Learning Objectives
By the end of this section, you will be able to do the following:- Evaluate the Keynesian view of recessions through an understanding of sticky wages and prices and the importance of aggregate demand
- Explain the coordination argument, menu costs, and macroeconomic externality
- Analyze the impact of the expenditure multiplier
Now that we have a clear understanding of what constitutes aggregate demand, we return to the Keynesian argument using the model of AD/AS. For a similar treatment using Keynes’ income-expenditure model, see the appendix on The Expenditure-Output Model.
Keynesian economics focuses on explaining why recessions and depressions occur, and on offering a policy prescription for minimizing their effects. The Keynesian view of recession is based on two key building blocks. First, aggregate demand is not always automatically high enough to provide firms with an incentive to hire enough workers to reach full employment. Second, the macroeconomy may adjust slowly to shifts in aggregate demand because of sticky wages and prices, which are wages and prices that do not respond to decreases or increases in demand. We consider these two claims in turn, and then see how they are represented in the AD/AS model.
The first building block of the Keynesian diagnosis is that recessions occur when the level of household and business sector demand for goods and services is less than what is produced when labor is fully employed. In other words, the intersection of aggregate supply and aggregate demand occurs at a level of output less than the level of GDP consistent with full employment. Suppose the stock market crashes, as occurred in 1929. Or, suppose the housing market collapses, as occurred in 2008. In either case, household wealth declined and consumption expenditure followed. Suppose businesses see that consumer spending is falling. This will reduces expectations of the profitability of investment, so businesses will decrease investment expenditure.
This seemed to be the case during the Great Depression, because the physical capacity of the economy to supply goods did not alter much. No flood or earthquake or other natural disaster ruined factories in 1929 or 1930. No outbreak of disease decimated the ranks of workers. No key input price, such as the price of oil, soared on world markets. The U.S. economy, in 1933, had just about the same factories, workers, and state of technology that it had had four years earlier in 1929—and yet the economy shrunk dramatically. This also seems to be what happened in 2008.
As Keynes recognized, the events of the Depression contradicted Say’s law that “supply creates its own demand.” Although production capacity existed, the markets were not able to sell their products. As a result, real GDP was less than potential GDP.
Link It Up
Visit this website for raw data used to calculate GDP.