Question

Real GDP can increase both because an economy has unemployment and because of economic growth. Explain fully the difference between these two ways of increasing GDP. Why does the Keynesian model focus only on increasing GDP by reducing unemployment and not on economic growth?

Answer 1

Real GDP can increase both by reducing unemployment and by economic growth.

Increasing GDP via reducing unemployment is possible only when the economy is operating on underemployment equilibrium. This means this only happens when there is excess capacity in the economy. When this excess capacity is utilised, real GDP rises. However, there is no capital formation for the long run sustainability in this growth process.

On the other hand, when GDP rises through economic growth, it implies that either the resources of the economy have increased or there are technical advancements in the economy. Growth via economic growth implies capital formation and growth sustainability in the long run as well.

Keynesian model focus only on reducing unemployment and not on economic growth because Keynesian model is a static model. It assumes that the capital formation is constant in an economy. It also rejects the assumption of Classical model that there is always full employment in the economy. Due to this, reducing unemployment is the only way to increase real GDP.