Explain the Classical Model of Aggregate Supply and Demand.

Classical Model of Aggregate Supply and Demand

The entire debate of various players in macroeconomic theory can be explained in terms of aggregate demand aggregate supply framework. First of all we will take up the classical model. According to the classical economists the level of output and employment are completely determined by supply factors. They assumed the AD  in an economy is the sum total of expenditures made by the three players i.e. consumer, firms and the government in a closed economy. If the economy is an open economy we will add the difference between exports and imports. We write Aggregate Demand equation  as follows:

    Y= C+I+G=(X-M)

The quantity of real GDP demanded is the total amount of final goods and services produced in an economy that people, businesses, governments, and foreigners plan to buy. A number of factors affect the Aggregate demand:

ü  price level

ü  expectations (about inflation, about the future state of the economy, about r)

ü  fiscal policy

ü  monetary policy

ü  world economy

We are interested in deriving a relationship between the price level, P, and the AD  at that price level, other things remaining constant. We are interested in developing  a model which can make predictions about the movements of the price level and the level of real GDP. The AD curve is more complex than a market or industry demand curve. The AD curve is not a market demand curve and is not the sum of all market demand curves in the economy.

The AD curve is downward sloping curve.  The logic given for microeconomic theory is not applicable to the AD curve. For the microeconomics market demand curve we assume that all other prices and incomes are fixed. For movements along a market demand curve, when the price of a good rises the quantity demanded of the good falls in part because the prices of other goods do not rise as well. The good becomes more expensive relative to other goods, so agents substitute other goods for the good whose price increased. Since income is held fixed, when the price of the good rises real income falls, which may lead to a lower quantity demanded as well.

The AD curve is also a negatively sloped curve with Price level changes.  Some factors that affect AD are assumed constant,  when the overall price level rises, the wage rates and incomes also rise. Thus, all other things do not remain the same. For the AD curve the ordinary substitution effect for a microeconomic demand curve of a rising price reducing the quantity demanded does not apply. As we shall see, the rising aggregate price level P reduces the equilibrium aggregate output demanded by tightening the money market, raising the interest rate, and thus reducing investment and consumption.

Why is AD Downward Sloping?

(1) Real Balance Effect (Pigou Effect):  With the price level increases, household wealth and asset holdings lose purchasing power. Therefore fewer units of real output are purchased.  Assume for the sake of simplicity that people can put their wealth in either money or in bonds. What happens to the real value of their assets, , as the price level rises? From inspection we see that

Thus, as the price level rises the real value of assets falls, households lose purchasing power and their consumption falls.

(2) Interest Rate Effect: As the price level rises, interest rate also tends to rise. Keynes argued that people care about the purchasing power of the money that they hold, their real money balances. When the price level rises the same nominal quantity of money is no longer as valuable. It commands fewer goods and services than it did before the increase in the price level. To restore their holdings of money in real terms to its former value, economic agents must hold a larger amount of nominal money than before. This increases the amount that people need to borrow. At a higher price level borrowing needs are greater and the demand for loans rises increasing the price of money, i.

 (3) Foreign Goods Substitution Effect: Another reason for negatively slopped Aggregate Demand curve is that if the price level rises people substitute into import consumption and exports fall.

Thus, .

Aggregate Supply Curve (Classical)

The level of GDP which can be produced and maintained depends upon the following factors.

Determinants Aggregate Supply:

(1) Availability of labour (L) and capital (K): increasing L or K will shift the Q_p to the right.

(2) Productivity of labour and capital: increasing productivity of labour or capital will shift Q_p to the right.

(3) Cost of labour and capital: e.g. increasing the price of oil can reduce Q_p.

(4) Institutional arrangements: the more efficient are markets the greater is Q_p. Note that government policy can affect Q_p. For example, government policies increasing the efficiency of the financial sector increases the potential output of the economy.

Classical economists took the following assumptions about the labour market. Both labour demand as well as labour supply are the functions of the real wage. There is a perfect knowledge of labour market to all the stake holders.  The money wage is perfectly flexible.  The flexibility of wage rate restores equilibrium in the labour market. Aggregate Supply is closely tied to labour market: The potential GDP is the quantity of real GDP supplied when unemployment is at its natural rate and there is full employment in the economy.

Natural Rate of Unemployment (NRU): The natural rate of unemployment is the rate at which unemployed workers are primarily voluntarily out of work. It is frictional unemployment plus structural unemployment. It is the unemployment rate at full employment. The natural rate is influenced by the structure of the labour force and public policy. It may vary with time. It varies because of:

1) Labour force structure changes: Increased labour-force participation of teenagers, minorities, and women may change the NRU.  The structure of labour force changes over time The changing composition of the labour force toward high-turnover, high-unemployed  workers increased the natural rate of unemployment.

(2) Public Policies: unemployment irnds to increase the average duration of unemployment. It also decreases the cost to employers of temporary layoffs.
                                           

Classical economists believed that if there is an increase in aggregate demand prices would rise and money wage has to rise proportionately with the price level.The real wage will remain unchanged and therefore the equilibrium quantity will remain unchanged in the new equilibrium.

In classical system, then, the role of aggregate demand is to determine the price level.

The classical theory of aggregate demand id an implicit theory based on the quantity theory of money. The quantity theory provides a direct and proportionate relationship between the money supply and the level of nominal income.  In the quantity theory other variables remaining constant if there is an excess supply of money there will be a corresponding demand for commodities which will cause an increase in aggregate price level. Thus, the classical model has a monetary theory of aggregate demand.

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