This attempts to explain the general ebb and flow of macroeconomics. To put it simply, economies experience good times, followed by bad times, followed by good etc. Where we are in that cycle depends on our real GDP growth. World history has shown us that the general trend for all countries is for there to be a general increase over time, punctuated with highs and lows. We have different names for where we are, as you can see below by hovering over the flash image.
We must also understand the concept of the 'natural rate of unemployment'. If we look at the Trade Cycle, we can see that we are able to produce above our potential real GDP. This, surely, makes no sense: how can you produce more than you are able to produce??
The answer lies with the natural rate of unemployment. This states that in every economy we want to have around 3% of unused factors of production. This is because it helps the economy remain fluid (workers can replace other workers, land has time to recover etc). If we use these resources, we therefore have a lower rate of unemployment than we should do - an inflationary gap. If we use less than 3% we have more unemployment than the natural rate - a recessionary gap.
Neoclassical economists are followers of the 'Father of Economics' - Adam Smith. They claim that, if left alone, the economy will always swing back into producing at potential GDP.
To understand this we must understand the following steps:
1) Aggregate Demand is more likely to fluctuate than Aggregate Supply in an economy
2) When it does move, AD changes prices
3) Prices are linked to wages
4) Wages are a cost of production
5) Wages thus influence the Short-Run Aggregate Supply curve
6) Aggregate Demand thus is intrinsictly linked to Short-Run Aggregate Supply
This relationship can be expressed below:
What is all this 'Short-Run' about? Well, according to their theories, there is a great difference between Short Run AS and Long Run AS. The difference is the time it takes for wages to adjust to price changes. This only happens in the Long Run, according to Neoclassical Economists. The Long Run Aggregate Supply is therefore the amount we produce when wages have been taken into account. According to Neoclassical economists, if we start at equilibrium, we will always end up there as inflationary and recessionary gaps will be taken into account naturally. Lets consider this below.
Take Diagram 1, above. We were at equilibrium (where AD met SRAS). Then, Aggregate Demand rose (for whatever reason). Prices therefore rose to P2. If Q1 was our Potential GDP, we now enter an inflationary gap. Workers therefore began to feel that life was a bit too expensive, and asked for a wage increase. If prices rose by - say - 10%, they asked for a 10% wage increase. This made it more expensive for producers to produce, so SRAS fell. We end up at P3 and Q3. Notice that Q3 is the same as Q1!
Because Q1 and Q3 are the same, neoclassicalists say that that quantity represents potential GDP, or the amount we always end up producing in the long run, no matter what happens in the economy. Or... our Long Run Aggregate Supply (LRAS). This takes us to Diagram 2 where we reinterpret the first Diagram. LRAS is our potential GDP. Even if AD increases, we end up at our potential GDP in the long run because wages change too.
AD does not influence our long run production even if it falls, as seen below.
We see that when AD falls, prices fall in the economy (as producers have to lower them in order to get rid of the goods as less people want them). As a result, firms get less revenue. Because of this, producers tell their workers they must take a wage cut. Having taken a wage cut, supply can then increase as it is cheaper to produce. SRAS shifts outwards (to SRAS1), causing us to produce the same amount as when we started the cycle. Recessionary gaps are thus just temporary.
Based on the works of John Meynard Keynes in the inter-war years, economists who follow this understanding of the economy have a very different view.
Their disagreement with the neoclassicalists starts with recessionary gaps. Supposedly, when AD falls, prices fall and so - therefore - do wages. "Rubbish!," say the Keynesians. Wages rarely really fall in the economy - trade unions, laws and just general common sense prevent them from doing so. No, the Keynesians prefer to break the economy up into 'stages' instead of having a SRAS and a LRAS.
Below we can see the Keynesian view of the economy.
What's going on here? Don't panic. Diagram 1 above helps explain this. In the blue section on the diagram, we can see that the supply curve is horizontal. If we imagine AD was on this flat segment, and we increased AD (by shifting it to the right) there would be no change in prices. This is the opposite to what neoclassical economists say! Why is this?
Keynesians claim that in the flat section, resources are abundant, and not being used. There is plenty of land, labour, capital and enterprise lying around unused. In fact, so much is not being used that even when we demand more, the price remains low (as its abundance makes it have less value).
Only when we approach the pink section can we see prices begin to rise. Along this section, resources begin to run out (called 'bottlenecks'). As AD increases on this section, we use up our factors of production - if you want more stuff, you start to have to pay more for it, as its no longer abundant. Somewhere on this section we have our potential GDP (which includes natural unemployment).
Finally, when approaching the yellow section, we are using ALL of our resources. We cannot increase production at this point. If AD keeps increasing then we will produce beyond our potential GDP and thus enter an inflationary gap. On this section, Keynesians agree that increasing AD will only lead to increasing prices.
So, what the Keynesians believe, overall that if we are in a recessionary gap (producing below p.GDP) then we can get stuck there if the government doesn't intervene to boost aggregate demand. This is shown in diagram 1 below, whilst if AD is above pGDP then we are in an inflationary gap and AD needs to be reduced, as seen in diagram 2.