Recessions are periods in which we have under utilized resources such as labor or capital goods. Classical theory suggests that unemployment could be reduced by cutting wages. The assumption is that employers would hire more workers at lower prices. In other words unemployment is caused by high wages in the short term. In the long term economic growth is determined by supply factors such as new technologies or more productive resources. This neo-classical synthesis is accepted by most "New Keynesian" economists. Prices do not adjust quickly enough in recessions. Therefore, we have short term demand problems that may require the use of monetary or fiscal policy to decrease short term unemployment.
Supply factors do constrain how far we can expand aggregate demand to increase production. On the other hand, wage and price deflation are also destabilizing. This article describes some of the channels by which they prevent economies from recovering from recession. Debtors have to cut spending in order to repay debts that remain constant as incomes fall. Some of their income goes to creditors who typically spend a smaller share of their income than debtors. Consumers and businesses, who anticipate falling prices, will also defer spending. Aggregate demand falls further and businesses will respond by cutting back on production and employment.
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