Question

Analyse the role of the components of aggregate demand on real variable. What are the policy implications of classical economics? 20 marks

Answer 1

The classical economy thoughts are the old school thoughts of economy. Classical economic thoughts propounded in generally in Britain. The classical model states that an economy is in full employment and wage and price both are fully flexible. In classical dichotomy the real variables and nominal variables are determined differently. Aggregate demand of an economy is the total demand for the goods and services of the economy at given time period.

Explanation:

The components of the aggregate demand be consumption expenditure, investment expenditure, government expenditure and net export.

The change in the components directly affect the change in the level of the total output. As output increases , it would directly change the level of employment and the real wage rate, here both price and money wage are fully flexible, so full employment level would be occurred. Due to classical dichotomy, change in output directly affects the real components instead of monetary components.

In classical economy, government imposes fiscal policy by change in government expenditure and tax rate. The government can impose expansionary fiscal policy by reducing tax rate and increasing government expenditure. That means due to increase in government expenditure , the components of the aggregate demand would expand and AD curve shift to rightward. As the result output and level of employment, and real wage would increase.

If government tries to impose contractionary fiscal policy, where tax rate increase and the government would cut off its expenses. Due to reduce in government spending, the aggregate demand would reduce. So the level of output would lead to decrease, but in classical economy there is full employment. But it would cut off the real wage rate.