Question

If there is a recession, use a supply and demand graph to explain what the Classicalists would argue will happen to get the economy to long run equilibrium. Be sure to label your graph, show changes, and explain what is happening.

Answer 1

The diagram depicts the full employment equilibrium as assumed by the classical economists. The classicists believed that the economy would operate under full employment equilibrium in the long run. They believed that the situation of recession which is a phase of business cycle which is a prolonged period of falling levels of income and employment and which , if unchecked , could slip into depression which is a greater danger for the economy.

The y-axis represents the general price level of all the goods and services produced in the economy while the x-axis shows the output produced at the given price level over a period of time.The AS curve is a linear Aggregate Supply line which shows the supply of all goods and factor services while the AD line shows the aggregate demand by various entities like firms, households and so on who spend on various expenditures. The Qf level of output shows the full employment level of output at which the AD curve intersects the AS curve and the economy is assumed to be operating at full employment level of equilibrium (shown by 'E') where all the given resources are optimally employed.

Due to a recessionary situation caused by supply shocks or due to fall in investment and consumption expenditure largely due to taxes and so on could lead the AD curve to shift downward from AD to AD'. This pulls the equilibrium down from E to E' and the price level stabilizes at a much lower level than its previous position --from P to P'. This fall in price level however is perceived as temporary phenomenon by classicists  since they believed in the operation of price mechanism --wherein the forces of demand and supply react on each other in such a way that in case of excess demand the price level rises up and stabilizes at the market equilibrium where the demand and supply intersect.

In case of excess supply, the prices would register a fall until the two forces intersect each other. Hence they perceived that an automatic adjustment would take place and in the long run, ultimately, the prevailing equilibrium would be one of full employment . They advocated that the adjustments would take a long time to stabilize and hence it is possible that though there could be points of disequilibrium in the short yet because of the inherent changes in the demand and supply forces , the long rub full employment is likely to regain and the price level will rise up to the previous level of 'P'.