Chapter 16
Keynesian Theory
The
focuses on changes in expectations of future profits and sales as
the impulse that creates business cycle. (These expectations are
often called animal spirits after Keynes' suggestion that
they change frequently.) When businesses become more pessimistic
about future sale and profits, that is, their animal spirits turn
negative, they decrease their investment. The decrease in
investment decreases aggregate demand, which leads to a decrease
in output and increase in unemployment.
The figure shows the Keynesian theory. In the figure, the initial aggregate demand curve is AD0, which decreases to AD1 when businesses become pessimistic about the future. The short-run aggregate supply curve is SAS and is horizontal. The economy moves from an initial equilibrium at a real GDP of $7.0 trillion to a recession with real GDP of only $6.0 trillion. Because the short-run aggregate supply curve is horizontal, the decrease in real GDP is greater than if the short-run aggregate supply curve were upward sloping.
In the Keynesian view, the economy will remain at the recessionary level of output until something happens to make expectations about the future more optimistic. Thus until the aggregate demand curve shifts rightward, the economy will remain mired in a recession. To review other business cycle theories, click on the appropriate figure. To go to a summary, click on the summary figure.
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