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The two keynesian assumptions in the ad/as model

These two Keynesian assumptions—the importance of aggregate demand in causing recession and the stickiness of wages and prices—are illustrated by the AD/AS diagram in [link] . Note that because of the stickiness of wages and prices, the aggregate supply curve is flatter than either supply curve (labor or specific good). In fact, if wages and prices were so sticky that they did not fall at all, the aggregate supply curve would be completely flat below potential GDP, as shown in [link] . This outcome is an important example of a macroeconomic externality    , where what happens at the macro level is different from and inferior to what happens at the micro level. For example, a firm should respond to a decrease in demand for its product by cutting its price to increase sales. But if all firms experience a decrease in demand for their products, sticky prices in the aggregate prevent aggregate demand from rebounding (which would be shown as a movement along the AD curve in response to a lower price level).

The original equilibrium of this economy occurs where the aggregate demand function (AD 0 ) intersects with AS. Since this intersection occurs at potential GDP (Yp), the economy is operating at full employment. When aggregate demand shifts to the left, all the adjustment occurs through decreased real GDP. There is no decrease in the price level. Since the equilibrium occurs at Y 1 , the economy experiences substantial unemployment.

A keynesian perspective of recession

The graph shows three aggregate demand curves and one aggregate supply curve. The aggregate curve farthest to the left represents an economy in a recession.
The equilibrium (E 0 ) illustrates the two key assumptions behind Keynesian economics. The importance of aggregate demand is shown because this equilibrium is a recession which has occurred because aggregate demand is at AD 1 instead of AD 0 . The importance of sticky wages and prices is shown because of the assumption of fixed wages and prices, which make the SRAS curve flat below potential GDP. Thus, when AD falls, the intersection E 1 occurs in the flat portion of the SRAS curve where the price level does not change.

The expenditure multiplier

A key concept in Keynesian economics is the expenditure multiplier    . The expenditure multiplier is the idea that not only does spending affect the equilibrium level of GDP, but that spending is powerful. More precisely, it means that a change in spending causes a more than proportionate change in GDP.

ΔY ΔSpending > 1

The reason for the expenditure multiplier is that one person’s spending becomes another person’s income, which leads to additional spending and additional income, and so forth, so that the cumulative impact on GDP is larger than the initial increase in spending. The details of the multiplier process are provided in the appendix on The Expenditure-Output Model , but the concept is important enough to be summarized here. While the multiplier is important for understanding the effectiveness of fiscal policy, it occurs whenever any autonomous increase in spending occurs. Additionally, the multiplier operates in a negative as well as a positive direction. Thus, when investment spending collapsed during the Great Depression, it caused a much larger decrease in real GDP. The size of the multiplier is critical and was a key element in recent discussions of the effectiveness of the Obama administration’s fiscal stimulus package, officially titled the American Recovery and Reinvestment Act of 2009 .

Key concepts and summary

Keynesian economics is based on two main ideas: (1) aggregate demand is more likely than aggregate supply to be the primary cause of a short-run economic event like a recession; (2) wages and prices can be sticky, and so, in an economic downturn, unemployment can result. The latter is an example of a macroeconomic externality. While surpluses cause prices to fall at the micro level, they do not necessarily at the macro level; instead the adjustment to a decrease in demand occurs only through decreased quantities. One reason why prices may be sticky is menu costs, the costs of changing prices. These include internal costs a business faces in changing prices in terms of labeling, recordkeeping, and accounting, and also the costs of communicating the price change to (possibly unhappy) customers. Keynesians also believe in the existence of the expenditure multiplier—the notion that a change in autonomous expenditure causes a more than proportionate change in GDP.

References

Harford, Tim. “What Price Supply and Demand?” http://timharford.com/2014/01/what-price-supply-and-demand/?utm_source=dlvr.it&utm_medium=twitter.

National Employment Law Project. “Job Creation and Economic Recovery.” http://www.nelp.org/index.php/content/content_issues/category/job_creation_and_economic_recovery/.

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
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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
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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
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Majeed
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Linda
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Karishma
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Chandra
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Karishma
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Sessay
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Majeed
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neha
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Abigail
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Majeed
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Karishma
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Doctor
yh
Abigail
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Sessay
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Doctor
split the price effect into income effect and substitution effect
Karishma
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Abigail
Hi
Godwin
hi
Hey, I am new here. Hope, discussion on Economics will clear our concepts more.
yasir
yes
Abigail
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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
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Doctor
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Doctor
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EDWINY
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Doctor
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EDWINY
hey
Ebong
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Ebong
hi
ian
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nelson
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Ayegba
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Amara
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Emmanuel
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Adamsvictor Reply
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gracious
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Antonio
market
aba
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Manu
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Amara
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Mohamed
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Anwesh
but these experiments are not completely controlled
Anwesh
Hello
Comfort
hey
suraj
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Milton
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Bertilla
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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
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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
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TMM
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Anjorin
gross domestic products
janet
GDP
Bertilla
GDP
Prof
GDP
Bertilla
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GDp
Mohamed
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agboola
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Prince
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Prince
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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
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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
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Shoaib
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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
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Ernest Reply
am late I missed alot
Ernest
A mixed economy is the best type of an economy.Discuss
Tawanda Reply
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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

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Source:  OpenStax, Principles of economics. OpenStax CNX. Sep 19, 2014 Download for free at http://legacy.cnx.org/content/col11613/1.11
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