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128 Aggregate Demand in Keynesian Analysis
What you’ll learn to do: describe the tenets of Keynesian Economics
In this section, you will learn about the basics behind Keynesian economics and analyze the AD-AS model through the lens of the Keynesian perspective.
Learning Objectives
Describe aggregate demand, recessionary gaps, and inflationary gaps as they apply to Keynesian analysis
Describe the Keynesian viewpoints on the determinants of consumption expenditure and investment expenditure
Describe the Keynesian perspective on factors that determine government spending and net exports
Aggregate Demand in Keynesian Analysis
The Keynesian perspective focuses on aggregate demand. The idea is simple: firms produce output only if they expect it to sell. Thus, while the availability of the factors of production determines a nation’s potential GDP, the amount of goods and services actually being produced and sold, i.e. real GDP, depends on how much demand exists across the economy. Suppose GDP is less than potential. Then changes in aggregate demand translate directly into changes in GDP, with no change in the price level. In short, real GDP is determined only by aggregate demand, not aggregate supply.
Watch It
Watch this video for an overview and introduction to Keynesian economics. We will explore the specifics from the video in more detail in this and subsequent modules.
The importance of aggregate demand is illustrated in Figure 1, which shows a pure Keynesian AD-AS model. The aggregate supply curve (AS) is horizontal at GDP levels less than potential, and vertical once Yp is reached. Thus, when beginning from potential output, any decrease in AD affects only output, but not prices; any increase in AD affects only prices, not output.
Keynes argued, for reasons we explain shortly, that aggregate demand is not stable—that it can change unexpectedly. Suppose the economy starts where AD intersects AS at P0 and Yp. Because Yp is potential output, the economy is at full employment. Because AD is volatile, it can easily fall. Thus, even if we start at Yp, if AD falls, then we find ourselves in what Keynes termed a recessionary gap. The economy is in equilibrium but with less than full employment, as shown at Y1 in the Figure 1. Keynes believed that the economy would tend to stay in a recessionary gap, with its attendant unemployment for a significant period of time.
In the same way (though not shown in the figure), if AD increases, the economy could experience an inflationary gap, where demand is attempting to push the economy past potential output. As a consequence, the economy experiences inflation. The key policy implication for either situation is that government needs to step in and fill the gap, increasing spending during recessions and decreasing spending during booms to return aggregate demand to match potential output.
Recall from previous r