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The Problem of an Unemployment Equilibrium

Keynes and the classical economists agreed that the economy would always tend toward equilibrium, but they disagreed about whether the level of output at which the economy stabilized would permit full employment. In the classical model the economy tends to stabilize at a full-employment equilibrium (at potential GDP). In the Keynesian model the economy tends toward equilibrium but not necessarily at full employment. When the economy is in equilibrium at less than full employment, an unemployment equilibrium exists.

We can illustrate why Keynes and the classical economists reached different conclusions about the likelihood of full employment by returning to the circular-flow diagram in Exh. 3. Recall that, in this example, households are saving $100 billion, businesses are investing $100 billion, and $1,000 billion is the economy's equilibrium output. To facilitate our comparison between the classical and Keynesian models, let's assume that $1,000 billion is the economy's potential GDP, and so the economy is operating at full employment.

Now, suppose that households decide to increase their saving from $100 billion to $200 billion. What will happen? Obviously, more money is leaking out of the circular flow, in the form of saving. But as we noted earlier, the classical economists did not believe saving would invalidate Say's Law. According to the classical model, this increased saving would simply increase the supply of loanable funds, which would drive down the interest rate and stimulate investment spending. Investment spending would rise from $100 billion to $200 billion, thus maintaining the equilibrium output at $1,000 billion—full employment.

Keynes found fault with this optimistic scenario. According to Keynes, interest rate adjustments cannot be relied on to make saving equal to investment because the interest rate is not the major motivating force in either the saving or the investment decision. In his view the level of income is the primary factor influencing the amount that households plan to save; the higher the income, the greater the level of saving. Changes in interest rates have a relatively minor impact on saving decisions. Investment decisions, said Keynes, are governed by profit expectations. The interest rate is only one factor influencing the profitability of an investment, and not the most important factor. If sales are poor and the future looks bleak, businesses are unlikely to undertake new investment, even if the prevailing interest rate is low. Since the interest rate is not the major force guiding saving and investment decisions, it cannot "match up" the plans of savers and investors. As a consequence, when households want to save more than businesses desire to invest, the level of output and employment in the economy will tend to fall. In short, increased saving (reduced spending) can lead to unemployment.

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