Cyclical Unemployment

Unemployment caused by deficient AD.

Equilibrium is at point X with real national output level at YFE and price level P1. A collapse in business/consumer confidence can shift AD1 to AD2. Thus lowers output from YFE to Y2, and lowers the price to P2. Since less output is being produced, firms employ fewer workers, shifting ADL1 to ADL2 on the diagram on the right. If wages are flexible (as free-market economists believe), the rate of unemployment is E1 at real wage rate W1. If wages are ‘sticky’ (as the Keynesian economists assume), the rate of unemployment drops further to E2, and real wages remain WFE.