Classical Model in AD AS Fremework

 

Classical Model:

According to classical model the level of output and employment are completely determined by the supply factors. They believed in vertical aggregate supply curve means a fixed supply at the full employment level in the economy.

Assumptions about the labour market:

1.      Labour demand as well as labour supply are the function of Real wage.

2.      Perfect knowledge of the market to all the participants

3.      Money wages are perfectly flexible and assures equilibrium in the labour market.

These assumptions lead to believe that in case of any increase in aggregate demand (AD)in the economy the equilibrium level of output and employment will remain unchanged because of vertical aggregate supply curve.  In case of any rise in AD only prices would rise and money wage will rise proportionately with the price level. Thus, Real Wage remains unchanged at the new equilibrium level.

In classical system the role of AD is to determine the price level as AS is fixed at natural level of output. The classical theory of AD is an implicit theory based on the quantity theory of money. The quantity theory provides a direct and proportional relationship between the money supply and the level of income, In quantity theory of money other variables remaining constant if there is an excess supply of money there will be a corresponding excess demand for commodities which will cause qn increase in the aggregate price level. Thus, the classical model has a monetary theory of aggregate demand.