Below Full Employment Equilibrium

What Is Below Full Employment Equilibrium?

Below full employment equilibrium is a macroeconomic term used to describe a situation where an economy's short-run real gross domestic product (GDP) is lower than that same economy's long-run potential real GDP. Under this scenario, there is a recessionary gap between the two levels of GDP (measured by the difference between potential GDP and current GDP) that would have been produced had the economy been in long-run equilibrium. An economy in long-run equilibrium is experiencing full employment.

Key Takeaways

  • The economy is below full-employment equilibrium when its short-run GDP is lower than the potential GDP. 
  • When the economy is operating below full employment, some labor, capital, or other resources are unemployed (beyond the natural rate of unemployment). 
  • Numerous factors might cause an economy to temporarily be below full employment equilibrium.
  • Normally, market forces would be expected to push the economy back toward long-run equilibrium at full employment.
  • A key aspect of Keynesian economics is the idea that an economy can get stuck in a below full employment equilibrium.  

Understanding Below Full Employment Equilibrium

When an economy is currently below its long-run, full-employment real GDP level, there will be economic unemployment of resources, which will lead to an economic recession. The economy is producing below, or inside, its production possibilities frontier (PPF). The long-run real GDP level represents what an economy can produce had it been under full employment. When an economy is not in full employment, it cannot produce what it would have been in full employment. That output gap is caused in part by the employment shortfall.

Full employment means the economy is utilizing all input resources (labor, capital, land, etc.) to its fullest potential. At full employment, the economy is producing on its PPF, fully utilizing available resources for production. Normally, there will still be natural unemployment in the labor market due to frictional and institutional unemployment. This is unavoidable but will be present to a much smaller degree than it would be during a recession. 

The economy can drop below full employment equilibrium for a number of reasons. For example, a negative economic shock can temporarily disrupt the economy, or a real resource crunch brought about by monetary policy-induced distortions in the structure of the economy might produce a rash of business failures. Even a positive economic shock in the form of a rapid technological advancement can lead to a period where some factors of production go unemployed as industries adjust to the new technology and shutter obsolete operations, a process known as creative destruction.  

Employment Gap and Economic Performance

For years, many people have tried to look into the future and determine the upcoming condition of an economy through a technique called economic forecasting. The presence of a gap in employment that puts the economy below full-employment equilibrium can be an economic indicator that the economy will see short-run growth. Barring other intervening factors, entrepreneurs, businesses, and investors have an incentive to make profits by employing under-utilized resources productively, so these normal market forces can be expected to push the economy back toward full employment. Business managers and government officials can attempt to use this technique to plan ahead for future operating activities and determine their monetary and fiscal policies.

While it's not likely that it will ever be possible to perfectly predict an upcoming economic state, developments in economic forecasting can help to reduce the impact of its volatility by giving notice of potential swings. 

Is Equilibrium Below Full Employment Possible?

However, other factors can also interfere with the process of economic adjustment toward full employment equilibrium. Institutional factors that prevent the economy from adjusting to changing conditions or liquidating unprofitable or obsolete investments are one factor. For example, excessive regulation that creates barriers to entry, or government policies that prop up so-called zombie institutions or businesses, will tend to slow the process of economic adjustment during periods when the economy is below full employment. Classical, neoclassical, and Austrian economists often argue along these lines. 

Keynesian economics in particular argues that the economy can actually get stuck in a new equilibrium that is below full employment for extended periods. Keynesian economists point to pessimism among consumers and investors along with other psychological factors, economic factors like price and wage stickiness, and financial factors such a liquidity traps, to argue that an economy might even remain below full employment indefinitely. They typically urge activist government management of the economy and fiscal policy to remedy the situation. 

Marxist and socialist economists frequently argue that the normal state of a capitalist economy is to be substantially below full employment, in order to maintain armies of unemployed workers to weaken labor bargaining power and allow capitalists to exploit workers more easily. One of the benefits they allege for socialism is that labor and other productive resources can be rationally organized for production instead of profit, and therefore, obtain full employment in the economy. 

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