8.4 Macroeconomic controversies: the Keynesian perspective
Keynesian economists base their ideas on the work of John Maynard Keynes, one of the most famous
economists of the 20th century, whose work in the first half of that century came to form basis of
modern macroeconomics.
Wage and price downward inflexibility
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Keynesian economists note that under conditions of an economic expansion and strong
aggregate demand, with unemployment lower than the natural rate and rising price level, wages
quickly begin to move upward.
Yet in a recessionary gap, where aggregate demand is weak and the economy is in recession
with unemployment greater than the natural rate, wages do not fall easily, even over long
periods of time, because of a variety of factors such as labor contracts, which fix wage rates for
certain periods of time.
Keynesian economists argue that not only wages, but also products process are inflexible in the
downward direction, even if an economy is in a recessionary gap. They argue that the event of a
recessionary gap prediction that the price level will fall is unlikely to happen. In a recession, if
wages won’t go down, firms will resist lowering their process because that would reduce their
profits.
According to the Keynesian perspective, both wages and prices are unlikely to fall even if the
economy is in a recessionary gap, and even if the recessionary gap persists over long periods of
time.
The inability of the economy to move into the long run
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If wages and prices do not fall easily even in the long periods of time, this in effect means
that the economy may get stuck in the short run, and cannot move into the long run.
This happens (shown in Figure 1.1): The economy is initially at point a, producing potential
output Yp. There occurs then a decrease in aggregate demand, so the AD shift from AD1 to
AD2; where there is a recessionary gap according to the neoclassical perspective, and the
price level falls from PL1 to PL2. In the long run it will move to pint c, where there is an even
lower price level PL3, and the economy is once again producing potential output Yp.
If the price level cannot fall from PL1, where it was initially, the economy will move to point
d on the new, lower, aggregate demand curve, AD2. Even if the price level succeeds in
falling to PL2, so that the economy moves to point b, the economy may get stuck there if
wages do not fall.
In the Keynesian perspective, inflexible wages and prices mean that the economy cannot
move into the long run. This is shown in the Keynesian AS curve, Figure 1.2.
Figure 1.1
Figure 1.2
The shape of the Keynesian aggregate supply curve shown in Figure 1.3
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The Keynesian aggregate supply curve has three segments. In segment I, real GDP is low, and
the price level remains constant as real GDP increases. In this range of real GDP, there is a lot of
unemployment of resources.
In segment II,as real GDP continues to increase, the AS curve begins to rise, so that the real GDP
increases are accompanied by increases in the price level. The reason is that as output increase,
so does so does employment of resources, and eventually bottlenecks in resources supplies
begins to appear.
At output level Yp, the economy has reached its full employment level of real GDP. This is also
its potential output level, and unemployment has fallen to the point where it is now equal to the
natural rate of unemployment (but is not maximum employment). It is possible for
unemployment to fall further, which is what happens when real GDP continues to increase
beyond Yp. Real GDP can continue to increase until it reaches segment III.
In segment III, the AS curve becomes vertical at Ymax, indicating that that real GDP reaches a
level beyond which it cannot increase anymore; at this point the level rises very rapidly. GDP can
no longer increase because firms are now using the maximum amount of labor and all other
resources that are available in the economy.
Figure 1.3