The Building Blocks of Keynesian Analysis

Keynesian economics focuses on explaining why recessions and depressions occur and offering a policy prescription for minimizing their effects. The Keynesian view of recession is based on two key building blocks:

1. Aggregate demand, AD, is not always automatically high enough to provide firms with an incentive to hire enough workers to reach full employment.

2. The macroeconomy may adjust only slowly to shifts in aggregate demand because of sticky wages and prices—wages and prices that do not respond to decreases or increases in demand.

Let's look at each of these two claims more closely. The first building block of the Keynesian diagnosis is that recessions occur when the level of household and business sector demand for goods and services is less than what is produced when labor is fully employed. In other words, the intersection of aggregate supply and aggregate demand occurs at a level of output less than the level of GDP consistent with full employment.

Suppose the stock market crashes, as occurred in 1929. Household wealth declines, and consumption expenditure follows. Businesses see that consumer spending is falling, which reduces expectations of the profitability of investment, so they decrease investment expenditure.

This seems to be what happened during the Great Depression since the physical capacity of the economy to supply goods did not alter much. No flood or earthquake or other natural disaster ruined factories in 1929 or 1930. No outbreak of disease decimated the ranks of workers. No key input price, like the price of oil, soared on world markets. The US economy in 1933 had just about the same factories, workers, and state of technology as it had had four years earlier in 1929—and yet the economy shrank dramatically.

Keynes recognized that the events of the Great Depression contradicted Say’s law, which states that supply creates its own demand. Although production capacity existed, the markets were not able to sell their products. As a result, real GDP was less than potential GDP.

Wage and price stickiness

Keynes also noticed that when AD fluctuated, prices and wages did not immediately respond as economists expected. Instead, prices and wages were “sticky,” making it difficult to restore the economy to full employment and potential GDP.

Keynes emphasized one particular reason why wages are sticky: the coordination argument. This argument points out that, even if most people would be willing—at least hypothetically—to see a decline in their own wages in bad economic times as long as everyone else also experienced such a decline, a market-oriented economy has no obvious way to implement a plan of coordinated wage reductions. There are a number of reasons why wages might be sticky downward, most of which center on the argument that businesses avoid wage cuts because they may in one way or another depress morale and hurt the productivity of the existing workers.

Some modern economists have argued in a Keynesian spirit that, along with wages, other prices may be sticky, too. Many firms do not change their prices every day or even every month. When a firm considers changing prices, it must consider two sets of costs. First, changing prices uses company resources—managers must analyze the competition and market demand and decide what the new prices will be, sales materials must be updated, billing records will change, and product labels and price labels must be redone. Second, frequent price changes may leave customers confused or angry—especially if they find out that a product now costs more than expected.

These costs of changing prices are called menu costs—because they are similar to the costs of printing up a new set of menus with different prices in a restaurant. Prices do respond to forces of supply and demand, but from a macroeconomic perspective, the process of changing all prices throughout the economy takes time.

To understand the effect of sticky wages and prices in the economy, consider Diagram A below, illustrating the overall labor market, and Diagram B, illustrating a market for a specific good or service.

The original equilibrium E0 in each market occurs at the intersection of the demand curve D0 and supply curve S0. When aggregate demand declines, the demand for labor shifts to the left—to D1 in diagram A—and the demand for goods shifts to the left—to D1 in diagram B. Because of sticky wages and prices, however, the wage remains at its original level, W0, for a period of time and the price remains at its original level, P0.

As a result, a situation of excess supply—where the quantity supplied exceeds the quantity demanded at the existing wage or price—exists in markets for both labor and goods, and Q1 is less than Q0 in both diagram A and diagram B. When many labor markets and many goods markets all across the economy find themselves in this position, the economy is in a recession; that is, firms cannot sell what they wish to produce at the existing market price and do not wish to hire all who are willing to work at the existing market wage.

Image credit: Figure 1 in “The Building Blocks of Keynesian Analysis” by OpenStaxCollege, CC BY 4.0

Two graphs show how sticky wages have varying effects based on whether the market is a labor market or a goods market.

The two Keynesian assumptions in the AD/AS Model

The two Keynesian assumptions—the importance of aggregate demand in causing recession and the stickiness of wages and prices—can be illustrated using an aggregate demand/aggregate supply, or AD/AS, diagram like the one below. Note that because of the stickiness of wages and prices, the aggregate supply curve is flatter than the supply curves in diagrams A and B above. 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.

This outcome is an important example of a macroeconomic externality, meaning that 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 AD0 intersects with aggregate supply. 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.

The expenditure multiplier

Another key concept in Keynesian economics is the expenditure multiplier. The expenditure multiplier is the idea that not only does spending affect the equilibrium level of GDP but that spending is powerful. More precisely, it means that a change in spending causes a more than proportionate change in GDP.

ΔY ​>1
ΔSpending

The reason for the expenditure multiplier is that one person’s spending becomes another person’s income, which leads to additional spending and additional income, and so forth, so the cumulative impact on GDP is larger than the initial increase in spending. The multiplier is important for understanding the effectiveness of fiscal policy, but it occurs whenever any autonomous increase in spending occurs. Additionally, the multiplier operates in a negative as well as a positive direction.

Thus, when investment spending collapsed during the Great Depression, it caused a much larger decrease in real GDP. The size of the multiplier is critical and was a key element in recent discussions of the effectiveness of the Obama administration’s fiscal stimulus package, officially titled the American Recovery and Reinvestment Act of 2009