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9.6 Full Employment and the Production Possibilities Frontier

The existence of an overall resource constraint is inherent in the concept of

full employment. A fully employed economy is one in which the supply-side

constraints are binding. The full employment of labour and other factors of

production gets us full-employment output and full-employment income.

This much is accepted by all schools of macroeconomic thought. But what

constitutes unemployment in the macroeconomically relevant sense? And

what can we make of the conventionally defined categories of frictional,

structural and cyclical components of unemployment? These are the issues

that separate the Austrians from other schools.

For Keynes, unemployment was to be gauged with reference to some

‘going wage’, which itself came into being during a period when the economy

The Austrian school 493

was suffering from no macroeconomic maladies. In subsequent periods the

economy’s actual state of macroeconomic health is determined, in the

Keynesian way of thinking, by comparing the quantity of labour demanded at

the going wage with the quantity of labour offered in supply. If these two

quantities (demanded and supplied) are the same, then labour (along with all

other resources) is fully employed. If, under less favourable market conditions,

the quantity demanded is deficient relative to the quantity offered in

supply at the previously established going wage, the discrepancy stands as a

measure of cyclical unemployment.

Central to this Keynesian reckoning was the idea that the going wage kept

going even after the market conditions that underlay it were gone. It was in

this context that Keynes (1936, p. 15) used the term ‘involuntary unemployment’,

the involuntariness deriving from the idea that the workers have fallen

victim to the institutions of capitalism – institutions that do not allow for

some uniform adjustment in the overall level of wages. Involuntary unemployment

is used here to mean cyclical unemployment. Here, we should

acknowledge Keynes’s belief, not shared by modern Keynesians, that ongoing

secular unemployment of the involuntary variety is inherent in the nature

of the market system.

Both Keynes and modern Keynesians allow for some unemployment even

in the absence of involuntary unemployment, that is, even when the economy

is not in recession. In a healthy economy, the unemployed consist of new

entrants into the labour force who haven’t yet accepted a job offer as well as

members of the labour force who are between jobs. Modern textbooks commonly

make the distinction between frictional unemployment, meaning simply

that in a market economy job applicants and job openings are not matched up

infinitely fast, and structural unemployment, meaning that there are significant

mismatches between applicants and openings, such as to require costly

retraining and/or relocation.

Though the difference between frictional and structural unemployment is a

substantive one, the ultimate purpose of this unemployment taxonomy is to

make a sharp distinction between these components of unemployment and

the remaining component, which alone is a measure of the economy’s departure

from its overall, macroeconomically relevant supply-side constraints. As

a rule of thumb, the frictional–structural unemployment may be 5–6 per cent

of the labour force. Hence a measured unemployment in a market economy

of, say, 8 per cent would suggest that the economy is in recession and that the

cyclical component of the measured unemployment, that is, the unemployment

attributable to recessionary conditions, is 2–3 per cent.

This well-known taxonomy of unemployment (frictional, structural and

cyclical) is spelled out here to facilitate an important contrast between the

Austrians’ reckoning of unemployment and this more conventional reckon494

ing. Capital-based macroeconomics features the intertemporal structure of

production. And, as will be seen in section 9.10 below, business cycles entail

a distortion of the structure, a misallocation of labour and other resources

among the stages of production. Hence, cyclical unemployment – or, at least,

an essential part of it – is a special case of structural unemployment. The

Austrians depart from convention, then, in their judgement that structural

unemployment and cyclical unemployment are not mutually exclusive categories.

A second feature of the Austrian’s reckoning of employment levels – and

of resource constraints generally – is illuminated by considering the monetarists’

notion of the natural rate of unemployment (see Chapter 4). Rather than

emphasize the different categories of unemployment as discussed above, the

monetarists make the two-way distinction between the rate of unemployment

that would ‘naturally’ exist even in a healthy market economy and rates of

unemployment that are in excess of this natural rate. (Milton Friedman coined

the term ‘natural rate of unemployment’ to emphasize its kinship with the

‘natural rate of interest’, a similarly defined term introduced by Swedish

economist Knut Wicksell; see Leijonhufvud, 1981.) The difference here between

the monetarists and the Keynesians is terminological rather than

substantive. The natural rate of unemployment is in the range of 5–6 per cent.

And an economy that is experiencing the natural rate of unemployment is

said to be fully employed; see Dixon (1995).

Consistent with this reckoning, an economy experiencing the natural rate

of unemployment can be said to be on its production possibility frontier. The

frontier, then, can allow for deviations in either direction. That is, an economy

in recession would be represented by a point inside its frontier, and an

overheated economy, one in which the unemployment rate has been pushed

temporarily below the natural rate, would be represented by a point beyond

its frontier. This is only to say that the frontier itself is defined in terms of

sustainable levels of output and not in terms of some short-run maximal level

of output.

Figure 9.6 depicts a wholly private economy’s production possibilities

frontier in terms of sustainable combinations of consumable output and investment.

This economy is experiencing full employment, its unemployment

rate being no more than 5–6 per cent. The vertical axis keeps track of

consumables in a way that conforms to final-stage output as represented by

the vertical leg of the Hayekian triangle. The horizontal axis keeps track of

gross investment. Hence, if capital depreciation just happened to be equal to

gross investment, the economy would be experiencing no economic growth.

Typically, depreciation will be something less than gross investment, and the

economy will enjoy a positive growth rate, the frontier itself expanding

outward from period to period. In the unlikely case in which gross investment

The Austrian school 495

Figure 9.6 The production possibilities frontier

recession

Consumable

output

Investment

overheated

economy

falls short of depreciation, of course, the economy would be in economic

decline, the frontier shifting inward from period to period.

As one of its critical features, capital-based macroeconomics allows for

movements along the frontier in one direction or the other in response to

changes in intertemporal preferences. A clockwise movement would represent

the sacrifice of current consumption in favour of additional investment.

The initial reduction of consumable output would eventually be offset and

then more than offset as the frontier itself shifts outward at an accelerated

rate. The time path of consumable output would be that depicted in Figure

9.2. A counterclockwise movement would represent a sacrifice in the opposite

direction. The initial increase in consumable output would carry the cost

of a decrease in the economy’s growth rate and possibly even a negative

growth rate.

Significantly, these possible clockwise and counterclockwise movements

are the sort of movements precluded by construction in Keynesian theorizing,

as will be shown in sections 9.9 and 9.11, and ignored in monetarist theorizing,

owing to the level of aggregation that characterizes the equation of

exchange. A major focus of Austrian theorizing is on the market mechanisms

that allow for such movements – and on policy actions that lead to a disruption

of these mechanisms. Macroeconomic health entails more than an

unemployment rate that stays within the range of 5–6 per cent. It also entails

a growth rate that is consistent with intertemporal preferences.

Three distinct but mutually reinforcing perspectives on the key relationships

of capital-based macroeconomics are provided by the production

possibilities frontier, the loanable funds market and the Hayekian triangle. In

the following section, these three graphical components, which come together

to create a capital-based macroeconomic framework, provide a firm

basis for the Austrian propositions about saving and growth and for the

Austrian theory of the business cycle.