|In view of the difficulties for the classical model in presenting a coherent explanation of the Great Depression, it is not surprising that in the 1930s new theories were called for. By far the most important player in this game was John Maynard Keynes, whose 1936 opus, "The General Theory of Employment, Interest, and Money" molded the direction of macroeconomics for the next 35 years.|
|The so-called Keynesian research program was to construct a theory of economic fluctuations based on aggregate demand, rather than on the aggregate supply shocks assumed by classical economists. In order to accomplish this, Keynes and Keynesian economists were forced to assume some failure on the part of real wages, w/p, to adjust sop that labor supply and demand were not necessarily equal. Once labor supply and demand had no automatic adjustment mechanism, there was no reason to suppose the labor market determines the level of output.|
|In order to highlight the role that aggregate demand shocks play in the Keynesian system, we will initially assume that p and w are completely fixed. In fact, we will not even attempt to model the labor market or aggregate supply (implicitly we will assume that aggregate supply curve is horizontal at the fixed price level). We will also assume, to begin with, that neither consumption nor investment depend on the interest rate. This will allow us to derive very simply the effect of demand shocks on output.|
|We will then start doing some work to develop a more relaistic theory. First, we describe the Keynesian theory of the determination of the interest rate. In contrast to the classical model, the money market plays a key role in setting the interest rate. We then put the interest rate theory back into consumption and investment to derive the full Keynesian theory of aggregate demand. The most popular exposition of the Keynesian theory with fixed prices is known as the IS-LM model.|
|Of course, it is unrealistic to assume that prices never change. Therefore, we introduce some partial price flexibility into the model. This is equivalent to assuming that the AS curve is neither horizontal (the fix-price Keynesian version) nor vertical (the classical version). The model used to describe this version of Keynes is known, elegantly, as the AS-AD model.|
|Note that the breakdown of the Keynesian model into three
a) aggregate demand without worrying about the interest rate,
b) aggregate demand with interest rates incorporated but prices fixed, and
c) aggregate demand with prices partially flexible
is partly pedagogical.
|However, it will also become evident that the approach
yields two distinctly useful final products:
a) The "IS-LM model", where prices are completely fixed, and which is assumed to be most useful for analysing the economy over short periods of time, say of a year or less.
b) The "AS-AD model", a version with some price flexibility, useful for analysing the economy over a time horizon of, perhaps, 1 to 3 years.
|Both of these models have their uses, and we will employ them in a number of applications.|
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|Review questions for this section can be found here.|