production; no productive exertion is properly rewarded; profits and
wages decrease; the employment of capital becomes less advantageous and
more hazardous; it is consumed piecemeal, not through extravagance, but
through necessity, and bec
ause the sources of profit are dried up. The
laboring classes experience a want of work; families before in tolerable
circumstances, are more cramped and confined; and those before in
difficulties are left altogether destitute. Depopulation, misery, and re
barbarism, occupy the place of abundance and happiness. Such are the
concomitants of declining production, which are only to be remedied by
frugality, intelligence, activity, and freedom.
However, the brief quote evokes several other controversie
s as well. Say claims the
producer is anxious to sell immediately. Unless production is intended for inventory, this is of
course true. However, the producer’s anxiety may well stem from his recognition that there is no
guarantee the product will ever se
ll. It is quite possible products intended to be sold get held by
the producer in a warehouse as unintended inventory investment.
The next line “Nor is he less anxious to dispose of the money” is a reference to the oldest
theory of depressions. Fear wa
s said to cause people to hoard money and thereby depress
demand. Say’s theory connects money with production. Any disruption of the money flow
affects production and any disruption of production affects the flow of money. Whether we
choose to focus on m
oney or production is in some ways arbitrary but historically quite
The Great Depression begins in England in the mid 1920’s and in the US in 1929. By
1930 it was clear periods of several years could pass with persistently high unemployment
just in specific fields but in most fields generally. However there was no clear theory underlying
the experience. The key idea comes from Richard Kahn in a 1931 Economic Journal article
introducing the income
expenditure multiplier that provides a sim
theory. John Maynard Keynes, the editor of the EJ, was searching for just a concept as its
absence from his Treatise on Money had led to scathing criticism, even from his friends. The
final product is The General Theory of Employ
ment Interest and Money which is a mainstay in
Macro. Keynes was also a rather good mathematician, and if you are interested in this aspect of
his work, consult
The General Theory is widely considered to be difficult to read and texts rarely make
direct use of Keynesian arguments. Instead, simple graphical explanations have evolved th
capture the ideas to some degree. We begin with the circular flow.
When a business produces it must pay workers for their time, the owners of land for use
of the property, buy machinery and distribute profits to owners. Ther
efore every dollar taken in
is allocated to some person and that person is a member of a household. In the diagram, $2000
worth of goods are produced and households are paid $2000. Not everything business produce
though are sold to households. Goods may
be kept on store shelves or sold to other businesses,
this is called investment. Note that in this context investment refers to goods and services not
sold to households, it does not include stocks or bonds. The investment may serve some useful
$2000 labor, machinery, land…
r it may not. Customers are unlikely to return to a store if it does not have what they
need, therefore inventory is important in maintaining long term relationships with customers.
Businesses may well build new factories with the hope of producing and s
elling goods in the
future. However it is possible the firm intended to sell the goods and could not, that is
unintended investment. The top flow represents goods sold to households, $1600.
Similarly, households do not spend all the income they receiv
e. Some funds are set aside
for retirement, education of children or a car they want to buy next year. The point of the
circular flow diagram is simply that what households choose to save must equal what businesses
whether they want to
or not. The difference between the top flow of $1600 and
the bottom flow of $2000 is $400, whether we measure it from the households or the
businessman’s point of view. The reason is simple, businesses do not sell what households do
not buy. What busines
ses do not sell is investment, what households do not buy is savings.
This idea is represented as Y = C+I = C+S. Y is total income, the $2000. C is what
households spend and businesses sell to households, $1600. I is investment and S is savings.
concept is that as businesses produce goods to be sold to households or business they
generate income. Then that income is divided between consumption and savings. After
cancelling out C we have I = S. This is an identity, it is true by construction.
The difficulty is
that it is possible that given the current business climate, businesses do not think additional plant
or inventories are likely to be profitable and may want to invest only $300. What will they do?
In the Keynesian version of the st
ory they cut production and workers are laid off
producing unemployment. In the classical version, prices fall, consumers buy more and there is
no unemployment. Clearly it makes quite a difference which is true. We will gradually allow
more and more dis
cussion of price flexibility but for the moment we follow the Keynesian lead
and assume output is reduced.
We have an identity linking the household and business sector and we have a crude
theory of behavior of firms
if there is unintended inventory
accumulation they cut production.
All we need is a theory of household behavior and we will have our first macroeconomic model.
The theory is households spend most of what they earn. In symbols:
Y = C + I = C + S (identity linking sectors
Id = If (desired investment is equal to some fixed amount)
C = Co + mpcY (Consumption is some initial amount plus a fraction of income)
mpc = maginal propensity to consume
We will construct more and more complex models, but the structure above
will be maintained.
Identities will link sectors and theories of behavior will be constructed in each sector. In the last
30 years simple rules of thumb have come into disfavor, carefully specifying the objective
function and constraints decision
face is more popular.
The model may be solved in several ways. First we will try it as a game, then solve graphically,
then solve algebraically.
Let there be 4 capitalists, each wishes to invest $100.
Each capitalist also decides how ma
ny to employ. A production line employs four workers and
each capitalist has the equipment for 3 lines. Therefore there are production facilities capable of
employing 3x4x4 = 48 people.
Let there be 40 workers. If the worker is employed he earns $50
and spends $35. If the worker
is unemployed he earns nothing but spends $10. Therefore the consumption function of a
particular worker is C = $10 +.5y, for the class of workers as a whole it is $400+.5Y, where y is
individual income and Y is the sum of i
ncome over the forty workers.
We need four volunteers to be capitalists, these people will decide how many lines to run, and
therefore how many workers to employ. The basic requirement for being a capitalist is that you
can pick a number between 0 and
3, we will work out the implications of the choices together.
The following table will keep track of our progress.
hired = L
Y = 50L
C = 400
S = Y
If you are doing this on your own, treat it like an exercise, given the different number of lines
operating, how many workers are hired? What is aggregate income? Aggregate savings? Since
actual investment equals savings we can compare
actual investment to the desired investment
level of $400. If actual > desired firms cut back. Where is the equilibrium?
The other way to find the equilibrium is graphically. Each block in the grid below represents
$100. A 45
degree line and the su
m of C+Id has been plotted. From the circular flow we know
that when Y = C +Id S = Id and firms neither expand or contract. Therefore where the red and
yellow lines cross is the equilibrium marked in green, which agrees with the result in the table.
sum up, if 1600 is produced, consumption is 400+.5(1600) = 1200, adding the 400 of desired
investment demand is 1600.
Therefore, at Y = 1600, all production finds a willing buyer.
Finding the Equilibrium Algebraically
= C + Id
Id = 400
C = 400 +.5 Y
Y = 800+.5Y
.5Y = 800
Y = 1600
We will learn a bit more if we leave the equations in symbolic form. Let
Y = C + Id
Id = If
C = Co+mpcY
Y = Co+mpcY + If
mpc) = If + Co
Y = (If+Co)/(1
ation says equilibrium income is equal to initial spending (spending at income zero)
times the multiplier. The multiplier is 1/(1
mpc) . In our example, initial spending is 800, and
the multiplier is 1/.5 = 2.
The multiplier as an infinite series:
Imagine a bag with 100 pennies in it. The teacher gives the bag to Anna. The student
counts out 20 pennies and puts them on the desk and passes the bag to Maxim. The 100 pennies
represents income, the 20 pennies savings and the 80 pennies consumption.
The next student
also saves 20%. Maxim places .2(80) = 16 and passes on the remaining 64.
Y = 100 + 80 + 64 +…… in an infinite series.
S = 20 +16 +……. also in an infinite series.
Adding up income would be tedious but we know what the limit of savi
ngs is as the process
continues. Eventually, there will be only one penny left in the bag. Our students will have to
split pennies to keep the game going. At this point, total savings is 99 cents (savings involves
taking pennies from a bag of 100).
And the limit of savings is 100. Finally we know savings =
.2 Y so Y = 100/.2 = 500. Here, the multiplier is 5: 1/(1
mpc) = 1/(1
.8) = 5.
What causes unemployment?
In this simple Keynesian story, the failure of households and businesses to coordin
behavior causes unemployment. Households save for retirement or to buy a house. Investment
in retirement communities and houses may or may not be equal. It depends on what businesses
think is likely to be demanded and the signals they are getting ar
e not particularly clear. When
you set aside $1000 what do you intend to do with it in the future? How do businesses know?
Classical economists find the claim such a story can be an equilibrium rather irritating
and point out several reasons for such
circumstances to put pressure on households and
businesses to change behavior
which of course implies the situation is not an equilibrium. For
example, they claim the demand for labor is equal to its marginal product (if real wages are on
the axis) and
the supply of labor is set so that the disutility of work equals the real wage.
Therefore the labor market clears where the disutility of work equals the marginal product of
labor. The only sensible way to define unemployment is to argue that the real w
age is above the
equilibrium inducing more people to seek work than can find it. In the diagram, the distance
between the yellow and green lines represents unemployment. (Blue is supply of labor and red is
the demand for labor).
quantity of labor
argue this can not last, they claim workers will take wage cuts. Keynes disagrees. We
can do no better than let him explain. The excerpt is taken from Chapter 2 of the General
Though the struggle over money
wages between individuals and grou
ps is often believed to
determine the general level of real
wages, it is, in fact, concerned with a different object. Since
there is imperfect mobility of labour, and wages do not tend to an exact equality of net advantage
in different occupations, any ind
ividual or group of individuals, who consent to a reduction of
wages relatively to others, will suffer a relative reduction in real wages, which is a
sufficient justification for them to resist it.
The other way to get the real wage down is through
price increases, but with unemployment and
unsold goods prices are more likely to fall.
Unemployment results due to a failure to coordinate household and business decision
making. The unemployment persists because nominal wages are sticky
. Unemployed workers
resist wage cuts for fear their relative wage will be permanently reduced.
Classicals doubt the coordination problem is severe and point out that there are markets
linking savings and investment. They believe wages are flexible in
the long run while Keynes
famous reply is that “In t
he long run we are all dead.”