Role of AS and AD in the Classical Model | Employment

In this article we will discuss about the role of Aggregate Demand (AD) and Aggregate Supply (AS) in the Keynesian Model, explained with the help of a suitable diagram.

Like the Keynesian model, the classical model also employs ag­gregate supply and aggregate demand—but with two important differ­ences. First, the aggregate supply schedule corresponding to SAS in Fig. 10 is assumed to be upward sloping at all points. So, any increase in aggregate de­mand will lead to a combina­tion of rising prices and rising output.

Secondly, this aggregate sup­ply schedule is considered to be a short-term one only. In the long run, after a period of one to two years, it gets replaced by a completely inelastic vertical aggregate supply schedule cor­responding to what is known as the natural rate of output.

As Fig. 10 shows, the effect of an increase in aggregate demand is different from that in the Keynesian model. In short, the short run prices rise move, so the gain in prosperity is less. In the long run, the entire demand effect is eaten up by rising prices and national output reverts back to ‘normal’.

Initially aggregate demand is given by AD₁ and national output OY₁ (point A). An increase in aggregate demand to AD₂ encounters output resistance, resulting in a less than proportionate increase in output, to OY₂, and a rise in the general price level, to OP₂ (point B).

In the long run, however, wages and other unit costs ‘catch up’ with the higher prices, so profit is squeezed back to its initial level. The output level therefore reverts to OY₁, which is the ‘natural’ level of national output, and the general price level stabilizes at OP₃ (point C). So the long-run gain in productivity is zero.

Classical economists would argue that it is a mistake to see the economy, and prosperity, as being ‘driven’ by spending, other than in the short run.

In the long run what spending determines is the general price level, national output, and prosperity, are determined by conditions of aggregate supply and the natural rate of output.