The AD/AS model showcases the tug-of-war between Keynes' Law and Say's Law. Keynes' Law dominates when the economy has slack, while Say's Law takes over at full capacity. Understanding these dynamics is crucial for grasping macroeconomic fluctuations.

Policy effectiveness varies across economic zones. In the Keynesian zone, demand-side policies can boost growth. In the neoclassical zone, supply-side measures are key. The intermediate zone requires a balanced approach, addressing both demand and supply factors.

Keynes' Law and Say's Law in the AD/AS Model

Keynes' Law vs Say's Law

• Keynes' Law applies to the horizontal portion of the aggregate supply curve, known as the Keynesian zone
  • Aggregate supply is highly elastic, changes in aggregate demand lead to changes in real output without affecting the price level
  • Characterized by high levels of unemployment and excess productive capacity (labor surplus, idle factories)
• Say's Law applies to the vertical portion of the aggregate supply curve, known as the neoclassical zone
  • Aggregate supply is inelastic, changes in aggregate demand only affect the price level without changing real output
  • Characterized by full employment and full utilization of productive capacity (labor shortages, factories at maximum output)
• The intermediate zone, located between the Keynesian and neoclassical zones, represents a transition between the two laws
  • Changes in aggregate demand affect both real output and the price level to varying degrees (moderate unemployment, some idle capacity)

Effects of aggregate demand shifts

• In the Keynesian zone:
  • An increase in aggregate demand leads to an increase in real output and a decrease in unemployment, with little to no effect on the price level (government stimulus spending, tax cuts)
  • A decrease in aggregate demand leads to a decrease in real output and an increase in unemployment, with little to no effect on the price level (reduced consumer spending, business investment)
  • The multiplier effect amplifies the impact of changes in aggregate demand on output and employment
• In the intermediate zone:
  • An increase in aggregate demand leads to an increase in both real output and the price level, with a moderate decrease in unemployment (increased exports, government spending)
  • A decrease in aggregate demand leads to a decrease in both real output and the price level, with a moderate increase in unemployment (stock market crash, trade restrictions)
• In the neoclassical zone:
  • An increase in aggregate demand leads to an increase in the price level (inflation) without affecting real output or unemployment (excess money supply, asset bubbles)
  • A decrease in aggregate demand leads to a decrease in the price level (deflation) without affecting real output or unemployment (tight monetary policy, reduced velocity of money)

Policy implications across economic zones

• In the Keynesian zone, where unemployment is high and productive capacity is underutilized, expansionary fiscal and monetary policies can be effective in increasing aggregate demand and stimulating economic growth
  • Expansionary fiscal policy involves increasing government spending or reducing taxes to boost aggregate demand (infrastructure investment, tax rebates)
  • Expansionary monetary policy involves increasing the money supply or lowering interest rates to encourage borrowing and spending (quantitative easing, federal funds rate cuts)
  • However, a liquidity trap may limit the effectiveness of monetary policy in severe recessions
• In the neoclassical zone, where the economy is operating at full employment and full capacity, expansionary policies may lead to inflation without increasing real output
  • Policymakers should focus on supply-side policies that aim to increase long-run aggregate supply (education funding, research and development incentives)
  • Contractionary fiscal and monetary policies may be necessary to control inflation if aggregate demand continues to increase in the neoclassical zone (spending cuts, tax increases, higher interest rates)

Economic Schools of Thought and Business Cycle

• Classical economics, associated with Say's Law, emphasizes the self-correcting nature of markets and minimal government intervention
• John Maynard Keynes challenged classical views, arguing for active government policies to manage aggregate demand and stabilize the business cycle
• The business cycle refers to fluctuations in economic activity, with periods of expansion and contraction
• Stagflation, a combination of high inflation and high unemployment, challenged both Keynesian and classical models
• The rational expectations theory suggests that economic agents use all available information to make decisions, potentially limiting the effectiveness of government policies