Keynesian Macroeconomics

The traditional Keynesian economics believes that business cycles (periods of declining aggregate economic activities followed by periods of rising ones) are caused by sticky prices and focuses on aggregate demand shocks. Also, traditional models (such as AS-AD) scratch the underlying assumptions of the neoclassical growth model in favour of a non-walrasian approach to modelling business cycles.

In this simple model, the AS curve is flat, money wages are sticky downward, but can rise quickly. However when AD falls, money wages do not, so output falls considerably. When it rises, the AS curve swiftly shifts upward as resource owners try to restore the purchasing power.

Therefore, we have serious recessions if AD falls and much higher prices along LAS if AD rises. A flat AS curve means money wage does not change. When AS shifts back to AD’, real GDP falls but the price level does not.

As we can see below, if AD’ shifts out to AD’’ then once the economy hits the potential real GDP along LAS, the AS curve shifts to AS’, as workers try to compensate for lost purchasing power. In this model they are very successful as money wages rise as fast as the price level once potential real GDP is reached.

According to this model, changes in aggregate demand have their greatest short run effect on real output an employment, not on prices. To illustrate this, the Phillips curve shows that the inflation is rising slowly only when unemployment falls.

Another point is that Keynesians believe that prices, and especially wages respond slowly to changes in supply and demand resulting in periodic shortages and surpluses, especially for labour.

The traditional Keynesian approach advocates activist stabilization policy to reduce the amplitude of the business cycle, which they rank among the most important of all economic problems. However this does not mean that Keynesians advocate adjusting government spending, taxes and the money supply every few...