Unit 5: Aggregate Demand and Supply
5.1: The basic AD/AS model
The aggregate demand and supply model brings together the expenditure / demand side of the economy with the production / supply side of the economy. “Aggregate” just means total – so when we talk about aggregate demand and aggregate supply, we are talking about the total, economy-wide demand and supply for goods and services.
Aggregate Demand
The aggregate demand curve gives the level of output demanded by all sectors of the economy as a function of the price level. To determine the relationship between the price level and output, we need to put together the financial and the real sectors of the economy.
When the price level rises, we know from our study of money markets that the demand for money rises.
As illustrated, the reduction in aggregate expenditures reduces equilibrium GDP in the economy, with a multiplier. Summarizing, higher price levels raise the interest rate, reducing aggregate expenditures, which in turn reduces GDP.
All in all, higher price levels reduce the equilibrium level of output in the economy. We can summarize this relationship by placing the price level on the vertical axis and the level of GDP (the economy’s output) on the horizontal axis. This is the aggregate demand curve.
One way to think of aggregate demand is that it is the summation of all the demand curves in the economy. If demand for goods and services generally falls when the price level rises, then it stands to reason that, if we combine together demand for all goods and services in the economy, that the overall aggregate demand for goods and services falls as well.
As usual, an increase in the price level causes a movement along the AD curve. Anything other than price that changes demand for goods and services in the economy will shift the AD curve.
Increases in consumption spending, investment spending, government spending or net exports shift AD to the right
Decreases in consumption spending, investment spending, government spending or net exports shift AD to the left
In particular, fiscal and monetary policy both shift the aggregate demand curve. Fiscal policy acts directly on aggregate expenditures by changing government spending or through tax changes that change consumption spending. Monetary policy acts indirectly on aggregate expenditures by changing the interest rate, which in turn impacts spending. But both fiscal and monetary policy act on the demand side of the economy by changing expenditures on goods and services.
Aggregate Supply
The aggregate demand curve is derived from the aggregate expenditures function and shows demand for goods and services at various price levels. We now turn to production of goods and services by firms. That is, the quantity of output supplied.
While the shape of the aggregate demand curve is uncontroversial, the shape of the aggregate supply curve is the subject of significant disagreement.
On the other hand, the Keynesian aggregate supply curve has the usual upward sloping shape. Under the Keyneisan supply curve, firms produce more goods and services as the price rises. There are a number of explanations for this phenomenon, but here are two popular ones.
At low levels of output, firms can use their most efficient workers, land, tools, etc… However, at higher levels of output, firms are forced to rely on land which might not be as suitable, workers who are less productive, etc… This use of inefficient inputs raises the costs of production and so firm prices have to rise.
When the overall price level in the economy rises, firms theoretically shouldn’t be affected. The price at which firms sell their output rises, but input costs rise too, so the firm faces no real change. This would justify a vertical aggregate supply curve. However, at least in the short-run, the firm probably pays more attention to the price of its own product than to other prices. Thus, the firm is “tricked” into thinking its product is selling for a higher price (really an illusion because all prices and costs have increased), and then it increases its output as a result.
With either explanation, an increase in the price level corresponds to a higher level of output. This is the upward-sloping Keynesian AS curve.
As always, changes in the price level cause movements along the aggregate supply curve. The following are examples of factors that shift the aggregate supply curve.
Technological changes that make it easier for firms to produce output
Changes in input costs (e.g. energy costs)
Changes in business taxes
Summarizing Fiscal and Monetary Policy Tools
Fiscal and monetary policy both act on the aggregate demand curve, not on the aggregate supply curve, because both have the effect of changing the level of spending in the economy. Fiscal policy changes spending directly by changing government spending or taxes. Monetary policy changes spending indirectly by changing interest rates, which in turn affects aggregate expenditures.
The table below summarizes the fiscal and monetary policy tools at the government’s disposal. The first two are fiscal policy tools. The last three are monetary policy tools.
Tool Expansionary Policy
Contractionary Policy
Shift AD right Shift AD left
Government
Spending Raise Lower
Taxes Lower Raise
RRR Lower Raise
Open Market
Operations Buy bonds Sell bonds
Discount Rate Lower Raise
The fiscal policy tools work by changing aggregate expenditures directly. Higher government spending or lower taxes increase the level of spending on goods and services. Lower government spending or higher taxes reduce the level of spending on goods and services.
To emphasize one more time, all these policy tools – both fiscal and monetary policy – work on the aggregate demand curve because all ultimately have the effect of stimulating spending on goods and services.
Expansionary Policy
Any of the expansionary policies in the table above, fiscal or monetary, has the effect of shifting the aggregate demand curve to the right.
As illustrated on the diagram, the economy’s GDP rises but the price level also rises (inflation). This is an important policy tradeoff. Expansionary fiscal and monetary policy raises GDP but it also causes inflation.
Expansionary policy is useful during times of recession or high unemployment, when GDP is below potential level. In these cases, a small increase in inflation might be an acceptable tradeoff for increasing the GDP and getting out of a recession.
Contractionary Policy
As illustrated on the diagram, the economy’s price level falls, but GDP also falls. Again, we see the tradeoff. Contractionary policies can successfully lower the price level, but they bring with them the side effect of reducing GDP as well.
Contractionary policy is useful during times of high inflation. In this case, the most important policy goal is to bring down inflation, even if GDP falls as a consequence.
So now we see the main policy tradeoff. Expansionary policies can raise GDP, but they also create inflation. Contractionary policies can reduce inflation, but they lower GDP.
Fiscal and Monetary Policy with a Classical AS Curve
With a classical AS curve, expansionary policy causes an increase in the price level but no change in the level of output. In fact, when the aggregate supply curve is perfectly vertical (the classical AS curve), you can see from the diagram that no change in the aggregate demand curve can ever change the equilibrium level of output in the economy.
This difference is characteristic of the disagreement between Keynesian and classical economists in two ways. First, fiscal and monetary policy can never change GDP in the classical model. This underscores the difference between their philosophies on the role of government in the economy. In the Keynesian model, the government can use fiscal and monetary policy to manage GDP. In the classical model, there is no role for the government to manage the economy.
Second, classical and Keynesian economists disagree with each other about the role of demand generally. In classical economics, the level of output is determined only by supply-side factors such as productivity and the level of capital. Keynesian economists strongly dispute that this is the
only determinant of demand, and they argue that spending and demand are also important.
Negative Supply Shocks
Suppose that there is a reduction in aggregate supply in the economy. One example is an increase in energy prices, which will significantly raise business production costs. The aggregate supply curve shifts left.
Stagflation is really hard to tackle from a policy perspective. Expansionary policy can raise GDP, but it will make inflation even worse. Contractionary policy can control inflation, but it will reduce GDP by an even larger amount.
Generally, inflation can come from two sources. Increasing price levels that result from reductions in aggregate supply are called cost-push inflation. On the other hand, inflation that results from increases in aggregate demand is called demand-pull inflation.
Supply-Side Economics
Growing the economy by using expansionary fiscal and monetary policy leaves us with some unanswered policy problems.
If we assume a Keynesian AS curve, then expansionary fiscal and monetary policy can raise GDP, but it is accompanied by the negative side effect of inflation. And if we assume a classical AS curve, then expansionary fiscal and monetary policy results in no increase to GDP at all.
But what if we instead target increases in the aggregate supply curve? Both our problems are now solved. First, when the AS curve shifts right, GDP rises and the price level falls, so there is no inflation tradeoff. Secondly, it doesn’t matter whether we assume a classical AS curve or a Keynesian AS curve. Rightward shifts of AS increase GDP regardless of our assumption about the AS curve, as shown in the diagram below.
The government can do things to promote supply-side growth, but those are more long-term and not really useful for short-run management. We discuss these issues in a later unit on long-run economic growth. In particular, some economists suggest lowering taxes for businesses and the wealthy as a way to stimulate production of goods and services. While this looks good on paper, it was tried in the 1980s, and the record is mixed and controversial.
5.2: Policy Issues
In this section, we will explore a number of important issues in macroeconomic policy. We will not cover any of these issues in great detail, but you should have an idea about the important issues and how they impact policy.
Okun’s Law
Two of our important macroeconomic targets, GDP and the unemployment rate, are related together through Okun’s Law. Logically, when output rises then there will be more people working in order to produce that output. So high GDP is associated with low unemployment (lots of output and lots of people working). Low GDP is associated with high unemployment (low output and lots of people out of a job). Basically, employment and GDP outcomes go together
Okun’s Law formalizes this relationship. It states that every 1% increase in the unemployment rate corresponds to a 2-3% decline in GDP. Okun came up with this just from observation of data. For lots of different countries over lots of different time periods, this relationship seems to hold fairly accurately. It’s more of an observation or a rule of thumb than a law.
The interesting thing to think about is why the relationship is not 1-for-1. Shouldn’t a 1% drop in output produced lead to 1% of workers losing their jobs? The answer is no. Employers invest a lot in their workers: training costs, benefits, etc… So most employers who cut their output by 10% are not immediately going to fire 10% of their workers. It is more likely that the employers will reduce their hours or their pay. Indeed, according to Okun’s Law, it takes a 2-3% decline in output to create a 1% increase in unemployment.
Lags
Imagine you have a car with excellent brakes. The only problem is that the brakes don’t work until 15 seconds after you step on the brake pedal. No matter how well the brakes work, the car would be very hard to control because you can’t respond to the situation as it’s happening. Rather, whatever action you take won’t have any impact until 15 seconds later. And who knows what the right thing to do will be then?
For fiscal policy, there is typically a long legislative process for implementing tax changes or approving funding for new projects – at the federal level, Congress and the President have to coordinate on a spending bill. This is called an implementation lag because it takes some time for the policy to be implemented.
For monetary policy, the problem is different. The Fed is pretty independent, so it can implement its policy changes right away. But say that the Fed wants to implement expansionary policy by buying bonds. First, the Fed must locate a suitable bondholder. Then the bank has to take the money from the bond sale and find someone to lend it to, which typically requires locating a firm with a suitable investment project. Even after the money is lent out, there could be a delay before the project is actually started. And the money multiplier process takes some time to repeat this process. All in all, there is a response lag between the time the policy is implemented and when we actually observe increased spending in the economy.
Neither fiscal nor monetary policy can create an impact on the economy immediately. Practically, the lag may be as much as two years. This means that whatever policy decisions are made now are actually going to have an impact on the economy two years from now. This is a problem. Say there’s a recession now, so the appropriate reponse is expansionary fiscal and monetary policy. But who knows whether these will still be the right policy choices two years from now?
In summary, micromanagement of the economy using fiscal and monetary policy is always challenging because of lags. Policies implemented now are likely to affect the future economy, not today’s economy.
The Phillips Curve
Periods of high demand, whether government-stimulated or not, correspond to high GDP and low unemployment. But they also correspond to higher inflation. Periods of low demand correspond to low GDP and high unemployment. But the inflation rate is also lower.
The Phillips Curve illustrates this tradeoff between unemployment and inflation. Stimulating aggregate demand reduces unemployment but it also increases inflation. Reducing aggregate demand reduces inflation, but at a cost of high unemployment (since GDP is lower).
The point of the Phillips curve is that, from a policy perspective, there is a tradeoff between the two. Note that stagflation puts the economy outside of the Phillips curve (high unemployment and
high inflation).
Keynesian and Classical Views on the Phillips Curve
The Phillips curve asserts a relationship between prices and employment. But why is it logical that there should be a relationship between the two?
The Keynesian explanation would be something like this. When prices and wages rise due to inflation, workers are initially “tricked” into believing that their wages are higher. That is, workers see higher money wages but do not immediately realize that the real value of their wages is lower because rising prices. This wage illusion tricks workers into believing that their wage is higher and tricks them into working more, which explains why unemployment falls.
Classical economists assert that, at least in the long run, the rate of inflation has no relationship whatsoever to employment and output. Workers and firms adjust their expectations consistent with the prevailing rate of inflation. Thus, ultimately, the rate of inflation has no impact on output or employment levels. The classical Phillips curve is vertical.
One might think of the vertical Phillips curve as a long-run Phillips curve and the downward-sloping Phillips curve as a short-run Phillips curve.
In the classical model, the prevailing rate of unemployment in the economy is the natural rate of unemployment. It depends on various institutional factors in the economy such has how easy it is to locate jobs and how much unemployment compensation is paid by the government. But it has nothing to do with price levels and inflation.
This disagreement highlights many features of the difference between Keynesian and classical approaches. First, classical economists emphasize the long-run and self-adjustment back to the natural rate of unemployment. Keynesian economists emphasize the short-run and that the economy may not attain this natural rate of unemployment on its own.
Second, classical economics consistently assumes rationality and rational adjustment of expectations. By contrast, Keynesian economics emphasizes imperfect information and decision-making, at least in the short run. This is highlighted by their opposing views on wage illusion.
Government Deficits and Debt
The deficit is a flow variable that measures the difference between government spending and taxes. If taxes are greater than spending, then there is a surplus. The national debt is a stock variable that measures the total amount of money owed by the government at any given point in time. The debt represents the total owed, and is the accumulation of previous deficits. By contrast, the deficit is the shortfall over the period of a year.
The US federal budget deficit in 2014 was $483 billion. The overall national debt in the US is currently around $18 trillion. About $13 trillion of this is debt owed to the public – Americans and foreigners who hold US government bonds. The other $5 trillion is owed internally to other government accounts.1
Here is the federal budget deficit since 1950, expressed in real 2014 dollars. A negative value indicates that the federal government was in surplus for that year.
In thinking about the deficit, it is first useful to distinguish between the cyclical deficit and the structural deficit. The cyclical deficit is the part of the deficit that is due to changes in the business cycle. During a recession, taxes are lower and government expenditures are higher (like unemployment and welfare payments), and this part of the deficit is cyclical. The structural deficit is the deficit that would exist even at full employment. For example, if the deficit is $30 billion, but it would have been $10 billion even at full employment, then the structural deficit is $10 billion, while the cyclical piece of the deficit is $20 billion.
To economists who believe that the government has a role in stabilizing the economy, one of the main purposes of government is to be countercyclical. That is, when the rest of the economy is
1 The social security program currently generates large surpluses, which are then lent to other parts of the
declining, the government can increase its own spending to compensate. And when the rest of the economy is going well and private sector spending is high, the government can scale back its spending. In other words, government spending can run against the business cycle.
The government is in a unique position to fill this role because the government can easily borrow lots of money at low interest rates – much lower than the rate at which any private entity can borrow. Thus, it’s easier for the government than for any private entity to stimulate spending during recessions. Even economists who believe in balanced budgets generally believe that the budget should be balanced over the long-term course of the business cycle rather than year on year. If the government plays a countercyclical role, then it is normal for the government to have a deficit during recessions. It is trying to stimulate spending.
In this framework, cyclical deficits are normal and expected – just part of the normal operations of business. During bad times, tax revenues are low (because incomes are low) and government expenditures are high (because the government is trying to offset the recession), so deficits are expected. Thus, we should be more concerned about structural deficits than we are about cyclical deficits.
But, in fact, even permanent, structural deficits may not present a problem. But why not? Doesn’t it stand to reason that we’re going to go bankrupt if the government keeps running deficits year after year? Well, not necessarily.
First, the government can actually permanently run deficits without ever running into financial problems. You might think that the government would eventually have to run surpluses to pay back the debt, but this ignores a key point – growth. Suppose an economy runs permanent deficits, and thus its debt rises by 3% every year. But the economy’s GDP grows by 5% per year. This economy will never be in trouble. Its income – its ability to pay back its debts – is growing faster than its debts. It’s fine for debt to grow as long as income grows even faster. It’s only when debt grows faster than GDP that we start to get worried about long-run sustainability.
Crowding Out
In general, crowding out occurs when an increase in spending in one sector results in lower spending in some other sector of the economy. Usually, people use the term to talk about government spending crowding out private-sector spending.
For example, when government spending increases, AD shifts to the right, which increases the price level. This increase in the price level raises the demand for money, which in turn raises the interest rate.
When the equilibrium interest rate in the economy rises, investment and consumption spending both fall. In this case, we say that higher government spending “crowds out” private investment and consumption spending.
If the reduction in private spending is exactly equal to the increase in government spending, then we say that there is complete crowding out. If there is complete crowding out, then government spending ultimately has no effect on the economy because increases in government spending are completely offset by reductions in private sector spending.
Monetarism – Equation of Exchange
The basic equation of exchange for understanding money circulation has four components.
𝑀 is the money supply
𝑉 is the velocity of money – the number of times each dollar changes hands in one year. The velocity of money in the US economy is around 10.
𝑃 is the price level
𝑌 is the economy’s output level (real GDP)
The fundamental equation of exchange states that 𝑀𝑉 = 𝑃𝑌.
This equation is an identity and is not in and of itself an economic theory. It just says that money circulation has to identically equal the value of output that is bought and sold.
The left side of the equation 𝑀𝑉 is the amount of money circulation in a year. If there are 200 dollars in circulation and each dollar changes hands 5 times a year, then there is a total of $1000 of money circulation in the economy over the year.
The right side of the equation 𝑃𝑌 is the value of goods and services exchanged in a year. If 500 units of output are sold, each at a price of $2, then $1000 worth of goods and services are exchanged over the course of the year.
But the two must be equal to each other in a simple accounting sense. If $1000 of goods and services are bought and sold within a year, then there must be $1000 of money that circulates in order to pay for the transactions.
Monetarism – Varying Views
The equation of exchange is an identity and not an economic theory. Indeed, there is serious disagreement about the relationship between these variables, especially about the role of money in the economy. The relationship between the money supply and output has been the subject of debate for a long time in economics.
According to monetarist theory, 𝑉 and 𝑌 are fixed. Using 𝑀𝑉 = 𝑃𝑌, this has two consequences.
Second, The only source of changes in 𝑃 is changes in the money supply 𝑀. A famous saying in monetarist theory is “inflation is always and everywhere a monetary phenomenon.”
Monetarists claim that there is a very rigid relationship between the money supply and the price level. The reason is basic economics – printing more money doesn’t make people rich. That is, printing money in and of itself does not increase production of goods and services. If the government prints additional money without any more goods and services produced, the only
possible outcome is that prices rise. There is more money “chasing” the same amount of goods and services available. Wealth and high standards of living come from production of goods and services, not from paper.
But Keynesians claim that the situation is not quite this simple. They say that, if the government prints more money, people may not immediately realize that the money is devalued. In other words, workers and firms have money illusion and actually believe that the economy is wealthier. Having more money circulating causes more people to work and causes firms to increase their production of goods and services. According to the Keynesians, at least in the short-run, increases in the money supply can raise output.
Classical economics supports the monetarist view, and this position is sometimes called the
classical dichotomy. According to classical economics, there is a complete separation between monetary variables and real variables. Changes in the money supply change price only, and have no effect on real output. Keynesian economists, by contrast, claim that monetary and real variables are in fact linked to each other. In Keynesian economics, increases in the money supply 𝑀 can increase both the price level 𝑃 and the level of output 𝑌.
This disagreement again highlights some common themes that distinguish classical and Keynesian economics. First, classical economics emphasizes rationality and full information. You can’t trick workers and firms by printing more money, because they realize that the new money is devalued. By contrast, Keynesian economics emphasizes limited rationality and imperfect information. The Keynesian view is more consistent with the short-run, whereas the classical view is more consistent with the long-run.
Depression on bad monetary policy. By contrast, Keynesians assert that the money supply is a useful tool for managing the economy.
Which is correct? Most economists these days agree that money plays an important role in the real economy in the short-run. The extreme version of monetarism that opposes any management of the money supply has little support among economists today.
5.3: Short-run and long-run AD/AS
Potential GDP
Potential GDP is the level of output when all the economy’s resources are used at their normal levels. For example, in the labor market, a normal rate of utilization is when there is full employment with workers working full time. Similarly, there is a normal rate of utilization for capital resources or for environmental resources like oil.
In the short-run, resources could be used above or below their normal rates of utilization. For example, the existence of many unemployed workers means that labor is being used below its normal rate of utilization. On the other hand, labor might be utilized above its normal level if many workers are working overtime or if the unemployment rate falls below the natural rate of unemployment. One can similarly imagine factories running above or below their normal capacity in the short-run.
As a result of this, at least in the short-run, actual GDP could be above or below potential GDP. If there are many unemployed or under-utilized resources, then actual GDP will fall below potential level. However, if resources are over-utilized, then it is also possible in the short-run to push GDP higher than its potential level.
Classical Adjustment – GDP above Potential
Remember that classical economics emphasizes self-adjustment and self-regulation of the economy. An important cornerstone of classical economics is that GDP will always tend automatically to return to potential level without any government intervention.
Suppose that short-run equilibrium GDP exceeds potential GDP. This means that resources are being used above their normal rates of utilization. In this case, people are working really hard and they all have jobs, so there is a shortage of resources – especially labor. Firms will find it harder and harder to attract workers, so basic economics tells us that this overutilization and shortage of labor will cause wages to rise, along with other resource costs. This increases production costs for firms, which shifts AS to the left.
This process will continue as long as labor is used above its normal level. Thus, wages will rise and AS will continue to shift left until equilibrium GDP falls back to the potential level.
Summarizing, the economy has an automatic adjustment mechanism to bring GDP back to the potential level when it rises above potential GDP in the short-run.
Expansionary Policy
For the short-run, GDP rises above the potential level. But, as discussed in the previous section, this causes wages and other input costs to rise as there is a shortage of resources. The increase in firm production costs eventually shifts AS back to the left, returning GDP back to potential level.
Thus, over the long run, government expansionary policy has no impact on GDP. GDP always returns to potential level on its own. However, the new equilibrium is at a higher price level. In the classical model, expansionary policy causes no increase in GDP but results in inflation.
Classical Adjustment – GDP below Potential
Suppose instead that GDP is below potential level in the short run. This means that resources are used below their normal level. Importantly, GDP below potential implies a high level of unemployment with many workers who do not have jobs.
In this classical model, high unemployment makes resource costs fall – especially wages. The argument is simple economics. When there is a large pool of unemployed workers, firms can get away with paying lower wages because there are many workers without a job who would be willing to accept a job at low pay. Indeed, employers might like it when the economy operates with some unemployment because they don’t have to pay high wages to attract workers. The reduction in wages lowers firm production costs and eventually shifts the AS curve to the right. In other words, firms increase their supply of output because of lower production costs.
This expansion will continue as long as GDP is below potential level, so eventually GDP will automatically return in the long-run back to potential level.
Long-Run Aggregate Supply
To summarize, the classical self-adjustment model asserts that GDP will always self-correct itself back to the potential level in the long run without any government intervention (or even in spite of government intervention).
When GDP is above potential, there is high demand for workers and other resources, causing wages to rise. This increase in firm costs reduces supply until GDP falls back to potential.
When GDP is below potential, there are many underutilized resources and lots of unemployment, causing wages to fall. This reduction in firm costs raises supply until GDP rises back to potential.
In the long-run, GDP always returns to potential level. In this model, the long-run aggregate supply curve is vertical at the potential level of GDP.
Thus, according to the classical model, fluctuations in aggregate demand have no impact on the level of GDP in the long-run. This is consistent with the general theme that the classical model is more supply-oriented, while the Keynesian model is more demand-oriented. According to this classical self-adjustment argument, the level of output is solely determined by aggregate supply. AD has no impact on equilibrium GDP.
Keynesian Criticism
always adjust in a way that makes the economy return to long-run equilibrium at potential GDP. For example, when the economy is in recession, wages should fall, which encourages firms to expand their hiring and raise output back to the potential level.
Keynesians strongly dispute the validity of the self-adjustment mechanism because they argue that wages are not flexible. This lack of flexibility in the real-world economy is a cornerstone of Keynesian economic theory.
Wage rigidities (or sticky wages) describes a situation in which it is difficult for wages to adjust even when market conditions imply that they should. For example, if there is a recession and a large number of unemployed workers, market economics implies that wages should fall. But Keynesians claim that they might not actually fall.
Why not? Keynesians point to three main sources of wage rigidities.
Long-term contracts: Many workers operate with long-term contracts and collective bargaining agreements. In these situations, it is very difficult to cut wages even when market conditions imply that the wage rate should fall.
Efficiency wages: Many firms are reluctant to cut wages because they believe that worker morale, loyalty and retention will suffer if wages are cut. There is some evidence for this.
Minimum wage laws: No matter what economic conditions imply should happen to wages, wages can never fall below the legal minimum wage.
All of these, according to Keynesians, are reasons to doubt the classical self-adjustment model. Keynesians claim that this model is over-simplistic and that there are institutional features of the economy that create sticky wages. Note that wage flexibility in the upward direction is not usually a problem. There is typically nothing that prevents wages from rising. Sticky wages are a problem in the downward direction.
Why does this matter? According to the classical argument, self-adjustment from a recession relies on falling wages: output is below potential, labor is underutilized with many unemployed workers, and so wages should fall, causing firms to increase hiring and raise their output. But if Keynesians are correct that wages don’t actually fall, then there is no automatic self-recovery!
In Keynesian economics, because the economy doesn’t self-adjust back to potential GDP, there is room for the government to get involved and to use fiscal and monetary policy to provide demand-side stimulus that raises GDP. As we see again, the general theme is that classical economics stresses self-regulation of the economy, whereas Keynesian economics stresses market imperfections and supports government management.
There is a second important Keynesian objection, besides sticky wages, to the classical self-adjustment model. Keynesian economists claim that supply of output by firms depends more on expectations about future demand than on production costs. In other words, no matter how low wages and production costs fall, firms will not expand their hiring and output if they don’t expect demand for their products. If the economy is in recession, bad expectations about the future among firms can create a negative cycle that keeps the economy in recession and keeps firms from expanding employment and output, no matter what happens to production costs.
Finally, lurking in the classical model is also an assumption about flexible prices. We are assuming that prices can adjust in a way that ensures equilibrium of demand and supply. Again, in reality, there may be institutional factors in the economy that make it difficult for firms to adjust prices. For example, most firms commit to prices in catalogs and contracts well in advance. That is, firms may not be able to easily adjust prices to maintain equilibrium.
