Real gdp p lr as ad ad 3 4 47 5 ad1 keynes believed

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Real GDP P LR-AS AD AD 3 4 4.7 5
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AD1, Keynes believed was the basic problem during recessions and depressions Demand, pull inflation occurs in the intermediate range of the AS curve THE KEYNESIAN SYSTEM The classical system/theory of equilibrium was great at explaining why we would either be at full employment or tending toward it but it wasn’t much good at explaining why, in the 1930s, the entire world was in a depression. We needed a new theory to explain why, and a policy prescription. J. M. Keynes provided both. Keynes used the same AS and AS approaches as the classical, but came up with very different conclusions. The key to Keynes analysis was the role of AD. According to Keynes, the equilibrium level of GDP was determined primarily by the volume of expenditures planned by consumers, businesses, government and foreigners. Keynes concentrated on AD because he viewed rapid declines in AD as the villain in recessions and depressions. Changes in AS – changes brought about by new technology, more capital and lore and greater productivity – came about slowly and could be neglected in the S-R Keynes stood Say’s Law on its head (Demand creates its own Supply) Keynes: AS is the economy prime mover Businesses produce out the output of goods and services they believe consumers, investors, government and foreigners will plan to buy DISEQUILIBRIUM AND EQUILIBRIUM In both the Keynesian and classical economic systems, the economy is always tending toward equilibrium – when AD and AS are equal. Real GDP P LR-AS AD 1 AD 2 AD 3 Inflation Recession
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1) AD > AS this sets off a chain reaction that continues until the economy is back in equilibrium. Inventories businesses order move inventory P↑ labor↑ – as plant utilization approaches capacity more plant and equipment order – as more people find employment C↑ AD↑ P↑ labor shortages 2) AS > AD (AS must have to fall) AS > AD production > sales inventories↑ orders to manufacturers↓ labor↓ C↓ (Retailers facing declining sales as well as smaller inventories, may reduce prices) eventually inventories are sufficiently depleted. 3) Summary: How Equilibrium is attained When the economy is in disequilibrium, it automatically moves back again to equilibrium. It is always AS that adjusts, when AD > AS; AS↑ and when AS > AD; AS↓ Keynesian Policy Prescriptions Classical School: Recessions are temporary because the economy is self-correcting Example: I↓ r↓ I↑ The role of government is to stand back and do nothing C↓ P↓, W Keynes Position Recessions were not necessarily temporary because the self-correcting mechanism of falling interest rates and falling prices and wages might be insufficient to push I and C back up again. Therefore, it would be necessary for the government to intervene since the private economy did not automatically move toward full employment. What should the government do? Spend money! AD = C+I+G+X n 1) the consumption was low 2) Investment was low
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