Explain the meaning of under-employment equilibrium. Explain two measures by which full-employment equilibrium can be reached.
Under employment equilibrium level refers to the situation when the actual or the equilibrium level of demand for output (ADE) is less than the full employment level of output (ADF). This refers to a situation of deficit demand. Algebraically, this is denoted as:
if ADE < ADF (situation of Deficit Demand)
Due to this deficiency in the aggregate demand, there exists a difference (or gap) between the actual level of aggregate demand and full employment level of demand. This difference is termed as deflationary gap.
Let us understand the situation of deficit demand and concept of deflationary gap with the help of the following figure.
In the figure below, AD1 and AS represents the aggregate demand curve and aggregate supply curve. The economy is at full employment equilibrium at point ‘E’, where AD1 intersects AS curve. At this equilibrium point, OY represents the full employment level of output and EY is the aggregate demand at the full employment level of output. On the other hand, CY denotes the actual aggregate demand. The vertical distance between these two represents deflationary gap. That is,
EY− CY = EC (Deflationary Gap)
Due to this deficiency in demand, the producers will experience piling up of unsold stock. As a result, the producers will attempt to clear the stock of unsold goods by reducing the production, thereby reducing the employment level. The producers will continue to reduce the production till the new equilibrium is reached at point ‘F’, where the new aggregate demand curve AD2 intersects the AScurve. At this new equilibrium, the economy is producing OY´ level of output and the aggregate output demanded by the economy is FY´. The new equilibrium level of output is lesser than that of at the full employment level of equilibrium. Thus, it can be observed that due to the deflationary gap created by the deficit demand, the economy has attained a less than full employment level of equilibrium.
The following are the two measures by which the full-employment equilibrium can be restored.
1. Fiscal Measure- In case of deficit demand, the government raises its expenditure in form of fresh investments. This raises the level of economic activity, which further leads to a rise in the overall level of employment, thereby, income increase. The increase in the income subsequently raises the aggregate demand sufficiently and deficiency in demand is wiped out.
2. Monetary Measure- In case of deficit demand, central bank reduces the bank rate, which reduces the cost of borrowings for the commercial banks. This implies that people can get loans at cheap rates from the commercial banks. This increases the demand for loans and credits in the market. Therefore, the consumption expenditure increases and finally the aggregate demand increase.
Note- Students who have written any other fiscal and monetary measures such as Taxation, Public Borrowings, Deficit Financing, Open Market Operations, Reserve Requiremnts, etc. are also correct.