Economists preceding John Maynard Keynes believed that a national economy would

Question

Economists preceding John Maynard Keynes believed that a national economy would be
in equilibrium only at the full employment level, or to put it another way, at the level at
which the economy’s output potential was fully realized. On what basis did Keynes argue
that the economy could be in equilibrium at much less than full employment
(substantially below its output potential) for extended period of time? Consider Keynes’
argument in terms of the basic/primitive version of the macroeconomic model.

Explanation / Answer

The basic difference lies between the two models is the assumption of wage price flexibility. While keynesian economics focuses on wage price rigidity classical economics focuses on wage price flexibility. Keynesian short run aggregate supply curve is a horizontal line because in his opinion there is no longer Run or long run is quite long and hence what the government should do is to use its policy tools to influence the aggregate demand in the short run. In contrast the aggregate supply curve of classical economics is vertical in the long run and somewhat upward sloping in the short run

This is the reason why equilibrium in the classical economics always occur at the long run potential output level because in the short run with and price are quick to adjust to shift the aggregate demand curve to the right and bring the economy back to its long run equilibrium. Keynesian economics are used for fixed wages and prices in the short run and their employees a shift in the aggregate demand to the night would increase the output level but not prices. Therefore the multiplier effect is maximum and economy can reach and equilibrium well before the full employment level.

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