<div>
<p>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 section on <a data-lesson="#the_expenditure_output_model" data-page="177" data-subject="economics" data-tutorial="the-keynesian-perspective" href="https://app.ulearngo.com/economics/the-keynesian-perspective/#the_expenditure_output_model">The Expenditure-Output Model</a>.)</p>
<p>Keynesian economics focuses on explaining why recessions and depressions occur and offering a policy prescription for minimizing their effects. The Keynesian view of <strong>recession</strong> 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 <strong>sticky wages and prices</strong>, 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.</p>
<p>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.</p>
<p>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.</p>
<p>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.</p>
<div class="ns-school-defn2" data-has-label="true">
<p>Visit this <a href="https://fred.stlouisfed.org/series/DPCERX1A020NBEA" rel="nofollow">website</a> for raw data used to calculate GDP.</p>
</div>
</div>

3174eb1e-1f1a-441e-ab1c-3ea3bb79e46a

The Building Blocks of Keynesian Analysis

Economics studies social behavior guiding the allocation of scarce resources to meet the unlimited needs and desires of the individual members of a given society, and for the production of goods and services, growth of production and welfare over time, and a great variety of other complex issues of vital concern to society. 

Economics

Discover the Keynesian perspective on macroeconomics, including concepts such as aggregate demand, consumption and investment expenditure, government spending, net exports, wage and price stickiness, and the Phillips Curve.


The Building Blocks of Keynesian Analysis

Track Your Learning Progress