Fredrick O. answered • 9d
Experienced High School teacher specializing in AP Macroeconomics
Classical Aggregate Supply Model: The Basics
The Classical AS model rests on a few key assumptions:
* Flexible Prices and Wages: Prices and wages adjust quickly to changes in supply and demand. This is crucial because it allows the economy to self-correct rapidly.
* Vertical Aggregate Supply Curve: The long-run aggregate supply (LRAS) curve is vertical at the full employment level of output (also known as potential output). This means that in the long run, the economy's output is determined by its productive capacity, not by aggregate demand.
* Rational Expectations: People make decisions based on the best available information and learn quickly from their mistakes.
How an Increase in Aggregate Demand Affects the Economy
1. Initial Impact: Suppose the government increases spending to boost aggregate demand (AD). Initially, this shifts the AD curve to the right. In the short run, this increased demand puts upward pressure on both prices and output.
2. Price and Wage Adjustments: Because prices and wages are flexible, they start to rise in response to the increased demand. Workers demand higher wages to compensate for the rising cost of living, and businesses increase prices to maintain their profit margins.
3. Return to Full Employment Output: As wages and prices rise, the short-run aggregate supply (SRAS) curve shifts to the left. This shift continues until the economy returns to the full employment level of output. At this point, the increased aggregate demand has been fully absorbed by higher prices.
Why Output and Unemployment Don't Change
* Output: In the classical model, the economy is always tending towards its full employment level of output. The vertical LRAS curve signifies that the economy's potential output is determined by real factors (technology, capital, labor), not by changes in aggregate demand. So, even though there might be a temporary increase in output, it quickly reverts to the full employment level as prices and wages adjust.
* Unemployment: Similarly, unemployment remains at its natural rate. The natural rate of unemployment is the level of unemployment that prevails when the economy is producing at its potential output. Since output returns to this level, unemployment also returns to its natural rate.
Why the Price Level Increases
* Inflation: The increase in aggregate demand, without a corresponding increase in aggregate supply, leads to a higher price level. This is because there is more money chasing the same amount of goods and services. The result is inflation.
In Summary
In the Classical AS model, an attempt by the government to boost aggregate demand only leads to higher prices in the long run. Output and unemployment remain unchanged because the economy is self-correcting and always tends towards its full employment equilibrium. The key takeaway is that in the classical view, monetary or fiscal policy is ineffective at influencing real economic variables like output and unemployment in the long run; it only affects nominal variables like the price level.
