Question

List the three assumptions of the classical model, and illustrate how a negative shock to AD would affect the labor market and the market for goods and services. Then show how a sudden desire on the part of households to save more would affect the market for loanable funds , as well as total demand for goods and services in the classical system. In both parts, explain clearly and label all graphs completely.

Answer 1

The assumptions of the classical model are:-

1) PRICES ARE FLEXIBLE- This assumes that prices can adjust quickly to equate supply and demand. This can also be said as market clearing assumption. Thus we get an equilibrium with a (price, quantity) tuple such that both AD and AS are equated.

2)PERFECT COMPETITION -There are large number of buyers and sellers in the in the labour market and commodity market. It is therefore not possible to affect or change the wages and prices in the markets.

3) SAVING = INVESTMENT- Savings and Investment are always equal. In the long run the rate of interest is the linking variable. If at any point of time there is mismatch between the two the changes in the rate of interest guarantees the equilibrium between the two.

4) SAY'S LAW- Supply creates its own demand. The economy may not face the conditions of over production.

5) HOMOGENOUS LABOR AND PRODUCT- The quality, efficiency, productivity of labour does not differ it is homogenous. Similarly, products of one industry are same in quality(utility).