<< Chapter < Page Chapter >> Page >
By the end of this section, you will be able to:
  • 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 aggregate demand/aggregate supply (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 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 only 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 will 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 will decline, and consumption expenditure will follow. Suppose businesses see that consumer spending is falling. That will reduce expectations of the profitability of investment, so businesses will decrease investment expenditure.

This seemed to be the case during the Great Depression, since 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, like 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 as it had had four years earlier in 1929—and yet the economy had 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.

Visit this website for raw data used to calculate GDP.

QR Codes representing a URL

Wage and price stickiness

Keynes also pointed out that although AD fluctuated, prices and wages did not immediately respond as economists often expected. Instead, prices and wages are “sticky,” making it difficult to restore the economy to full employment and potential GDP. Keynes emphasized one particular reason why wages were sticky: the coordination argument    . This argument points out that, even if most people would be willing—at least hypothetically—to see a decline in their own wages in bad economic times as long as everyone else also experienced such a decline, a market-oriented economy has no obvious way to implement a plan of coordinated wage reductions. Unemployment proposed a number of reasons why wages might be sticky downward, most of which center on the argument that businesses avoid wage cuts because they may in one way or another depress morale and hurt the productivity of the existing workers.

Questions & Answers

how to study physic and understand
Ewa Reply
what is conservative force with examples
Moses
what is work
Fredrick Reply
the transfer of energy by a force that causes an object to be displaced; the product of the component of the force in the direction of the displacement and the magnitude of the displacement
AI-Robot
why is it from light to gravity
Esther Reply
difference between model and theory
Esther
Is the ship moving at a constant velocity?
Kamogelo Reply
The full note of modern physics
aluet Reply
introduction to applications of nuclear physics
aluet Reply
the explanation is not in full details
Moses Reply
I need more explanation or all about kinematics
Moses
yes
zephaniah
I need more explanation or all about nuclear physics
aluet
Show that the equal masses particles emarge from collision at right angle by making explicit used of fact that momentum is a vector quantity
Muhammad Reply
yh
Isaac
A wave is described by the function D(x,t)=(1.6cm) sin[(1.2cm^-1(x+6.8cm/st] what are:a.Amplitude b. wavelength c. wave number d. frequency e. period f. velocity of speed.
Majok Reply
what is frontier of physics
Somto Reply
A body is projected upward at an angle 45° 18minutes with the horizontal with an initial speed of 40km per second. In hoe many seconds will the body reach the ground then how far from the point of projection will it strike. At what angle will the horizontal will strike
Gufraan Reply
Suppose hydrogen and oxygen are diffusing through air. A small amount of each is released simultaneously. How much time passes before the hydrogen is 1.00 s ahead of the oxygen? Such differences in arrival times are used as an analytical tool in gas chromatography.
Ezekiel Reply
please explain
Samuel
what's the definition of physics
Mobolaji Reply
what is physics
Nangun Reply
the science concerned with describing the interactions of energy, matter, space, and time; it is especially interested in what fundamental mechanisms underlie every phenomenon
AI-Robot
what is isotopes
Nangun Reply
nuclei having the same Z and different N s
AI-Robot
Got questions? Join the online conversation and get instant answers!
Jobilize.com Reply

Get Jobilize Job Search Mobile App in your pocket Now!

Get it on Google Play Download on the App Store Now




Source:  OpenStax, Macroeconomics. OpenStax CNX. Jun 16, 2014 Download for free at http://legacy.cnx.org/content/col11626/1.10
Google Play and the Google Play logo are trademarks of Google Inc.

Notification Switch

Would you like to follow the 'Macroeconomics' conversation and receive update notifications?

Ask