Unemployment in the AD/AS Diagram

Unemployment in the AD/AS Diagram

Two types of unemployment were described in the Unemployment tutorial. Cyclical unemployment bounces up and down according to the short-run movements of GDP. Over the long run, in the United States, the unemployment rate typically hovers around 5% (give or take one percentage point or so), when the economy is healthy. In many of the national economies across Europe, the rate of unemployment in recent decades has only dropped to about 10% or a bit lower, even in good economic years. This baseline level of unemployment that occurs year-in and year-out is called the natural rate of unemployment and is determined by how well the structures of market and government institutions in the economy lead to a matching of workers and employers in the labor market. Potential GDP can imply different unemployment rates in different economies, depending on the natural rate of unemployment for that economy.

In the AD/AS diagram, cyclical unemployment is shown by how close the economy is to the potential or full employment level of GDP. Returning to this figure, relatively low cyclical unemployment for an economy occurs when the level of output is close to potential GDP, as in the equilibrium point E₁. Conversely, high cyclical unemployment arises when the output is substantially to the left of potential GDP on the AD/AS diagram, as at the equilibrium point E₀. The factors that determine the natural rate of unemployment are not shown separately in the AD/AS model, although they are implicitly part of what determines potential GDP or full employment GDP in a given economy.