Suppose that you own and operate a single firm. For whatever reason, it seems that the demand for what your firm produces has declined. Recognizing this, what should you do? Well, if consumers do not want to buy as much of your output as they did before, you should not produce as much output as you did before. There's no profit to be made in producing stuff nobody wants to buy.
Now that you have decided to scale back your output, it occurs to you that you no longer require as many inputs as you once did. Among your many inputs is labor. If you do not require as much labor as you did before, some of your workers must be laid off.
Responding to a fall in demand, therefore, you have in a very small way raised the unemployment rate. Your ex-workers do not have jobs, but continue to actively seek employment. But why has the demand for your firm's output pulled back? Presumably, other firms in the economy have either begun producing the same goods and services more cheaply (due to technological progress, say), or begun producing different goods and services which consumers want more than the goods and services you produce (due to a shift in consumer preferences, say). Whichever is the case, just as the demand for what you produce is falling, the demand for what others produce is rising. Needing to produce more output to meet growing demand, these other firms must draw upon more inputs--in particular, more labor. This raises the demand for labor, offsetting the fall caused by your firm, thereby restoring full employment in relatively short order. The unemployment rate is elevated only slightly, and only briefly.
Suppose instead that the aggregate demand for goods and services produced by the US economy declines. Much like your firm, the economy "recognizes" that the demand for its output has fallen, causing it to scale back production. Just as your firm would do in the course of scaling back production, the economy disemploys many of its inputs--most visibly, labor. The unemployment rate rises as in the previous case.
In contrast to our earlier example, however, a fall in aggregate demand is not offset elsewhere in the economy. Remember that, in this instance, we're talking about the economy as a whole--there is no elsewhere. Does this mean that the unemployment rate will be permanently elevated?
Ideally, no. The reason is that, usually, prices adjust to clear markets. In our first example, the way that the economy signals to the newly unemployed workers to shift out of your declining firm into other expanding firms is by pushing down the wages you offer, while pushing up the wages they offer. Similarly, if the aggregate demand for goods and services produced by the economy declines, this ought to lower wages in general, encouraging firms to hire more workers. And if wages fall far enough, quickly enough, the number of people looking for work but unable to find it will be as low as always. That is, the unemployment rate will quickly return to normal levels.
In reality, however, this does not happen. The reason, in the view of many macroeconomists, is that wages are 'sticky', or 'rigid'. When there is a drop in aggregate demand, instead of wages falling instantaneously, many wages fall rather sluggishly, or in lots of cases not at all. No single theory as to why this is the case commands a consensus, but the evidence in favor of wage stickiness is quite solid. If wages do not fall immediately when aggregate demand falls, then laid off workers will continue to apply for increasingly scarce job opportunities, keeping the unemployment rate elevated in the short run. In the long run, wages will fall far enough to restore the economy to full employment, but as J. M. Keynes famously remarked, "in the long run, we are all dead." A lot of unnecessary suffering is evitable if policymakers properly deploy the instruments at their disposal to stimulate aggregate demand, encouraging the economy to scale up production, which in turn encourages the re-employment of unemployed workers. In my next post, I will explain how best to do just that.
[Earlier posts in this series:
Announcing my bid for the US presidency