Aggregate Demand, Productive Potential, and Full Employment

Godley’s first lesson to the CEPG concerned the effects of fluctuations in aggregate demand relative to productive potential, for which he referred to Godley and Shepherd (1964). Potential output could be measured and predicted by observing the past trend with allowance for demographic and participation trends (labour supply) and the trend increase of output per person employed (productivity) which was assumed to reflect longer-term processes of structural change in different production sectors. Employment relative to population would vary less than in proportion to aggregate demand relative to productive potential and unemployment would vary less than employment as part of any shortfall in employment was reflected in reduced labour force participation. On the basis of past experience, it was assumed that a rate of unemployment in the UK of 2—2.5% represented a normal or reasonable level that would allow sufficient flexibility in the labour market. These rule- of-thumb observations were supposed to be broadly consistent with Okun’s findings for the USA. To maintain a high level of employment and low unemployment, the government would have to manage aggregate demand in line with productive potential defined relative to this unemployment target.