Full Employment and the Production Possibilities Frontier
The existence of an overall resource constraint is inherent in the concept of
full employment. A fully employed economy is one in which the supply-side
constraints are binding. The full employment of labour and other factors of
production gets us full-employment output and full-employment income.
This much is accepted by all schools of macroeconomic thought. But what
constitutes unemployment in the macroeconomically relevant sense? And
what can we make of the conventionally defined categories of frictional,
structural and cyclical components of unemployment? These are the issues
that separate the Austrians from other schools.
For Keynes, unemployment was to be gauged with reference to some
‘going wage’, which itself came into being during a period when the econ
was suffering from no macroeconomic maladies. In subsequent periods the
economy’s actual state of macroeconomic health is determined, in the
Keynesian way of thinking, by comparing the quantity of labour demanded at
the going wage with the quantity of labour offered in supply. If these two
quantities (demanded and supplied) are the same, then labour (along with all
other resources) is fully employed. If, under less favourable market conditions,
the quantity demanded is deficient relative to the quantity offered in
supply at the previously established going wage, the discrepancy stands as a
measure of cyclical unemployment.
Central to this Keynesian reckoning was the idea that the going wage kept
going even after the market conditions that underlay it were gone. It was in
this context that Keynes (1936, p. 15) used the term ‘involuntary unemployment’,
the involuntariness deriving from the idea that the workers have fallen
victim to the institutions of capitalism – institutions that do not allow for
some uniform adjustment in the overall level of wages. Involuntary unemployment
is used here to mean cyclical unemployment. Here, we should
acknowledge Keynes’s belief, not shared by modern Keynesians, that ongoing
secular unemployment of the involuntary variety is inherent in the nature
of the market system.
Both Keynes and modern Keynesians allow for some unemployment even
in the absence of involuntary unemployment, that is, even when the economy
is not in recession. In a healthy economy, the unemployed consist of new
entrants into the labour force who haven’t yet accepted a job offer as well as
members of the labour force who are between jobs. Modern textbooks commonly
make the distinction between frictional unemployment, meaning simply
that in a market economy job applicants and job openings are not matched up
infinitely fast, and structural unemployment, meaning that there are significant
mismatches between applicants and openings, such as to require costly
retraining and/or relocation.
Though the difference between frictional and structural unemployment is a
substantive one, the ultimate purpose of this unemployment taxonomy is to
make a sharp distinction between these components of unemployment and
the remaining component, which alone is a measure of the economy’s departure
from its overall, macroeconomically relevant supply-side constraints. As
a rule of thumb, the frictional–structural unemployment may be 5–6 per cent
of the labour force. Hence a measured unemployment in a market economy
of, say, 8 per cent would suggest that the economy is in recession and that the
cyclical component of the measured unemployment, that is, the unemployment
attributable to recessionary conditions, is 2–3 per cent.
This well-known taxonomy of unemployment (frictional, structural and
cyclical) is spelled out here to facilitate an important contrast between the
Austrians’ reckoning of unemployment and this more conventional reckon494
Modern macroeconomics
ing. Capital-based macroeconomics features the intertemporal structure of
production. And, as will be seen in section 9.10 below, business cycles entail
a distortion of the structure, a misallocation of labour and other resources
among the stages of production. Hence, cyclical unemployment – or, at least,
an essential part of it – is a special case of structural unemployment. The
Austrians depart from convention, then, in their judgement that structural
unemployment and cyclical unemployment are not mutually exclusive categories.
A second feature of the Austrian’s reckoning of employment levels – and
of resource constraints generally – is illuminated by considering the monetarists’
notion of the natural rate of unemployment (see Chapter 4). Rather than
emphasize the different categories of unemployment as discussed above, the
monetarists make the two-way distinction between the rate of unemployment
that would ‘naturally’ exist even in a healthy market economy and rates of
unemployment that are in excess of this natural rate. (Milton Friedman coined
the term ‘natural rate of unemployment’ to emphasize its kinship with the
‘natural rate of interest’, a similarly defined term introduced by Swedish
economist Knut Wicksell; see Leijonhufvud, 1981.) The difference here between
the monetarists and the Keynesians is terminological rather than
substantive. The natural rate of unemployment is in the range of 5–6 per cent.
And an economy that is experiencing the natural rate of unemployment is
said to be fully employed; see Dixon (1995).
Consistent with this reckoning, an economy experiencing the natural rate
of unemployment can be said to be on its production possibility frontier. The
frontier, then, can allow for deviations in either direction. That is, an economy
in recession would be represented by a point inside its frontier, and an
overheated economy, one in which the unemployment rate has been pushed
temporarily below the natural rate, would be represented by a point beyond
its frontier. This is only to say that the frontier itself is defined in terms of
sustainable levels of output and not in terms of some short-run maximal level
of output.
Figure 9.6 depicts a wholly private economy’s production possibilities
frontier in terms of sustainable combinations of consumable output and investment.
This economy is experiencing full employment, its unemployment
rate being no more than 5–6 per cent. The vertical axis keeps track of
consumables in a way that conforms to final-stage output as represented by
the vertical leg of the Hayekian triangle. The horizontal axis keeps track of
gross investment. Hence, if capital depreciation just happened to be equal to
gross investment, the economy would be experiencing no economic growth.
Typically, depreciation will be something less than gross investment, and the
economy will enjoy a positive growth rate, the frontier itself expanding
outward from period to period. In the unlikely case in which gross investment
recession
Consumable
output
Investment
overheated
economy
falls short of depreciation, of course, the economy would be in economic
decline, the frontier shifting inward from period to period.
As one of its critical features, capital-based macroeconomics allows for
movements along the frontier in one direction or the other in response to
changes in intertemporal preferences. A clockwise movement would represent
the sacrifice of current consumption in favour of additional investment.
The initial reduction of consumable output would eventually be offset and
then more than offset as the frontier itself shifts outward at an accelerated
rate. The time path of consumable output would be that depicted in Figure
9.2. A counterclockwise movement would represent a sacrifice in the opposite
direction. The initial increase in consumable output would carry the cost
of a decrease in the economy’s growth rate and possibly even a negative
growth rate.
Significantly, these possible clockwise and counterclockwise movements
are the sort of movements precluded by construction in Keynesian theorizing,
as will be shown in sections 9.9 and 9.11, and ignored in monetarist theorizing,
owing to the level of aggregation that characterizes the equation of
exchange. A major focus of Austrian theorizing is on the market mechanisms
that allow for such movements – and on policy actions that lead to a disruption
of these mechanisms. Macroeconomic health entails more than an
unemployment rate that stays within the range of 5–6 per cent. It also entails
a growth rate that is consistent with intertemporal preferences.
Three distinct but mutually reinforcing perspectives on the key relationships
of capital-based macroeconomics are provided by the production
possibilities frontier, the loanable funds market and the Hayekian triangle. In
the following section, these three graphical components, which come together
to create a capital-based macroeconomic framework, provide a firm
basis for the Austrian propositions about saving and growth and for the
Austrian theory of the business cycle.
The existence of an overall resource constraint is inherent in the concept of
full employment. A fully employed economy is one in which the supply-side
constraints are binding. The full employment of labour and other factors of
production gets us full-employment output and full-employment income.
This much is accepted by all schools of macroeconomic thought. But what
constitutes unemployment in the macroeconomically relevant sense? And
what can we make of the conventionally defined categories of frictional,
structural and cyclical components of unemployment? These are the issues
that separate the Austrians from other schools.
For Keynes, unemployment was to be gauged with reference to some
‘going wage’, which itself came into being during a period when the econ
was suffering from no macroeconomic maladies. In subsequent periods the
economy’s actual state of macroeconomic health is determined, in the
Keynesian way of thinking, by comparing the quantity of labour demanded at
the going wage with the quantity of labour offered in supply. If these two
quantities (demanded and supplied) are the same, then labour (along with all
other resources) is fully employed. If, under less favourable market conditions,
the quantity demanded is deficient relative to the quantity offered in
supply at the previously established going wage, the discrepancy stands as a
measure of cyclical unemployment.
Central to this Keynesian reckoning was the idea that the going wage kept
going even after the market conditions that underlay it were gone. It was in
this context that Keynes (1936, p. 15) used the term ‘involuntary unemployment’,
the involuntariness deriving from the idea that the workers have fallen
victim to the institutions of capitalism – institutions that do not allow for
some uniform adjustment in the overall level of wages. Involuntary unemployment
is used here to mean cyclical unemployment. Here, we should
acknowledge Keynes’s belief, not shared by modern Keynesians, that ongoing
secular unemployment of the involuntary variety is inherent in the nature
of the market system.
Both Keynes and modern Keynesians allow for some unemployment even
in the absence of involuntary unemployment, that is, even when the economy
is not in recession. In a healthy economy, the unemployed consist of new
entrants into the labour force who haven’t yet accepted a job offer as well as
members of the labour force who are between jobs. Modern textbooks commonly
make the distinction between frictional unemployment, meaning simply
that in a market economy job applicants and job openings are not matched up
infinitely fast, and structural unemployment, meaning that there are significant
mismatches between applicants and openings, such as to require costly
retraining and/or relocation.
Though the difference between frictional and structural unemployment is a
substantive one, the ultimate purpose of this unemployment taxonomy is to
make a sharp distinction between these components of unemployment and
the remaining component, which alone is a measure of the economy’s departure
from its overall, macroeconomically relevant supply-side constraints. As
a rule of thumb, the frictional–structural unemployment may be 5–6 per cent
of the labour force. Hence a measured unemployment in a market economy
of, say, 8 per cent would suggest that the economy is in recession and that the
cyclical component of the measured unemployment, that is, the unemployment
attributable to recessionary conditions, is 2–3 per cent.
This well-known taxonomy of unemployment (frictional, structural and
cyclical) is spelled out here to facilitate an important contrast between the
Austrians’ reckoning of unemployment and this more conventional reckon494
Modern macroeconomics
ing. Capital-based macroeconomics features the intertemporal structure of
production. And, as will be seen in section 9.10 below, business cycles entail
a distortion of the structure, a misallocation of labour and other resources
among the stages of production. Hence, cyclical unemployment – or, at least,
an essential part of it – is a special case of structural unemployment. The
Austrians depart from convention, then, in their judgement that structural
unemployment and cyclical unemployment are not mutually exclusive categories.
A second feature of the Austrian’s reckoning of employment levels – and
of resource constraints generally – is illuminated by considering the monetarists’
notion of the natural rate of unemployment (see Chapter 4). Rather than
emphasize the different categories of unemployment as discussed above, the
monetarists make the two-way distinction between the rate of unemployment
that would ‘naturally’ exist even in a healthy market economy and rates of
unemployment that are in excess of this natural rate. (Milton Friedman coined
the term ‘natural rate of unemployment’ to emphasize its kinship with the
‘natural rate of interest’, a similarly defined term introduced by Swedish
economist Knut Wicksell; see Leijonhufvud, 1981.) The difference here between
the monetarists and the Keynesians is terminological rather than
substantive. The natural rate of unemployment is in the range of 5–6 per cent.
And an economy that is experiencing the natural rate of unemployment is
said to be fully employed; see Dixon (1995).
Consistent with this reckoning, an economy experiencing the natural rate
of unemployment can be said to be on its production possibility frontier. The
frontier, then, can allow for deviations in either direction. That is, an economy
in recession would be represented by a point inside its frontier, and an
overheated economy, one in which the unemployment rate has been pushed
temporarily below the natural rate, would be represented by a point beyond
its frontier. This is only to say that the frontier itself is defined in terms of
sustainable levels of output and not in terms of some short-run maximal level
of output.
Figure 9.6 depicts a wholly private economy’s production possibilities
frontier in terms of sustainable combinations of consumable output and investment.
This economy is experiencing full employment, its unemployment
rate being no more than 5–6 per cent. The vertical axis keeps track of
consumables in a way that conforms to final-stage output as represented by
the vertical leg of the Hayekian triangle. The horizontal axis keeps track of
gross investment. Hence, if capital depreciation just happened to be equal to
gross investment, the economy would be experiencing no economic growth.
Typically, depreciation will be something less than gross investment, and the
economy will enjoy a positive growth rate, the frontier itself expanding
outward from period to period. In the unlikely case in which gross investment
recession
Consumable
output
Investment
overheated
economy
falls short of depreciation, of course, the economy would be in economic
decline, the frontier shifting inward from period to period.
As one of its critical features, capital-based macroeconomics allows for
movements along the frontier in one direction or the other in response to
changes in intertemporal preferences. A clockwise movement would represent
the sacrifice of current consumption in favour of additional investment.
The initial reduction of consumable output would eventually be offset and
then more than offset as the frontier itself shifts outward at an accelerated
rate. The time path of consumable output would be that depicted in Figure
9.2. A counterclockwise movement would represent a sacrifice in the opposite
direction. The initial increase in consumable output would carry the cost
of a decrease in the economy’s growth rate and possibly even a negative
growth rate.
Significantly, these possible clockwise and counterclockwise movements
are the sort of movements precluded by construction in Keynesian theorizing,
as will be shown in sections 9.9 and 9.11, and ignored in monetarist theorizing,
owing to the level of aggregation that characterizes the equation of
exchange. A major focus of Austrian theorizing is on the market mechanisms
that allow for such movements – and on policy actions that lead to a disruption
of these mechanisms. Macroeconomic health entails more than an
unemployment rate that stays within the range of 5–6 per cent. It also entails
a growth rate that is consistent with intertemporal preferences.
Three distinct but mutually reinforcing perspectives on the key relationships
of capital-based macroeconomics are provided by the production
possibilities frontier, the loanable funds market and the Hayekian triangle. In
the following section, these three graphical components, which come together
to create a capital-based macroeconomic framework, provide a firm
basis for the Austrian propositions about saving and growth and for the
Austrian theory of the business cycle.
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