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A-Level Economics · AD shift left (recession) diagram question

The gap between Y₂ and Y₁ is a negative output gap. On the KEYNESIAN view, what happens next if wages are sticky?

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The answer

The economy stays stuck at F with a permanent negative output gap — high unemployment, low incomes, large social costs. Workers are not receptive to cuts in nominal wages whatever the state of the economy, so the economy does not heal itself. It sits at F. Classicals say wages are fixed in the short run but variable in the long run, so lower wages cut costs, SRAS shifts right and output returns to full employment. Keynesians say wages are very sticky downwards even in a recession — so the economy is stuck in the recession, with a permanent negative output gap, high unemployment and large social costs over the long term. That disagreement is the whole essay.

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