Full Employment GDP: Definition and Examples

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  • 1:21 Illustrating Full…
  • 2:17 Full Employment GDP…
  • 3:14 Full Employment and…
  • 4:22 Full Employment and Inflation
  • 5:11 Full Employment and Savings
  • 5:53 Lesson Summary
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Lesson Transcript
Instructor: Dr. Douglas Hawks

Douglas has two master's degrees (MPA & MBA) and a PhD in Higher Education Administration.

In this lesson, you'll learn about an economy that is in balance. The full employment level of GDP is when economic output is at its highest sustainable level, when unemployment is at its most efficient level and when inflation is neither rising nor falling.

What Is Full Employment GDP?

Full employment GDP is a term used to describe an economy that is operating at an ideal level of employment, where economic output is at its highest potential. It is a state of balance in which savings is equal to investment and the economy is neither expanding too rapidly nor falling into a recession. This level of economic output, as measured by real GDP, is neither too high to cause rising inflation nor too low to bring about falling prices.

In economics, equilibrium is that perfect state of balance, like two friends on a teeter-totter that weigh exactly the same. Absent any external force or change in weight, two friends that weigh the same will sit on a teeter-totter and it will rest completely horizontal. But, as soon as the weight of one side changes, the other side reacts. The two economic forces that must be in equilibrium to achieve full employment GDP are unemployment and inflation.

When unemployment goes down, inflation tends to go up, and when unemployment goes up, inflation tends to fall. All economies have a state of balance like this that we call the full employment level of gross domestic product, or full employment GDP for short.

Illustrating Full Employment GDP

Here is how economists illustrate full employment GDP. The red upward-sloping curve is called the short-run aggregate supply curve, or SRAS for short. This curve represents the economy's total supply of goods and services. The blue downward-sloping curve is the aggregate demand curve, or AD for short. This curve represents the economy's total demand for goods and services. Finally, the black vertical line is called the long-run aggregate supply curve, or LRAS for short. It represents the economy's long-run potential output of goods and services.

GDP Full Employ

When all three of these lines intersect, there is both a short-term and a long-term equilibrium. In other words, the teeter-totter is horizontal - everything is in perfect balance and everyone lives happily ever after.

Full Employment GDP and Economic Growth

However, life is not always like that. The ups and downs of the economy - the expansions and contractions - in real GDP that we continue to experience over time will bring it above or below full employment.

For example, during a recession, additional unemployment is generated, which we call cyclical unemployment, or unemployment that is directly caused by an economic slowdown. As firms and employees adjust their expectations to the ups and the downs, cyclical unemployment dissipates and the economy generally moves back towards its potential output, or full employment.

In the long run, economic output, as measured by GDP, returns to the full employment level, which classical economists refer to as potential output. Potential output is the highest level of real GDP that an economy can sustain over time.

Full Employment and the Labor Market

So far, we've looked at full employment from the economy-wide level. Now let's take a look at it from the perspective of the labor market. Full employment GDP occurs when the labor market is in equilibrium. This means that there is no surplus of workers above the economy's natural rate of unemployment nor any shortage of workers below it.

Economists would say it this way: All available labor is being used efficiently. The largest amount of people who could be employed are employed. The only unemployment that occurs during this time is when workers are in between jobs - something economists call frictional unemployment and something that is always expected to happen.

Why is this important? Because the natural rate of unemployment is not zero. You would think the economy's potential would be zero unemployment, but as long as some people are in between jobs, it will never be zero. The natural rate of unemployment is estimated to be somewhere between 2% and 4%. This represents a state of equilibrium within the labor market.

Full Employment and Inflation

When the economy is at the full employment level, this level of economic output as measured by real GDP and the level of employment is neither too high to cause rising inflation nor too low to bring about falling prices. Yale economist James Tobin called this the non-accelerating inflation rate of unemployment.

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