One Recession, Two Diagnoses: The AD/AS Model Read by Both Schools

The idea

The exam's aggregate-demand-and-supply item and its theorists item meet in one exercise: take a single recession and let each school read the same diagram. The event first. Confidence collapses, consumption and investment fall, aggregate demand shifts left, and the intersection with short-run aggregate supply moves down and to the left: output below potential GDP, cyclical unemployment above the natural rate, the price level lower or, with sticky prices, unchanged. That much both schools accept, because it is the model. The Keynesian reading: the economy is now in the flat left zone of the supply curve, where Keynes's law holds, demand creates its own supply; wages and prices are sticky, so the market will not clear on its own, quantities adjust rather than prices, and a macroeconomic externality keeps firms from cutting; the recessionary gap calls for expansionary fiscal policy, spending or tax cuts, which the multiplier enlarges, and a little inflation is an acceptable price along a downward-sloping Phillips curve. The neoclassical reading: the same recession is a detour; prices are flexible in the long run, expectations, rational or adaptive, govern how fast, and the economy returns to potential GDP on its own, since the long-run supply curve is vertical; stimulus in the steep right zone, where Say's law holds, moves only the price level, so the Phillips curve is vertical and Friedman's temporary tradeoff becomes permanent inflation; the wiser policy is long-term growth and a lower natural rate. The anchor's balance: most mainstream economists are Keynesian for the short run and neoclassical for the long, and the dispute is over which zone the economy occupies and how fast it moves between them, a question the diagram poses and does not settle. Behind the two stand the older schools the exam names: mercantilism's finite wealth, Smith's invisible hand and free trade, Marx's class conflict and inevitability, and the twentieth century's argument between Keynes and the monetarists over what a government can do with demand.