Demand Deficient Unemployment

Once all the factors causing ‘full employment unemployment’ are taken into account, any additional unemployment left over must be the result of too little aggregate demand. This is called demand deficient unemployment. Demand deficient unemployment occurs when the number of people unemployed (U) is greater than the number of unfilled job vacancies (V). If accurate values could be determined for U and V, full employment could be defined as occuring when V >= U. Unfortunately, even though reasonably good unemployment data exists, the number of job vacancies is difficult to determine—many job vacancies are never advertised, and sometimes managers may even disagree over whether a particular vacancy exists or not! For this reason, full employment is usually taken to be some set target  rate of unemployment. The full employment rate of employment varies over time for any one country and varies substantially between countries.

If we know that the economy is operating at full employment, then actual (Y) and potential (Q) output will be equal. When this occurs, we can measure the potential output of the economy. It also follows that the larger the gap between Y and Q, the higher will be unemployment. The output gap, as a percentage, is equal to (Q-Y)/Q x 100. Arthur Okun has conducted research on the empirical relationship between the unemployment rate and the output gap and has found a stable relationship for a 25-year period in the U.S. economy, starting in the late 1940s, with the following equation, known as Okun’s Law:

In other words, for each 3% that actual output falls short of potential output, the unemployment rate will exceed the full employment rate by 1%. So if Y is 12% below Q, U will be 4% above U_F. Looking at it another way, Okun’s Law states that for every 1% additional unemployment, 3% of potential output is lost and gone forever.

Since Okun’s Law was formulated in 1962, further empirical evidence has suggested that the parameter value of 1/3 is not immutable. However, the law provides a reasonable measurement of the loss in real output attributable to demand deficient unemployment.