According to the classical view, if money increases, the price level increases too. How is that...

According to the classical view, if money increases, the price level increases too. How is that explained using AD/AS analysis?

Expert Solution

In a classical economy, the basic assumption is that the variables are flexible and adjust quickly to the new market conditions. So, if the money supply increase in the market, it will leave the people in the market with a higher money in there hand. They will demand more.

At a higher demand, the price will increase and the firms will supply more. But, as the variables adjust quickly the wages will also increase with the price. And at higher wages, the input price will rise. At a higher input price, the price will increase more and the supply will decrease. Leaving the original output same but the price at a higher level.

In the graph shown here, the economy was initially at the equilibrium point A, Form here are the money supply increase it will increase the demand and shift the AD curve to AD2. At this increased demand the supply is higher than usual and the real wages are low because of increased prices.the economy is at equilibrium point B.

The labors will judge the situation quickly and ask for a wage increase. This will act as a negative supply shock and the Supply curve will shift to SRAS2 i.e. at a higher price and lower output. And the equilibrium will be at C. THe output will remain same at Y1 and the price increased to P3.

Rahul Sunny answered 2 years ago

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