Question

how does the classical model explain a lower period of lower output and rising prices (higher inflation)?

Answer 1

Shocks are unanticipated changes in economic conditions. Demand shocks are unanticipated changes that impact the Aggregate Demand (AD) curve. The basic idea of the self-correction mechanism is that shocks only really matter in the short run. If AD changes, then output and unemployment will change in the short run, but not in the long run. Output gaps due to a change in AD exist in the short run only because prices haven’t had a chance to fully adjust to that change yet. Once those prices have fully adjusted in the long run, the output gap will close.

Rising labor costs causes SRAS to decrease. This happens because expectations of further inflation and higher resource costs lead firms to produce less and charge higher prices. Output decreases and the price level increases. Output keeps falling and price level keeps rising until real GDP returns to full employment output. As long as output is higher than full employment output, an unemployment rate that is higher than the natural rate will put upward pressure on wages and prices. The long-run outcome is that real GDP returns to the full employment level of output and the unemployment rate is equal to the natural rate. The price level, however, is now permanently higher.

Supply shocks are a little different from demand shocks. In this case, the long run impact will depend on whether those shocks are temporary or permanent. For example, suppose an increase in the price of oil leads to a negative supply shock (because an increase in input prices will cause SRAS to decrease). Here’s what will happen: As a result of the negative supply shock, output goes down, but inflation and unemployment go up. The increase in unemployment will theoretically lead to lower wages (because their is less competition for labor, so firms do not have to compete for workers with higher wages). SRAS increases once wages have adjusted, because a decrease in the price of a input to production will lead to an increase in SRAS. Output returns to the full employment output.

On the other hand, if a shock is permanent, there is an entirely different impact. Suppose that there is a permanent negative supply shock that makes the entire economy less productive, such as stricter regulations on production. Here’s what will happen: The capacity of the economy has decreased, so LRAS shifts to the left. Because such regulations make the cost of production higher, SRAS will also decrease until output has returned to the full employment output. In this case, output is permanently lower and the price level permanently higher.

The self-adjustment mechanism occurs because the amount of output that a country can sustainably produce ultimately depends on its stock of resources, not on AD or SRAS.

The LRAS is vertical at the full employment output. This is the amount of output associated with any point on the PPC. Unless the amount of resources a country changes, that maximum sustainable output won’t change either.

For example, if a country has 100100100 workers working 8-hour shifts every day, that’s 800800800 hours worth of labor being used to produce. You might be able to temporarily make everyone work overtime and squeeze out 1{,}0001,0001, comma, 000 hours worth of effort, but that isn’t sustainable. Unless the number of workers increases, you are stuck with however much output 800800800 hours worth of labor will produce. If you did get more workers, then the PPC would shift out and the LRAS curve would also shift out. That shift in LRAS represents economic growth. Temporarily pushing output past that amount doesn’t count as economic growth.

• When classical theory emerged, society was undergoing many changes. The primary economic question involved how a society could be organized around a system in which every individual sought his own monetary gain.
• Classical economics focuses on the growth in the wealth of nations and promotes policies that create national economic expansion.
• Classical theory assumptions include the beliefs that markets self-regulate, prices are flexible for goods and wages, supply creates its own demand, and there is equality between savings and investments.