142 Assignment Solution: Keynesian and Neoclassical Economics

Solution:

Figure 1 shows the 3 zones of an AS curve: The neoclassical zone where the curve is steep near potential GDP, the Intermediate zone where the curve is medium sloped, and the Keynesian zone where the curve is quite flat.

A minor recession would shift the AD curve slightly to the left, while keeping the new short run equilibrium within the neoclassical zone where the effect of the decrease in demand would be mainly a fall in the aggregate price level with only a small decrease in real GDP (and by extension, in employment). In such a scenario, the cost of allowing the economy to return to the new long run equilibrium at a lower price level still would be relatively small.

A major recession, by contrast, would shift the AD curve significantly to the left, into the Keynesian zone where the effect of the decrease in demand would be a significant decline in real GDP and employment and not much ore effect on the aggregate price level. Under such a scenario, the cost of waiting for the economy to recover on its own would be significant, and so a Keynesian expansionary fiscal policy would likely be a more appropriate response.