Classical AD/AS Model

• Classical school of thought


  Unique interpretation of aggregate supply
• Keynesian school of thought


  Own interpretation of aggregate supply
• Both schools have different ideas on how the macro economy needs to be managed
• Classical model assumptions

  • There is a big difference between the short run and the long run
  • Short-run aggregate supply curve position is determined by costs of production
  • Long-run aggregate supply curve position is determined by quantity and quality of factors of production
  • Long-run aggregate supply curve is vertical at full employment level of output
• Keynes disagrees with the classical model's assumptions about the difference between short-run and long-run aggregate supply
• Short run (classical model)

  Wages and resource prices are fixed
• Long run (classical model)

  Wages and resource prices are variable
• There are no time frames put on the short run and long run in the classical model
• In the classical model, the economy will always move back to the full employment level of output in the long run without government intervention
• How the classical model explains an economy in recession

  1. Aggregate demand shifts left

  2. Short-run equilibrium at lower output and price level

  3. Firms try to reduce costs, mainly by cutting wages

  4. Wages are fixed in the short run so firms accept lower output and higher unemployment

  5. In the long run, workers revise down wage expectations, allowing wages to fall and SAS to shift right to full employment
• Characteristics of a recessionary/deflationary gap in the classical model

  • Lower output
  • Higher unemployment
• How the classical model explains an overheating economy

  1. Aggregate demand shifts right

  2. Short-run equilibrium at higher output and price level

  3. Firms can produce more than full employment by using factors unsustainably

  4. Wages are fixed in the short run so firms don't have to raise wages

  5. In the long run, workers demand higher wages, shifting SAS left to full employment but with higher inflation
• Characteristics of an inflationary gap in the classical model

  • Output greater than full employment level
  • Unemployment lower than natural rate
• Classical economists are known as supply-side economists who believe the only way to reduce unemployment and grow sustainably is through supply-side policies