How does the classical/neoclassical theory’s “Say’s Law” (or the saving-investment mechanism) suggest that the economy will...

How does the classical/neoclassical theory’s “Say’s Law” (or the saving-investment mechanism) suggest that the economy will adjust when a demand-side “shock” caused by a decline in consumption spending occurs? Why did Keynes believe (and why do many economists still believe) that these adjustments will not occur? Answer both of these questions with regard to a demand-side “shock” caused by a decline in investment spending.

Expert Solution

Say's law states that supply creates its own demand. So that any changes in Aggregate Demand does not affect output and employment but only the price level i.e prices are fully flexible. The classical Aggregate Supply curve is a vertical line so that output always remains at its equilibrium level. As shown in the graph below, when Aggregate demand shifts down due to a decline in consumption or investment spending, only the prices fall from P to P' and there is no change in output. Due to fully flexibilty of prices and wages, markets adjusts in such a way that there is no involuntary unemployment.

Keynes on the other had assumed that prices and wages are sticky in the short run and thus we get a horizontal SRAS (short run aggregate supply). So when AD curve shifts back to AD' and markets does not adjusts quickly due to sticky prices and wages, as a result output falls and unemployment increases.

Rahul Sunny answered 2 years ago

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