Understanding the Keynesian Model

Using a diagram, explain what it means for the shape of the aggregate supply curve if wages and
prices are inflexible in the downward direction. (2 marks)

Wages and price levels are inflexible in the downward direction. This is because when an
economy is expanding, wages and price levels are quick to rise as well. However, when an economy is in
a recessive state, wages are first unlikely to move down due to minimum wage laws, contracts with
workers, or resisting worker unions. Thus, wages would not decrease within a short time span. If wages
were not going to fall and companies still had to keep their profits during the recessionary period, then it
is unlikely for then to reduce their prices. Furthermore, if one company were to reduce its prices, then
another company might reduce its price further to gain a bigger market share, leading to a chain effect
where every company ends up having to lower its prices, thus meaning that every company would be
worse off. Thus, companies do not reduce their prices, meaning that both wages and price levels are
unlikely to decrease, also called being inflexible in the downward direction.
The argument is that when in a recession, both prices and wages do not fall immediately, leading
to a section of the Keynesian AS curve being horizontal to prove this, to show how neither wages nor
price levels can fall quickly. This is shown in section 1 of the Keynesian AS diagram, which is from a
real GDP of 0 up to Yp, where price level is constant, showing how the shape of the Keynesian AS curve
is affected by the downward inflexibility of wages and price levels.

Can the economy move into the long run? How? Why? What would it take? (4 marks)
 In the Keynesian model, there is an asymmetry between price and wage changes in the upward
and downward directions. During a period of economic expansion, economies are quick to have rising
wages and price levels and an unemployment level lower than the natural rate of unemployment (NRU).
Under recessive conditions however, the wages and price levels do not fall as quickly as they rose during
expansion conditions. This is because of various factors such as minimum wage laws, labor contracts, and
worker union resistance to lowering the wages. Apart from the wages, the price levels do not fall quickly
either, as if wages remain the same during a recessionary period, then firms will not lower prices as
profits would decrease. If one firm were to reduce its prices however, this would start a price war that
would cause other firms to lower their prices more, meaning that in the end all the firms will be worse off,
in a situation similar to the prisoner’s dilemma model of game theory. Thus, firms will be reluctant to
lower their prices as well, hence leading to a downward inflexibility in both price levels and wages.
In the diagram, this is reflected by the shift of the equilibrium from point a to point b, as a result
the AD curve shifts to the left from AD1 to AD2 under recession conditions. If wages were to fall quickly,
then the SRAS shifts to the right from SRAS 1 to SRAS2. This results in the short-run equilibrium moving
back to being on the LRAS, so at the same level of GDP, but at a lower price level However, as this does
not happen in the Keynesian model, the wages instead remain inflexible and do not decrease, therefore
not allowing the SRAS curve to shift to the right, and thus SRAS remains at SRAS 1, meaning that for the
recessionary gap to be eliminated, the equilibrium would have to shift back to point d, where the
recessionary gap is eliminated, but the economy gets stuck in the short run equilibrium as a result.
With the help of government intervention, however, the economy can move into the long run. As
the Keynesian model assumes that economies are not self-correcting and need external influence to return
to long-run equilibrium after a disbalance, the government has to intervene in order for the economy to
return to its equilibrium. As the problem of getting stuck in the short run is caused by insufficient
aggregate demand, the government can opt to stimulate aggregate demand, by providing money to
consumers to encourage spending, or reducing interest rates. By doing so, the government can get
consumers to spend more, restoring aggregate demand to its needed level, and thus moving the economy
back into the long-run equilibrium.

What does the horizontal section of the AS curve tell us about spare capacity in the economy? (2
marks)
Spare capacity refers to the physical capital that firms have available but do not use. This means
that firms have the means available to increase their output without having to raise the resource prices
they pay or the wages they hand out to their workers. This means that they will not have to raise the price
levels for their products, thus meaning that the price level can remain constant while the output increases
rapidly, and subsequently, the GDP can increase with no change in the price level. Referring to the
diagram from the first question, the section 1 is shown by the part of the Keynesian AS curve from GDP
levels 0 to Yp, where the curve is completely flat as a result of the spare capacity slowly being used up by
firms as they ramp up production. Thus, the horizontal section of the Keynesian AS curve tells us that
there is some spare capacity in the economy, but how much spare capacity is available is shown by how
far the point on the graph is from the start of section 2 of the graph, as defined in the first question.

What do the flat and upward sloping sections of the Keynesian AS curve indicate about the
relationship between the price level and real GDP? (2 marks)
The flat section of the graph, which is the section 1 as defined in the first question, shows that as
GDP increases, the price level remains constant. This is because of all the spare capacity in the economy,
which allows the firms to increase their output without having to increase their costs, thus not having any
reason to increase the prices they charge for their products, hence meaning that the price level will remain
constant.
However, as firms continue to increase output, they will eventually reach a point, Y p, where all
the spare capacity available has been employed and as a result the GDP level has reached its potential
level. The level of unemployment in the economy is also equal to the natural rate of unemployment. After
this point, the price level will start to increase gradually as output further increases due to the resources
becoming increasing scarce, and thus becoming more expensive, meaning that the cost of production is
increased and firms must increase their prices in order to maintain the same level of profits. Therefore,
past the flat section of the Keynesian AS, a growing level of output and GDP leads to an increase in price
levels. Therefore, in the upward sloping section of the graph, there is a positive cause-and effect
relationship between the GDP and price level, in that when GDP increases, it is accompanied by an
increase in the price level.

Why can an economy remain in an equilibrium position where there is less than full employment (a
recessionary gap) for long periods of time in the Keynesian model? (2 marks)
The economy can remain in a recessionary gap equilibrium for a long time because of the inflexibility in
the downward shift of the wages and the price level, and a weak aggregate demand. This means that the
components of aggregate demand are not enough to make firms increase their output, and without
external stimulation to increase aggregate demand, the economy can remain in a state of recessionary gap
for an indefinite period of time. This when the equilibrium point, the point of intersection between the
Keynesian AS and the AD curve, happens to fall on the horizontal section of the Keynesian AS curve
implying that there is spare capacity and that the equilibrium point does not reflect the potential level of
GDP and output. Apart from the wage and price level inflexibility, it is also assumed in the Keynesian
model that the economy is not self-correcting and requires government intervention to bring it back to
equilibrium. This explains why without any intervention, the economy can get stuck in the short run, as
opposed to the monetarist model where the economy can naturally correct itself and that any economic
fluctuation is only in the long run.