Download The Classical View Page 1 of 2

Aggregate Demand/Aggregate Supply Model
Differences in the Long Run and the Short Run
The Classical View
Page 1 of 2
From time to time you’ll hear a macroeconomist refer to the classical perspective on some problem, or a classical
model. What does an economist mean by the term “classical”? It means simply this—that wages and prices adjust
instantly to clear markets. The classical perspective in macroeconomics is to be contrast with the Keynesian
perspective. The Keynesian perspective is a view of the world as if wages and prices are sticky, but the classical
perspective imagines that wages and prices adjust instantly to clear markets and asks what is the outcome of fiscal
and monetary policy going to be in a world where prices and wages adjust instantly?
Let’s look first at he classical view of the labor market. It’s very simple. The wage or the price of labor adjusts
immediately to give us equilibrium. Here’s the wage or the price of labor, and here’s the quantity of labor supplied and
demanded in the labor market. The demand curve for labor represents the behavior of firms that hire labor in order to
produce goods and services. The demand curve for labor is downward-sloping because at higher wages firms will use
less labor and substitute to capital and other inputs instead. Also, at higher wages, firms use less labor because
they’re producing less output. The demand curve for labor will shift when labor productivity changes, or whenever
capital or the endowment of other resources changes, which makes firms willing to hire more labor at any given wage
rate. So we’ve got this downward sloping demand curve for labor. The supply curve for labor, for the sake of
simplicity, is going to be drawn vertically.
Now, it isn’t always going to be the case that the supply curve for labor is vertical, but in a classical view of the world
there are a certain number of people who want to work, and full employment means giving them all a job. So
whatever the wage rate is in this simple, classical view of the world, we’ve got a certain number of people. We can call
this lf, full employment, that are ready and able to work. So what happens in the classical view of the world is this.
The intersection of demand and supply points us towards an equilibrium wage rate, say, $5.00 an hour, and this is the
wage rate at which the quantity of labor demanded, and the quantity of labor supplied are equal. If the wage were
above this equilibrium, we would have fewer workers demanded that are wanting to show up for a job at that wage
rate, and there will be excess supply of labor.
In that case the bidding mechanism would immediately correct this situation by pushing the wages downward. The
same number of people, of course, would show up for work under the assumption of this inelastic supply. However,
with lower wages now, firms find it profitable to hire more workers and use less capital, or simply to hire more workers
to produce more output than before. On the other hand, suppose we have a wage rate that is below equilibrium? In
this case we have an excess demand for labor. There are more jobs that are looking for people to fill them than there
are people who want to work. In this case firms will bid up the wage rate in order to try to take workers away from
each other. Competition for labor bids up the wage rate so that firms then choose to move along their demand curve,
economizing on labor, and using more capital instead, or simply producing less output.
In the end we have an equilibrium wage rate. The classical view of the economy is this: we are always at this point.
We are always at the price and quantity at which the labor market clears. Any change in the demand for labor is
going to immediately move us to a new wage rate. There’s not going to be any period of unemployment or any period
of excess employment. A shift in the demand curve for labor brings about an immediate adjustment in the wage rate
to clear the labor market, and that’s the way things work in the classical view of the economy.
Now, if this is the case, then the economy is always at full employment. The given number of workers are always
going to be working at whatever the going wage rate is, and we’re going to be producing an amount of output that
depends on only two things—the technology that is available to us, and the number of workers that are available to
work. We’ve got a given work force, we’ve got a given technology. Put those two things together and we’ve got a set
amount of output that can be produced in our economy, and that’s called the “full employment output level.” So the
resource endowment of your economy and the technology that these workers can use, which is going to also depend
on capital stocks and the endowments of other natural resources, determines full employment output level. And full
employment output level then determines the amount of output that will be produced in the classical macro economy.
Let me go ahead and put on the vertical axis here now the overall price level in the macro economy and on the
horizontal axis, output in our macro economy and let me also go ahead and put in the classical supply curve. The
Aggregate Demand/Aggregate Supply Model
Differences in the Long Run and the Short Run
The Classical View
Page 2 of 2
classical aggregate supply curve is the total amount of output that is going to be produced in our economy at full
employment.
Well, the view of the classical economist is we are always at full employment, that the price level will change so as to
bring us to the point where aggregate demand and aggregate supply are equal, and that will be the equilibrium price
level in our economy. So suppose we were at some price level that was too low? If prices were too low then the
aggregate demand in our economy would be large. That is, prices are low; the given money supply is plentiful relative
to the amount of shopping that people are doing. Interest rates are low. People are buying stuff. Businesses are
buying capital goods, and there’s a lot more demand than is being met by the output of our factories when workers are
fully employed.
Well, in this case the bidding mechanism will kick in, push up the aggregate price level, and as the aggregate price
level rises, the real money supply shrinks, or people demand more money to do their shopping, interest rates go up,
and consumer spending and business spending is curtailed until we get to our equilibrium point, P*. If we have a price
level that’s above equilibrium, then in this case people are trying to demand a whole lot of money to do their shopping;
interest rates have been pushed way, way up as people scramble to get the cash to make their purchases, and in this
case we wind up with consumers and businesses doing very, very little purchasing because interest rates are so high,
and in this case we have a situation where aggregate supply exceeds aggregate demand. In that case the prices will
begin to fall because stuff is piling up on businesses’ shelves, excess inventories lead businesses to cut prices, and
as they do then the demand for money falls because people don’t need as much money to do their shopping, interest
rates fall, and consumers and businesses increase their spending until we get back to our equilibrium price level, P*.
This is the way the classical economy works. We are always at P* and we are always at the full employment level of
output. Wages and prices adjust continually, instantly, so as to keep us at full employment. When you hear the term
“classical,” you know we’re talking about a world where wages and prices adjust and we are always at full
employment. That’s what it means. So if something happens to shift out the aggregate demand curve, say an
increase in the money supply, which lowers interest rates and leads people to do more shopping at every price level.
Then what will happen is, at the original price level we have excess demand for goods. This excess demand pushes
up prices, increases the demand for money, raises interest rates, and eventually brings us back to full employment at
a new higher price level. The interesting thing to notice about this classical adjustment is that prices do all the work.
There’s no increase in output because you can’t ever have an output level that differs from full employment.
Prices and wages adjusting constantly, instantly, frictionlessly, so as to keep us at the point where supply equals
demand. The labor market clears, full employment output is the only option in this model, and if you’re not there,
prices are going to adjust instantly to take you there. It’s an extreme view of the world, but it’s one that’s quite simple
to analyze, because you always have to be on the vertical blue line, and if you’re not there, some wage or some price
is going to adjust pretty fast to take you back there.