Keynesian theory challenges the idea that markets always self-correct. It argues that during recessions, sticky wages and prices prevent quick adjustments, leading to prolonged economic downturns. This theory suggests government intervention is necessary to boost aggregate demand and stimulate recovery.

Understanding aggregate demand shifts is crucial in Keynesian economics. These shifts can significantly impact output, employment, and price levels. The expenditure multiplier effect further explains how initial changes in spending can have amplified effects on the overall economy.

Keynesian Theory and Aggregate Demand

Sticky Wages and Prices

• Keynesian theory posits wages and prices adjust slowly to economic changes (sticky wages and prices)
  • Nominal wages fixed by contracts or social norms prevent quick downward adjustment during recession
  • Prices slow to adjust due to menu costs, long-term contracts, maintaining customer goodwill
• When aggregate demand falls during recession, sticky wages and prices hinder reaching new equilibrium
  • Firms face lower demand but unable to sufficiently lower prices or wages
  • Firms reduce output and lay off workers, increasing unemployment and further decreasing aggregate demand
• Keynesian theory argues government intervention (increased spending, tax cuts) necessary to stimulate aggregate demand and aid economic recovery

Aggregate Demand Shifts

• Aggregate demand (AD) represents total demand for goods and services in economy
  • AD composed of consumption (C), investment (I), government spending (G), net exports (X - M)
  • AD curve shows relationship between price level and quantity of output demanded
• Rightward AD curve shift (increased aggregate demand) leads to:
  • Higher output (real GDP) at each price level
  • Increased employment as firms hire more workers to meet higher demand
  • Potential inflationary pressure if economy near full capacity
• Leftward AD curve shift (decreased aggregate demand) results in:
  • Lower output (real GDP) at each price level
  • Decreased employment as firms lay off workers due to reduced demand
  • Potential deflationary pressure and increased unemployment

Expenditure Multiplier Effect

• Expenditure multiplier measures total change in GDP from initial change in autonomous spending
  • Autonomous spending independent of income level (government spending, investment)
  • Expenditure multiplier formula: $\frac{1}{1 - MPC}$ (MPC: marginal propensity to consume)
• Initial increase in autonomous spending triggers chain reaction of increased consumption and income
  • Government increasing infrastructure spending directly increases GDP
  • Workers and firms involved spend portion of additional income, further increasing GDP
• Multiplier effect size depends on MPC
  • Higher MPC means consumers spend larger portion of additional income, larger multiplier effect
  • Lower MPC implies consumers save more additional income, smaller multiplier effect
• Expenditure multiplier explains significant impact of autonomous spending changes on GDP and employment levels