How can we illustrate the dynamics of Keynesian Economics within an aggregate supply – aggregate demand (ASAD) framework? The following post explains the Keynesian dynamics that we discussed in a previous post using an AS-AD model.
Before we start with the economic dynamics, let us just briefly revise the the AS-AD model. The AS-AD model is a macroeconomic model that connects the price level (inflation) and output growth through the relationship of aggregate supply and aggregate demand. The figure below presents a stylized AS-AD model. In the AS-AD model, the downward slowing orange curve represents aggregate demand. The upward sloping blue line represents aggregate supply in the short run. The green dotted line represents long run aggregate supply, which represents an economy’s growth potential. Remember that aggregate demand is the key concept of Keynesian economics. Hence, in Keynesian reasoning, the impulse that generates economic dynamics comes from changes in aggregate demand.
How do Keynesian dynamics work in an AS-AD model? Let us continue with the example that I laid out in this previous post. In the figure above, the economy is in an equilibrium in which current output growth is equal its growth potential. Assume now that the economy enters in a recession and aggregate demand decreases. In this case the orange line shifts back and to the left. The new equilibrium also moves down and to the left. We observe a reduction in output and a decrease in inflation.
Under the assumption of wage-stickiness, a common assumption of Keynesian economics, firms need to lay off people. Thus, a reduction in aggregate demand decreases jobs and increases unemployment. In this setting, there may be some important second-order effects. The long run aggregate supply curve may end up to the left as well. The reason being that some laid-off workers may end up being demoralized, might lose their workplace contacts and be less integrated in society. In the longer run, those people might loose the skill and end up being less productive. In this case the economy used knowledge and skills. We observe a decrease in the economy’s growth potential.
In a concise way, this article explained how Keynesian dynamics can be presented in an AS-AD framework. Particularly, the blog post explained how a drop in aggregate demand propagates within an AS-AD model and explained how second-order effects can lead to a permanent decrease in output. The next post on the series of Keynesian economics focuses on how to get out of a recession and elaborate on the Keynesian remedies to do so.
4) How to get out of a recession?
5) Drawbacks of Keynesian Economics