<< 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

opportunity cost means the lose of other alternatives when the alternative is chosen
saad Reply
is the benefits that you loose by not selecting a certain alternative.
EDWINY
individual wants maybe unlimited, but means to satisfy them are limited there one has to forgo some alternative in order to acquire other alternative and it must according priority, that is when scale of preference set in for individuals to make choice
Rhaiymornd
hello everyone
Aliyu
Next best alternative forgiven
Shoaib
demand is the amount of goods and services that consumer is willing and able to purchase at a particular prices over given period of time
Rhaiymornd Reply
yep
Abraham
what's demand?
labi Reply
What customers want the most...
Abraham
not only what customers wants, want is just mere desire but demand is backed by purchasing power, ability and willingness
Rhaiymornd
thanks
Abraham
What's opportunity cost?
Abraham
what are the differences between demand and supply
Zakariyah Reply
who is called lender of the last resort
Divyanshu Reply
Hi
Linda
hlw
Karishma
Central bank
Majeed
hy
Karishma
Hello
Majeed
hy
Karishma
How are you
Majeed
Am gud
Linda
fine
Karishma
Am gud
Linda
hello
Chandra
Well! what's going on
Majeed
r u study in economics
Karishma
anybody there?
Chandra
r u study in economics
Karishma
the central bank
Sessay
Has completed already
Majeed
hey
neha
yes
Abigail
Yesss
Majeed
ok
Karishma
hey
Doctor
yh
Abigail
more questions
Sessay
how ar you
Doctor
split the price effect into income effect and substitution effect
Karishma
fine and u
Abigail
Hi
Godwin
hi
Hey, I am new here. Hope, discussion on Economics will clear our concepts more.
yasir
yes
Abigail
do u speak hindi or english
Karishma
how to consumer equlibrium through ic
Karishma
consumer equilibrium demand equals supply
Kenneth
the consumer is in equilibrium when the indifference curve is tangential to the budget line. or when the BL and IC intersect
Sessay
reasons indifference curve slopes downwards?
Kenneth
fine Abby any good,
Doctor
ur lost
Doctor
hey. im new year. economics teacher how we can discuss some thing interesting.
EDWINY
which one
Doctor
what do u understand the concept of poverty cycle.
EDWINY
hey
Ebong
I'm New here
Ebong
hi
ian
just new here guy's and also an Economics fresher of Kogi State University Anyigba
nelson
wxup
Ayegba
who can tell the laboratory of economic?
Amara
, Dennis Weissman Associates, LLC Laboratory Economics is the monthly business newsletter that gets behind the headlines and press releases.
Ayegba
sooo teah me what an LLC
Emmanuel
what's the topic
Adamsvictor Reply
economic systems
gracious
hello
Antonio
market
aba
hello where can I find the diagrams
Manu
Hello I am totally out ,I am not understanding why we are here. can someone help me out?
Amara
why Economic is not a pure science can someone help me out
Mohamed
because economics like science put forth a some hypotheses and then do experiments to prove them
Anwesh
but these experiments are not completely controlled
Anwesh
Hello
Comfort
hey
suraj
hi people can you help me out on "demand and supply"
Milton
Am not understanding can someone enlighten me pls
Bertilla
hi people can you help me out on "demand and supply"
Sessay
hello. if Mr.Patrick's income is #900.00 while that of Mr.Shodawe is #1300.00 if Mr.Patrick and Shodowe pay #90.00 and #130.00 as taxes,the tax system is?
Benjamin
I need the answer please
Benjamin
regressive tax system
shaikh
OK thanks
Benjamin
Isn't this called proportional tax rate because the rate stays the same - 10%? Tell me if I'm wrong
Ioan
Supply is perfectly elastic and demand increases.
kishore Reply
whose there
Waseem
show the demand curve
Hameed Reply
it slopes downward from left to right
Ama
how resources are allocated in a free economy
Charlotte Reply
explain how discriminating Monopoly increase profits
Charlotte
factors responsible for the emergence of monopoly situation
adelakun Reply
total output produced by a country over a given period of time .... can someone give me the term plz
TMM Reply
GDP
Anjorin
thaks man
TMM
Woman. 👍👍
Anjorin
gross domestic products
janet
GDP
Bertilla
GDP
Prof
GDP
Bertilla
gross domestic product
gross domestic product
GDp
Mohamed
gdp
agboola
what is recession pertaining to GDP
Prince
what is recession pertaining to GDP
Prince
what is recession
Prince
law of demand and supply
Zakariyah
All thing been equal
Temple
no i think recession is pertaining to GNP
owolabi
gross national production
Abraham
what is embago
Peter
all things being equal
Raphael
embargo restriction on trade by government of a country
owolabi
an official ban on trade or other commercial activity with a particular country.
Ayegba
Embargo.....an order by a common carrier or publ regulatory agency prohibiting or restric freight transportation
Ayegba
it's a complete band on important n export
Bertilla
who is Really Good in Mathematics. put me Through. Let Do Group Reading; am Preparing to Write Jamb this Year.
Andrew
Hi. C+I+G+x-m
Shoaib
Gdp aggregate demand are bit same
Shoaib
Dpd = c+i+g+(x-m) is aggregate demand
Shoaib
Gdp=c+i+g+(x-m) is aggregate demand
Shoaib
GDP= c+i+s+g+(x-m)
Saboor
Topic ended waiting for next topic
Shoaib
What is Terms of Trade (TOT)?
DADA
At what point a Terms of Trade can be favorable?
DADA
What is long run supply curve of a industry
Rashika Reply
enlightened
Ernest
all on board am here
Ernest Reply
am late I missed alot
Ernest
A mixed economy is the best type of an economy.Discuss
Tawanda Reply
Agreed Mixed economics is d combination of both capitalist and socialist economy, it give room for both individual and government to make decisions whereby giving room to a rapid development of d economy.
Anjorin
?
Andres
agreed
Ernest
Explain more about the Macroeconomics
Lizzy Reply
what is macroeconomic
Ekye
macro economics has to do with the of study economics at national level i.e the study of national economy as a whole. While micro is concerned with the study at individual, group or company level.
Andres
Andres explain
Ernest
ok
Ernest
what topic is capitalist economy based on
ADIBE
pls am not really understanding
Bertilla
pls can u explain more
Bertilla

Get the best Principles of economics course in your pocket!





Source:  OpenStax, Principles of economics. OpenStax CNX. Sep 19, 2014 Download for free at http://legacy.cnx.org/content/col11613/1.11
Google Play and the Google Play logo are trademarks of Google Inc.

Notification Switch

Would you like to follow the 'Principles of economics' conversation and receive update notifications?

Ask