Aggregate Demand and Aggregate Supply
Chapter 9: Aggregate Demand and Aggregate Supply
Before You Start
Chapter 9 focuses on the aggregate demand-aggregate supply (AD-AS) model, a crucial tool for studying output fluctuations, price level changes, unemployment dynamics, and the factors influencing long-term economic growth.
Short-term fluctuations in growth are primarily driven by shifts in economic activities, reflecting the dynamic nature of markets.
Changes to the long-term growth trend are also fundamentally caused by the nature and intensity of economic activities within a nation.
9.1 Aggregate Demand (AD) and the Aggregate Demand Curve
Learning Objectives
Define key terms related to aggregate demand, ensuring a strong foundational understanding.
Explain the aggregate demand curve in detail, breaking down its components: consumption (C), investment (I), government spending (G), and net exports (X-M), to understand their individual impacts.
Explain the determinants of each component of aggregate demand, elaborating on the factors influencing each element:
Consumption (C): Analyze how consumer confidence, interest rates, wealth fluctuations, income taxes, levels of household indebtedness, and expectations of future price levels collectively shape consumption patterns.
Investment (I): Detail how investment decisions are affected by interest rates, business confidence, technological advancements, business taxes, and the extent of corporate indebtedness.
Government spending (G): Discuss how political and economic priorities dictate the levels and types of government expenditure.
Net exports (X-M): Explore how the economic health of trading partners, exchange rates, and various trade policies impact net exports.
Explain shifts in the aggregate demand curve, detailing how changes in the determinants of its components lead to increases or decreases in aggregate demand.
Draw the aggregate demand curve and illustrate shifts, demonstrating the effects of changing economic factors on the curve's position.
Explaining Aggregate Demand and the Aggregate Demand Curve
Aggregate demand (AD): Defined as the total quantity of aggregate (total) output, or real GDP, that all buyers in an economy are willing to purchase at different possible price levels, ceteris paribus, reflecting overall economic activity.
The aggregate demand (AD) curve illustrates the relationship between the aggregate output buyers are willing to purchase (real GDP demanded) and the economy's price level, ceteris paribus, showing the dynamics between output and prices.
The horizontal axis of the AD curve represents aggregate output or real GDP, measuring the total economic production.
The vertical axis measures the general price level in the economy, calculated as an average of the prices of all goods and services, indicating overall inflation or deflation.
Aggregate demand comprises all components of aggregate expenditure, ensuring a comprehensive view:
Demand of consumers (C), which includes spending on durable and non-durable goods and services.
Demand of businesses (firms) (I), focusing on investments in capital goods, inventories, and structures.
Demand of government (G), considering both direct purchases and infrastructure investments.
Demand of foreigners for exports (X) minus the demand for imports (M) (X-M or net exports), capturing the trade balance.
Aggregate demand represents the total amount of real output (real GDP) that consumers, firms, the government, and foreigners plan to buy at each possible price level over a specified time period.
The aggregate demand (AD) curve provides a visual representation of the relationship between the total real output demanded by these components and the economy's price level over a specific period.
It slopes downward, demonstrating the inverse relationship between the price level and the aggregate output demanded, vital for understanding economic responses to price changes.
The Negative (Downward) Slope of the Aggregate Demand Curve
The explanation for the downward slope of the aggregate demand curve is further detailed in supplementary material within the digital coursebook, covering the wealth effect, interest rate effect, and foreign trade effect.
The Determinants of Aggregate Demand (Shifts in the AD Curve)
Movements along the AD curve occur due to changes in the price level, representing adjustments within the existing demand framework.
Shifts of the AD curve are caused by the determinants of aggregate demand, illustrating changes in overall economic conditions.
A rightward shift in the AD curve (e.g., from AD₁ to AD₂) signifies an increase in aggregate demand, where a larger quantity of real GDP is demanded at any given price level, boosting economic activity.
A leftward shift in the AD curve (e.g., from AD₁ to AD₃) indicates a decrease in aggregate demand, with a smaller amount of real GDP demanded at each price level, signaling potential economic slowdown.
Causes of Changes in Consumption Spending
Changes in consumer confidence: High consumer confidence encourages spending and shifts the AD curve to the right, reflecting optimism about future economic conditions. Conversely, low consumer confidence reduces spending, shifting the AD curve to the left.
Governments track consumer confidence to anticipate consumer spending trends and adjust economic policies accordingly.
Changes in interest rates: Elevated interest rates increase borrowing costs, which decreases consumer spending and shifts the AD curve to the left. Lower interest rates reduce borrowing costs, thus increasing consumer spending and shifting the AD curve to the right.
Central banks influence interest rates through monetary policy to manage economic activity.
Changes in wealth: Increased consumer wealth, such as rising home values or stock prices, elevates spending and shifts the AD curve to the right, creating a wealth effect. Decreased wealth reduces aggregate demand, shifting the AD curve to the left.
Changes in income taxes: Higher income taxes diminish disposable income, lowering consumer spending and shifting the AD curve to the left. Lower income taxes boost disposable income, increasing spending and shifting the AD curve to the right. Tax adjustments are a key aspect of fiscal policy.
Changes in the level of household indebtedness: High household debt prompts consumers to prioritize debt repayment, reducing consumption and shifting the AD curve to the left. Low debt levels free up income for consumption, shifting the AD curve to the right.
Expectations of future price levels: Anticipation of falling prices may lead consumers to delay purchases, causing a decrease in AD and a leftward shift. Expectations of future price increases can spur current spending, shifting AD to the right as consumers aim to buy before prices rise.
Causes of Changes in Investment Spending
Changes in business confidence: Optimistic firms increase investment, shifting the AD curve to the right, driving economic expansion. Pessimistic firms reduce investment, shifting the AD curve to the left, signaling contraction.
Changes in interest rates: Higher interest rates increase borrowing costs, reducing investment spending and shifting the AD curve to the left. Conversely, lower interest rates decrease borrowing costs, encouraging more investment and shifting the AD curve to the right. Central banks use monetary policy to adjust interest rates.
Changes (improvements) in technology: Technological advancements often drive investment spending, increasing aggregate demand and shifting the AD curve to the right as firms adopt new technologies to enhance productivity.
Changes in business taxes: Higher business taxes (corporate income taxes) reduce after-tax profits, decreasing investment spending and shifting the AD curve to the left. Lower taxes enhance after-tax profits, increasing aggregate demand and shifting the AD curve to the right. Business tax policy is a component of fiscal policy.
The level of corporate indebtedness: High levels of corporate debt can deter investment, shifting the AD curve to the left as firms focus on deleveraging. Low debt levels encourage investment and shift the AD curve to the right.
Legal/institutional changes: Factors such as access to credit and strong property rights significantly influence investment spending, particularly in developing economies, by fostering a conducive business environment.
Causes of Changes in Government Spending
Changes in political priorities: Increased government spending on infrastructure or defense, for example, shifts the AD curve to the right, while decreased spending shifts it to the left.
Changes in economic priorities: Government efforts to stimulate aggregate demand through strategic spending are part of fiscal policy, aiming to stabilize or grow the economy.
Causes of Changes in Export Spending Minus Import Spending
Changes in national income abroad: Rising national income in a trading partner increases their imports from the home country, shifting the home country's AD curve to the right, thereby improving export revenues. Conversely, declining income reduces exports and shifts the AD curve to the left.
Changes in exchange rates: A stronger domestic currency makes exports more expensive and imports cheaper, reducing net exports (X-M) and shifting the AD curve to the left. A weaker currency has the opposite effect, boosting net exports and shifting the AD curve to the right.
Changes in trade policies, or the level of trade protection: Trade restrictions can lead to decreased exports, shifting the AD curve to the left. Imposing restrictions can increase net exports, shifting the AD curve to the right as imports decrease.
Summary of Factors Causing Shifts of the Aggregate Demand Curve
Changes in consumer spending:
Consumer confidence: Influenced by economic outlook and job security.
Interest rates (monetary policy): Set by central banks affecting borrowing costs.
Wealth: Affected by changes in asset values like stocks & real estate.
Personal income taxes (fiscal policy): Directly impacts disposable income.
Household indebtedness: High debt reduces available spending money.
Expectations of future price levels: Inflation expectations can drive current demand.
Changes in investment spending:
Business confidence: Related to expected future profitability.
Interest rates (monetary policy): Impact the cost of capital for investments.
Technology: Innovation pushes investment in new equipment.
Business taxes (fiscal policy): Affect after-tax returns on investment.
Corporate indebtedness: Debt levels impact investment capacity.
Legal/institutional changes: Regulatory environment and property rights security.
Changes in government spending:
Political priorities: Reflect government focus on different sectors.
Economic priorities (fiscal policy): Stimulus packages or austerity measures.
Changes in foreigners' spending:
National income abroad: Economic health of trading partners affects exports.
Exchange rates: Currency values impact export competitiveness.
Trade protection: Tariffs and quotas affect trade volumes.
Shifts in the AD curve and national income
Changes in national income cannot initiate any AD curve shifts; instead, income changes are a result of AD shifts.
Real GDP, measured on the horizontal axis, represents national income, therefore, national income cannot itself cause a shift of the curve.
9.2 Short-Run Aggregate Supply and Short-Run Equilibrium in the AD-AS Model
Learning Objectives
Define key terms related to short-run aggregate supply, ensuring conceptual clarity.
Explain the short-run aggregate supply (SRAS) curve, detailing how it represents the relationship between price level and real output.
Explain the determinants of the SRAS curve, including:
Costs of factors of production: Impact of wages, raw materials, and energy prices on the SRAS.
Indirect taxes: How taxes like VAT or sales tax affect production costs and supply.
Explain shifts of the SRAS curve due to changes in its determinants, clarifying how changes affect output decisions.
Draw the SRAS curve and illustrate shifts, showing the visual impact of supply-side changes.
Explain macroeconomic equilibrium in the short run, detailing how AD and SRAS interact to determine price level and output.
Draw a diagram illustrating short-run equilibrium and changes in short-run equilibrium, demonstrating effects of shifts in AD or SRAS on the overall economy.
Short-Run Aggregate Supply
Aggregate supply is a subject of extensive debate among economists, particularly regarding the shape and elasticity of the aggregate supply curve.
Chapter 9 provides an overview of three main types of aggregate supply curves: the short-run aggregate supply (SRAS), the long-run aggregate supply (LRAS), and the Keynesian aggregate supply curve.
The Short Run and Long Run in Macroeconomics
In macroeconomics, the short run is characterized by resource prices that remain relatively fixed or adjust slowly, particularly wages. This inflexibility occurs despite changes in the price level.
The long run is defined as a period where the prices of all resources, including labor costs (wages), are fully flexible and adjust in response to changes in the price level.
Wages are of particular importance because they constitute the largest portion of firms' production costs.
Wages often exhibit stickiness over short periods due to several factors:
Labor contracts set wage rates for definite periods.
Minimum wage laws establish a wage floor.
Workers and unions resist wage reductions.
Wage cuts can negatively impact worker morale and productivity.
The distinction between the short run and the long run is crucial for understanding aggregate supply behavior.
Defining Aggregate Supply and the Short-Run Aggregate Supply Curve
Aggregate supply represents the total quantity of goods and services produced in an economy (real GDP) over a specific time period at various price levels.
The short-run aggregate supply curve (SRAS) illustrates the relationship between the price level and the quantity of real output (real GDP) that firms produce when resource prices, especially wages, remain constant.
The SRAS curve generally slopes upward, indicating a positive relationship between the price level and real GDP supplied: as the price level rises, the quantity of real GDP supplied increases, and vice versa.
Why the SRAS Curve Is Upward-Sloping
The upward slope reflects that firms are incentivized to produce more when the price level rises because their revenues increase while their costs remain stable in the short run.
Higher price levels increase output prices, leading to increased firm profitability given constant resource costs. As production becomes more profitable, firms increase output, leading to a positive relationship between the price level and real GDP supplied.
Conversely, falling price levels reduce output prices, decreasing firm profitability when resource prices are sticky, prompting firms to reduce production.
Changes in Short-Run Aggregate Supply (Shifts in the SRAS Curve)
Several factors, other than changes in the price level, can shift the SRAS curve, reflecting changes in production conditions.
A rightward shift from SRAS₁ to SRAS₂ signifies an increase in short-run aggregate supply, where firms produce more real GDP at any given price level.
A leftward shift from SRAS₁ to SRAS₃ indicates a decrease in aggregate supply, where firms produce less real GDP at any given price level.
Important Factors That Cause SRAS Curve Shifts
Changes in wages: Increased wages raise firms' production costs, leading to a leftward shift in the SRAS curve. Decreased wages lower production costs, shifting the SRAS curve to the right.
Changes in non-labor resource prices: Changes in the prices of resources like oil, equipment, and capital goods affect the SRAS curve similarly to wage changes. Increased resource prices shift the SRAS curve to the left, while decreased prices shift it to the right.
Changes in indirect taxes: Higher indirect taxes increase production costs, shifting the SRAS curve to the left. Lower indirect taxes decrease production costs, shifting the SRAS curve to the right.
Changes in subsidies offered to businesses: Increased subsidies lower production costs and shift the SRAS curve to the right. Decreased subsidies raise production costs, shifting the SRAS curve to the left.
Supply shocks: These are events causing sudden and significant changes in short-run aggregate supply. Adverse events like wars disrupt production and shift the SRAS curve to the left. Favorable events, such as technological breakthroughs or exceptionally good weather, shift the SRAS curve to the right.
Over the short term, the SRAS curve primarily shifts due to factors affecting firms' costs of production and supply shocks.
Short-Run Equilibrium in the AD-AS Model
Short-run equilibrium occurs at the intersection of the aggregate demand (AD) and short-run aggregate supply (SRAS) curves, determining the equilibrium price level and real GDP.
At any price level and real GDP away from the equilibrium, excess supply or demand pressures move the economy toward the equilibrium point.
Impacts of Changes in Short-Run Equilibrium
Increases in aggregate demand shift the AD curve to the right, resulting in a higher price level, increased real GDP, and decreased unemployment.
Decreases in aggregate demand shift the AD curve to the left, resulting in a lower price level, decreased real GDP, and increased unemployment.
A rightward shift in the SRAS curve leads to a lower price level, a higher real GDP, and decreased unemployment, indicating economic improvement.
A leftward shift in the SRAS curve leads to a higher price level, decreased real GDP, and increased unemployment, signaling economic decline or stagflation.
9.3 Long-Run Aggregate Supply and Long-Run Equilibrium in the Monetarist/New Classical Model
Learning Objectives
Define key terms related to long-run aggregate supply, ensuring clarity of concepts.
Explain the monetarist/new classical perspective on the long-run aggregate supply (LRAS) curve, detailing assumptions and implications.
Explain that macroeconomic equilibrium in the long run, in the monetarist/new classical model, occurs at full employment (or potential) output, highlighting the economy's self-correcting tendencies.
Explain that at long-run equilibrium (full employment equilibrium), unemployment equals the natural rate of unemployment, emphasizing the concept of frictional and structural unemployment.
Draw the LRAS curve and illustrate macroeconomic equilibrium in the long run, demonstrating the model graphically.
Explain inflationary and deflationary (recessionary) gaps, detailing their causes and consequences.
Explain how, in the monetarist/new classical perspective, the economy automatically adjusts to full employment output, emphasizing the role of flexible wages and prices.
The Monetarist/New Classical Model
The monetarist/new classical perspective builds on classical economics, emphasizing the price mechanism and competitive market equilibrium, viewing the economy as a self-regulating system tending toward full employment.
This approach differentiates between the short run and long run to understand how aggregate supply behaves as resource prices adjust fully to price level changes.
The long-run aggregate supply (LRAS) curve graphically represents the supply relationship in the long run and is vertical at potential GDP (Y_p), indicating that output is determined by real factors, not the price level.
A vertical LRAS curve implies that changes in aggregate demand only affect the price level in the long run, while real GDP remains at its potential level.
Long-run equilibrium occurs where the aggregate demand curve intersects the short-run aggregate supply curve at a point on the LRAS curve.
The Long-Run Aggregate Supply Curve and Long-Run Equilibrium
The long-run aggregate supply (LRAS) curve is vertical at the full-employment level of output, indicating that the economy produces potential GDP independently of the price level in the long run.
Long-run equilibrium is achieved when the SRAS and AD curves intersect on the LRAS curve at full employment or potential output.
Long-Run Equilibrium and the Natural Rate of Unemployment
At potential output, the economy is considered to be at 'full employment'.
The natural rate of unemployment is the unemployment rate that exists when the economy is producing at its full employment output, accounting for frictional and structural factors.
Why the LRAS Curve Is Vertical
With wages and resource prices adjusting proportionally to output price changes, firms' real costs of production remain constant, neutralizing incentives to alter output levels in response to price level changes.
Short-Run Equilibrium Positions in Relation to Long-Run Equilibrium: Deflationary (Recessionary) Gaps and Inflationary Gaps
Long-run equilibrium is achieved when AD and SRAS intersect on the LRAS curve, reflecting stable and sustainable economic conditions.
Deflationary or inflationary gaps arise when AD and SRAS intersect off the LRAS curve, indicating imbalances in the economy.
Y*p represents potential output, determined by the position of the LRAS curve, where unemployment is at its natural rate.
Deflationary (Recessionary) Gap
If equilibrium real GDP (Ye) is less than potential GDP (Yp), the economy experiences a deflationary gap, causing unemployment to exceed the natural rate.
This gap occurs because aggregate demand is insufficient to support production at potential GDP, leading firms to reduce output and employment.
Inflationary Gap
An inflationary gap arises when equilibrium real GDP (Ye) exceeds potential GDP (Yp), resulting in unemployment falling below the natural rate.
With excessive aggregate demand, firms increase production beyond potential GDP, driving up prices and pulling unemployment below its natural rate.
Full-Employment Level of Real GDP, or Potential Output
The economy is at full employment when equilibrium real GDP equals potential GDP, and unemployment matches the natural rate, indicating neither inflationary nor deflationary pressures.
Recessionary and Inflationary Gaps
These gaps represent the economy's short-run equilibrium conditions, showing deviations from sustainable, long-run equilibrium.
A deflationary (recessionary) gap signifies that real GDP is below potential due to insufficient aggregate demand.
An inflationary gap indicates that real GDP is above potential GDP, due to excess aggregate demand.
Full-employment equilibrium is achieved when the AD curve intersects the SRAS curve at potential GDP, eliminating any output gaps.
Shifts in AD or SRAS as Possible Causes of the Business Cycle
Business cycles can be initiated by shifts in either aggregate demand or aggregate supply, leading to economic fluctuations.
A drop in aggregate demand results in a recessionary gap, decreasing output and increasing unemployment.
An increase in aggregate demand causes an inflationary gap, increasing output and prices and reducing unemployment.
A decrease in SRAS causes stagflation, marked by falling real GDP, rising unemployment, and higher prices.
An increase in SRAS leads to economic expansion, with rising real GDP, falling unemployment, and lower prices.
Automatic Adjustment to Full Employment Equilibrium at the Level of Potential GDP
Monetarist/new classical economists propose that market adjustments can naturally correct inflationary and deflationary gaps over time.
Deflationary Gap Automatic Adjustment
During a deflationary gap, falling aggregate demand leads to reduced real GDP and price levels. Flexible wages and resource prices eventually decrease, shifting the SRAS curve rightward until the economy returns to full employment.
Inflationary Gap Automatic Adjustment
During an inflationary gap, excessive aggregate demand causes real GDP and price levels to rise. Rising wages and resource costs eventually shift the SRAS curve leftward, returning the economy to full employment.
Changes in Aggregate Demand
The monetarist/new classical perspective asserts that aggregate demand changes affect real GDP only temporarily; in the long run, they primarily influence the price level without altering real output.
Long-run increases in aggregate demand typically lead to inflation.
9.4 Aggregate Supply and Equilibrium in the Keynesian Model
Learning Objectives
Define key terms related to the Keynesian model, ensuring familiarity with foundational concepts.
Explain the Keynesian perspective on the aggregate supply (AS) curve, detailing assumptions about wage and price stickiness.
Explain equilibrium in the Keynesian model, emphasizing the role of aggregate demand in determining output and employment.
Draw a diagram showing equilibrium in the Keynesian model, illustrating the potential for persistent output gaps.
Explain that in the Keynesian model, deflationary/recessionary gaps can persist because the equilibrium level of output may differ from the full-employment level.
The Keynesian Model
Keynes challenged classical views of the economy as self-correcting, arguing that economies can remain in short-run equilibrium for prolonged periods without achieving full employment.
Getting Stuck in the Short Run
Keynes suggested that wage and price rigidities prevent economies from quickly recovering from demand shocks.
Wage and Price Downward Inflexibility
Unlike the monetarist view, Keynesians argue wages and prices are sticky downward, meaning they do not easily fall during economic downturns due to factors like labor contracts and minimum wage laws.
The Inability of the Economy to Move Into the Long Run
Wage and price inflexibility can trap the economy in short-run conditions, preventing natural adjustments toward full employment.
Keynesian Model: Wages & Prices Do Not Fall
In the Keynesian model, if aggregate demand decreases, wages, and prices might not adjust downward, leading to persistent recessionary gaps.
Downward Inflexible Wages & Price
Wage and price inflexibility are illustrated by a horizontal or nearly horizontal section of the Keynesian aggregate supply (AS) curve, indicating that output can change without significant price adjustments.
Keynesians
Keynesians advocate for government intervention to mitigate long-lasting recessions, as they believe inaction can lead to prolonged unemployment and lost output.
The shape of the Keynesian aggregate supply curve
Section 1
With low GDP and significant unemployment, the Keynesian AS curve is horizontal, indicating that output can increase without affecting the price level.
This section represents substantial unused capacity and unemployed resources, allowing firms to increase output without increasing costs.
Section 2
As the economy approaches full employment, bottlenecks in resource supply cause wages and prices to rise, leading to an upward-sloping AS curve.
Here, increased output leads to higher prices as resources become scarcer.
Level Y_p
At full employment (Y_p), the economy reaches its potential output level, and unemployment falls to its natural rate.
Section 3
Beyond full employment, the AS curve becomes vertical, indicating that further increases in aggregate demand only lead to higher prices, as all resources are fully utilized.
Three equilibrium states of the economy in the Keynesian model
Macroeconomic equilibrium is determined by the intersection of the AD curve and the Keynesian AS curve.
Figure 9.11(a)
If the AD curve intersects the AS curve in its horizontal section, the economy is in a recessionary gap with high unemployment and weak aggregate demand.
Figure 9.11(b)
If the AD curve intersects the AS curve to the right of Y*p, the economy is in an inflationary gap with strong aggregate demand and low unemployment.
Figure 9.11(c)
The economy achieves full employment equilibrium when the AD curve intersects the AS curve at Y*p, indicating sustainable output and stable prices.
Keynesian Concepts
The Keynesian model suggests that economies can remain stuck in deflationary gaps indefinitely, contrasting with the monetarist view of automatic adjustment. Additionally, Keynesians argue that increasing aggregate demand does not necessarily cause inflation when the economy is operating below full employment.
9.5 Shifting Aggregate Supply Curves Over the Long Term
Learning Objectives
Define key terms related to long-term shifts in aggregate supply, establishing foundational knowledge.
Explain factors that shift the AS curve over the long run (monetarist/new classical LRAS model) or over the long term (Keynesian model), including:
Changes in the quality and/or quality of factors of production: Including labor and capital.
Technological improvements: Raising potential output.
Changes in efficiency: Reducing waste and improving productivity.
Institutional changes: Affecting incentives and productivity.
Draw diagrams showing shifts in the Keynesian AS and LRAS curves, demonstrating long-term economic growth.
Changes in Aggregate Supply Over the Long Term
Long-term economic growth results from increases in potential output, shifting aggregate supply curves to the right.
Factors That Change Aggregate Supply (Shift AS Curves) Over the Long Term
Increases in the quantities of factors of production, such as labor and capital, shift the curve to the right.
Improvements in the quality of resources, such as increased education levels, enhance productivity and shift the curve to the right.
Technological improvements enable more output from the same resources, shifting the curve to the right.
Efficiency gains, through better management or resource allocation, shift the curve to the right.
Institutional changes, such as improved property rights or regulatory frameworks, can promote economic efficiency and shift the curve to the right.
Reductions in the natural rate of unemployment increase potential output, shifting AS curves to the right.
Are there any factors that shift the LRAS curve
While some factors mainly affect the SRAS, those that alter the economy's productive capacity can shift the LRAS.
Temporary shocks like bad weather do not shift the LRAS curve, but factors that permanently change the economy's productive capacity do.
9.6 Implications of the Keynesian Model and the Monetarist/New Classical Model
Learning Objectives
Discuss the differing assumptions of the Keynesian and monetarist/new classical models and their implications for the economy and policy, clarifying the contrasting views.
Automatic Self-Correction Versus Persistence of Deflationary Gaps over Long Periods of Time
The monetarist/new classical model posits automatic correction of deflationary gaps, while the Keynesian model suggests these gaps can persist.
Automatic Self-Correction
The monetarist/new classical model assumes that wages and prices adjust freely to changes in the price level, ensuring that the economy returns to full employment.
Insufficient Demand
The Keynesian model suggests that insufficient aggregate demand can trap the economy in a state where firms do not find it worthwhile to produce at potential GDP, necessitating government intervention to stimulate demand.
Increases in Aggregate Demand Need Not Cause Increases in the Price Level
Monetarist/new classical economists believe that increasing aggregate demand leads to inflation, particularly in the long run.
Increases In the Keynesian View
Keynesians suggest that in a deflationary gap, increasing aggregate demand can boost output without causing inflation, justifying policies aimed at stimulating demand to close output gaps.