The Two Keynesian Assumptions in the AD/AS Model

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 this figure. 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 this figure. 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 (AD₀) 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 Y₁, the economy experiences substantial unemployment.

A Keynesian Perspective of Recession

The equilibrium (E₀) 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 AD₁ instead of AD₀. 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 E₁ occurs in the flat portion of the SRAS curve where the price level does not change.