58 Keynes’ Law and Say’s Law in the AD/AS Model
Learning Objectives
By the end of this section, you will be able to:
- Identify the neoclassical zone, the intermediate zone, and the Keynesian zone in the aggregate demand/aggregate supply model
- Use an aggregate demand/aggregate supply model as a diagnostic test to understand the current state of the economy
We can use the AD/AS model to illustrate both Say’s law that supply creates its own demand and Keynes’ law that demand creates its own supply. Consider the SRAS curve’s three zones which Figure 24.11 identifies: the Keynesian zone, the neoclassical zone, and the intermediate zone.
Figure 24.11 Keynes, Neoclassical, and Intermediate Zones in the Aggregate Supply Curve Near the equilibrium Ek, in the Keynesian zone at the far left of the SRAS curve, small shifts in AD, either to the right or the left, will affect the output level Yk, but will not much affect the price level. In the Keynesian zone, AD largely determines the quantity of output. Near the equilibrium En, in the neoclassical zone at the SRAS curve’s far right, small shifts in AD, either to the right or the left, will have relatively little effect on the output level Yn, but instead will have a greater effect on the price level. In the neoclassical zone, the near-vertical SRAS curve close to the level of potential GDP largely determines the quantity of output. In the intermediate zone around equilibrium Ei, movement in AD to the right will increase both the output level and the price level, while a movement in AD to the left would decrease both the output level and the price level.
Focus first on the Keynesian zone, that portion of the SRAS curve on the far left which is relatively flat. If the AD curve crosses this portion of the SRAS curve at an equilibrium point like Ek, then certain statements about the economic situation will follow. In the Keynesian zone, the equilibrium level of real GDP is far below potential GDP, the economy is in recession, and cyclical unemployment is high. If aggregate demand shifted to the right or left in the Keynesian zone, it will determine the resulting level of output (and thus unemployment). However, inflationary price pressure is not much of a worry in the Keynesian zone, since the price level does not vary much in this zone.
Now, focus your attention on the neoclassical zone of the SRAS curve, which is the near-vertical portion on the right-hand side. If the AD curve crosses this portion of the SRAS curve at an equilibrium point like En where output is at or near potential GDP, then the size of potential GDP pretty much determines the level of output in the economy. Since the equilibrium is near potential GDP, cyclical unemployment is low in this economy, although structural unemployment may remain an issue. In the neoclassical zone, shifts of aggregate demand to the right or the left have little effect on the level of output or employment. The only way to increase the size of the real GDP in the neoclassical zone is for AS to shift to the right. However, shifts in AD in the neoclassical zone will create pressures to change the price level.
Finally, consider the SRAS curve’s intermediate zone in Figure 24.11. If the AD curve crosses this portion of the SRAS curve at an equilibrium point like Ei, then we might expect unemployment and inflation to move in opposing directions. For instance, a shift of AD to the right will move output closer to potential GDP and thus reduce unemployment, but will also lead to a higher price level and upward pressure on inflation. Conversely, a shift of AD to the left will move output further from potential GDP and raise unemployment, but will also lead to a lower price level and downward pressure on inflation.
This approach of dividing the SRAS curve into different zones works as a diagnostic test that we can apply to an economy, like a doctor checking a patient for symptoms. First, figure out in what zone the economy is. This will clarify the economic issues, tradeoffs, and policy choices. Some economists believe that the economy is strongly predisposed to be in one zone or another. Thus, hard-line Keynesian economists believe that the economies are in the Keynesian zone most of the time, and so they view the neoclassical zone as a theoretical abstraction. Conversely, hard-line neoclassical economists argue that economies are in the neoclassical zone most of the time and that the Keynesian zone is a distraction. The Keynesian Perspective and The Neoclassical Perspective should help to clarify the underpinnings and consequences of these contrasting views of the macroeconomy.
Bring it Home
The Pandemic-Induced Recession: Supply or Demand?
We mentioned earlier that a pandemic could cause a shock in the short- or long-run aggregate supply curve by temporarily reducing labor supply and slowing or stopping production of goods and services. Pandemics can also affect aggregate demand. When people are hesitant to spend or travel, or if they are not allowed to spend or travel because of social restrictions, this will affect spending in the economy. Consumers spend less at restaurants, hotels, and travel, among other areas, while firms stop investing because of the lack of demand and an uncertain future. Both actions lead to a leftward shift in the aggregate demand curve.
While there is some debate over whether the pandemic-induced recession that the U.S. economy experienced in 2020 was primarily a supply- or demand-driven one, most likely, it is a combination of both. In March and April 2020, workers left the labor market en masse, and later in the year, they were hesitant to return due to health and safety concerns. Many people were also forced to cancel travel plans or voluntarily did so out of concern for their safety, further reducing aggregate demand. These changes caused deep cuts in the global economy that continued to be felt two years after the initial pandemic-induced shocks.
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