New Classical/Monetarist Approach

• Aggregate Demand decreases due to change in one of the components of AD

• Actual Output falls from Yfe to Y1, creating a recessionary gap (Potential GDP > Actual GDP)

• Price Wage Flexibility allows for prices/wages to increase & decrease

• If the economy enters a recessionary gap, due to a decrease in AD, the average price level will decrease, as real output decreases. As the average price level falls (increasing purchasing power), firms can pay workers a lower salary, resulting in a decrease in the cost of production for the firms.

• This decrease in the cost of production allows firms to increase their output and hire more workers, now on the lower wages, increasing the SRAS. 

• This brings the economy back to its full potential level of output, at the level of output of Yfe and a lower Average Price Level of PL3, closing the recessionary gap. 

Keynesian Perspective

• Aggregate Demand falls in the economy, due to a change in one of the components of AD, such as falling consumer confidence.

• Actual Output falls from Yp to Y1 creating a recessionary gap. (Potential GDP > Actual GDP)

• Due to wages/price inflexibility, (or wages being sticky downwards), actual output (real GDP) falls however price levels remain constant. 

• As such, the economy becomes stuck in the recessionary gap at the output of Y1. Animal Spirits cause low levels of Consumption (C) and Investment (I). 

• Therefore, the only way for the economy to return to its full potential is through Government Intervention and Government Spending (G), to increase the overall levels of AD. 

• Increasing government spending increases AD and Real GDP back to the potential output. 

New Classical/Monetarist Approach

• Increasing AD will simply lead to an increase in the APL in the Long Run, without an increase in the Actual GDP as the economy is always at its full potential in the Long Run. 

• This is due to increasing AD will not increase the quality and quantity of factors of production for firms, therefore increasing the potential output of the economy. 

• For example, central banks lowering interest rates, will lead to an increase in consumer spending, however, this just increases the money supply, without increasing the economic output, forcing prices to rise and leading to inflation.

• Therefore, from the classical perspective, governments should avoid encouraging an increase in AD. 

Keynesian Perspective

• If the economy is in a recessionary gap (real GDP of Y1), in order to close the recessionary gap, governments should increase government spending through expansionary Monetary (use of interest rates) or Fiscal (use of Government Spending and Taxation) policies to increase the levels of Aggregate Demand.

• As there is spare capacity in the economy, the average price level does not increase as physical capital (such as machinery) or labour already exist in the economy and therefore, whilst this exists in abundance, the average price level will not rise. (AD1 --> AD2)

• As the economy approaches its potential output and the spare capacity begins to be fully used up, the average price level will begin to rise. (AD2 --> AD3)

• As the economy produces above its full potential, the actual output does not increase however, the average price level does, due to the increasing scarcity of resources. (AD3 --> AD4)

• Therefore, in contrast to the Classical View, increasing Aggregate Demand does not always lead to an increase in the Average Price Levels due to the existence of Spare Capacity. Only once the economy approaches its potential output will an increase in AD lead to an increase in the Average Price Level.