Equilibrium in Keynesian Model

According to Keynes, equilibrium income can be achieved at the level of underemployment or overemployment. What is important here is the level of aggregate demand. Since it is difficult to change the production capacity that determines aggregate supply in the short term, the level of income depends on aggregate demand or aggregate expenditures. In other words, firms give their production decisions according to the expected aggregate expenditure or aggregate demand level.

If the economic units plan to spend more, the sales expectations of the companies will increase and they will make more production. As it is seen, Keynes links the deviations from full employment to the inadequacy of aggregate expenditures in the economy. Accordingly, full employment in the economy can be achieved by an adequate level of aggregate expenditure. Then, Keynesian theory criticizes the views expressed by Classics on investment as a function of the interest rate and on wage-price elasticity.

The Keynesian theory argue that the economy is not always be at full employment equilibrium because flexible prices and wages are not always valid. According to this opinion, there are many factors that prevent wages and prices from being flexible. For this reason, markets are moving away from fully competitive structure. In some sectors the existence of firms that do not want to reduce prices may be the case. Prices in these sectors can remain at the same level for a long time instead of falling when there is a fall in demand or expenditure.Because of the existence of strong labor unions and long term wage contracts, the same is also true in labor markets.