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Please evaluate the following statement in detail; in order for an aggregate demand shock to have...

Please evaluate the following statement in detail;

in order for an aggregate demand shock to have a real effect, there must be some friction in the economy that prevents market from clearing.

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Answer #1

According to Keynesian model, fluctuations in output largely from nominal aggregate demand. These transformations have real effects because price and nominal wages are fixed. In the 1970s the assumption of nominal wage rigidities was explained via labor contracts. Hence, real effects of the nominal demand shocks can be large even if friction preventing full market clearing flexibility are slight. An increase in the rate of inflation causes firms to adjust prices more frequently to maintain the increasing prices. A more frequent change in prices implies more quick adjustment to demand shocks which means less real effects.

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