Keynesian models of business cycles have fallen out of favor in recent years, due to the lack of an adequate mechanism describing the cause of persistent recessions. This paper provides such a mechanism, one however that it is derived from supply rather than demand side factors.

This paper analyzes recessions from the perspective of microeconomic producer theory. It argues that since firms are unable to adjust their physical capital in the short run, (which corresponds to the duration of a typical recession), average fixed costs rise as production falls. This impairs any possibility of self-correction stemming from supply expansion due to falling wages. Instead, with prices remaining relatively constant, decreasing wages are likely to accelerate a decline in demand as that labor’s purchasing power is diminished. With the economy’s self-correcting mechanism blocked in the short run, recessions would persist until full employment can be reestablished through long run capital growth.

This paper affirms the need for Keynesian-style spending policies that employ slack resources, thus restoring production efficiency when the economy is below full employment. The paper points out however that once production efficiency is restored, such policies are likely less effective.