Answer to Question #119014 in Macroeconomics for Aynul

Question

Explain the Keynesian Consumption Model in details using an example. Suppose the economy is stuck in a Recessionary Gap, using a graph explain how you can utilize the concept of the Keynesian Consumption Model to explain how government can push back the economy to the long-run equilibrium.

Answer 1

Keynesian economics provide that the macroeconomic can be in disequilibrium during recession period. Further, Keynesian school of thought postulate that there is need for a fiscal intervention through increased government spending to restore the economy back. A recessionary gap, also known as a contractionary gap, is one in which the country’s real GDP is lower than its gross domestic production (GDP) at full employment. The gap represents the variance between the actual and potential production in the economy. At the recessionary gap, the actual production is lower than the potential production and this causes a downward pressure on prices in the long run. It is typical to have high unemployment rates during recessionary cycles. A good epitome of a recessionary gap was in the United States in December 2018 where the labor market was reportedly at full employment. The unemployment rate stood at 3.7 percent. Full employment was however differentiated across states such as New York City were at full employment, other cities such as Virginia experienced recessionary gap. 

In the graph above, equilibrium exists at the point Q_E where the quantity of labor supplied is equal to the quantity of labor demanded. During recession period, there is decreased demand as shown by the curve D₁. To close the recessionary gap and return the economy back to equilibrium at point Qe on the curve D₀, the real wage has to return to equilibrium where the quantity of labor demanded is equal to the quantity of labor supplied (Q_E). The government can push back the economy to the long-run equilibrium by adopting a stabilization policy to close the recessionary gap through the increase of real GDP.