Classical vs. Keynesian Models of Aggregate Supply and Demand

Introduction

• Two major schools of thought:
  • Classical
  • Keynesian
• Different interpretations of aggregate supply (AS)
• Aggregate demand (AD) similarities: AD = C + I + G + (X - M)
• Differences in AS impact views on macroeconomic management

Classical Model

Assumptions

• Distinction between short run and long run
• Short-run aggregate supply (SRAS) curve:
  • Position determined by costs of production (e.g., wages, raw materials)
  • Upward sloping (SRAS)
  • Shifts left if production costs rise
• Long-run aggregate supply (LRAS) curve:
  • Determined by quantity and quality of production factors
  • Vertical, representing full employment level (maximum sustainable output)
  • Shifts right if production factors improve

Equilibria

• Short-run equilibrium: AD = SRAS
• Long-run equilibrium: AD = LRAS

Classical View on Wages

• Short-run: Wages and resource prices are fixed
• Long-run: Wages and resource prices become variable
• No specific time frame for short-run/long-run transition

Economic Self-Healing

• Classical economists believe economies self-correct to full employment
• No need for government intervention

Example: Economy in Recession

• Initial equilibrium at full employment (AD intersects SRAS at LRAS)
• AD shifts left (e.g., due to investment drop) -> recession
• Short-term response: Firms face lower output and price level
  • Firms may avoid laying off skilled workers
  • Lowering production costs (e.g., via wage cuts) could shift SRAS back to the right
• Why short-run wage cuts are unviable:
  • High minimum wages, generous unemployment benefits, strong trade unions
• Long-run response: Unemployed workers accept lower wages
  • SRAS shifts right, restoring full employment at a lower price level

Example: Economy Overheating

• Initial equilibrium at full employment
• AD shifts right -> short-term higher output and price level
• Wages remain fixed, enabling higher production temporarily
• Long-run response: Workers demand higher wages
  • SRAS shifts left, restoring equilibrium with higher inflation
• Key takeaway: Increased AD leads to higher inflation, not sustained higher output

Policy Implications

• Classical economists favor supply-side policies
  • Believe in natural full employment in the long run
  • Demand-side (expansionary) policies lead to inflation, not increased output

Next: Keynesian Model

• Comparison with Keynesian model in next lecture/video