Using regular classical model the economy immediately adjust to long run

equilibrium making it difficult to show the effects of a recession and fiscal

stimulation. On the other hand using the misperception model makes it
easier to illustrate short run disequilibrium brought on by misperceptions of
the economy.

The misperception theory can help to explain why an economy enters a

recession.

The misperception theory doesn’t use disequilibrium like the Keynesian theory
does. Instead, it uses the idea that businesses get fooled into reducing production
and employment.

Generating a recession: start, again, with a drop in AD (a drop in C, or I, or G, or

NX). Prices begin to fall. As prices fall, businesses don’t realize that prices
across the entire economy are falling. Instead, businesses fear that the price of
their product is falling because there’s a lack of demand for their specific product.
That is, businesses confuse the macroeconomic event (the fall of AD and all
prices) with a microeconomic event (fall of demand for their product and the price
of their product). When companies fear that demand for their product is falling,
what do they do? They cut production and lay workers off. In the short run,
income is down and unemployment is up: that’s a recession. In the long run,
companies will realize that demand for their product did not fall. It was just
prices across the entire economy and their resource costs are falling to match.
Companies will return production and employment back to normal, long run
equilibrium, full employment, natural rate.

The Worker-Misperception Model

The second model of aggregate supply is very similar to the sticky-wage model. The worker-
misperception model differs in three ways from the sticky-wage model. First, in this model, the
wage is flexible, and so it adjusts to bring the labor market into equilibrium. Second, this model
assumes that workers cannot accurately perceive the price level. Third, this model supposes that
the supply of labor depends upon the real wage.

Since firms and workers have different information about the price level (firms know the true
price level, while workers have an expectation of the price level), it follows that labor demand
depends upon the actual real wage, while labor supply depends upon the expected real wage.

With these differences in mind, the basic story is the same. If the price level turns out to be
higher than workers realize, then they are fooled into supplying more labor, and output is higher.
The converse is true if the price level is lower than workers anticipate. This argument can be
illustrated in a diagram with the nominal wage on the vertical axis: