Brookings Papers on Economic Activity, 1: 1988 -Output is demand determined. When price rigidity is imposed on a Walrasian market. so that the market does not clear. it is natural to assume that quantity equals the smaller of supply and demand, so that output falls below the Walrasian level when price is either above or below the Walrasian level. But Keynesians believe that when prices are rigid, increases in demand, which mean prices below Walrasian levels raise output, just as decreases in demand reduce output. This result is built into many Keynesian models through the unappealing assumption that output is demand determined even if demand exceeds supply. For example, in the gray- Fischer contract model, firms hire as much labor as they want, regardless of the preferences of workers. i5 In contrast, under imperfect competition, demand determination arises naturall Firms set prices and then meet demand. Crucially, if demand rises, firms are happy to sell more even if they do not adjust their prices, because under imperfect competition price initially exceeds marginal cost. Thus changes in demand always cause changes in output in the same direction - Booms raise welfare. Under perfect competition, the equilibrium level of output in the absence of shocks is efficient. Thus increases in output resulting from positive shocks, as well as decreases resulting from negative shocks, reduce welfare. In the gray- Fischer model, for example, half the welfare loss from the business cycle occurs when workers are required to work more than they want. In actual economies unusually high output and employment mean that the economy is doing well. 16 And this is the case in models of imperfect competition. Since imperfect competition pushes the no-shock level of output below the social optimum, welfare rises when output rises above this level. ployment through low aggregate de- mand. In 1970s models with sticky nominal wages, unemployment occurs hen prices fall short of the level expected when wages were set, so that real wages rise and firms move up their labor demand curves. In actual economies, however, firms often appear to reduce employment because demand for their output is low, not because real wages are high. This fact is not necessarily a problem for Keynesian theories if the goods market is imperfectly competitive. In this case, a firms labor demand 15. Fischer, ""Long-Term Contracts, and Gray, "" On Indexation. 16. Of course economists worry that low unemployment may be inflationary. But sticky-price models with perfect competition imply that low unemployment is undesirable