Chapter 9 – Classical View

 Say’s Law: Supply creates its own demand. Applies both in barter economy and money economy.
 Main assumptions of this theory:
o Interest rates are flexible – Savings = Investment (at equilibrium)
o Wage rates are flexible – When Unemployment increases, wages decrease
When Unemployment decreases, wages increase
 Price Level is flexible – it can increase or decrease, when there is any change in AD, SRAS or LRAS

Natural Real GDP: The amount of output that can be produced when all the resources are fully employed.

Three states of the Economy:

 Long-run Equilibrium – AD, SRAS and LRAS intersect at one point (Slide 9, graph c)
 Recessionary Gap – AD and SRAS intersect on the left side of LRAS (Slide 9, graph a)
 Inflationary Gap – AD and SRAS intersect on the right side of LRAS (Slide 9, graph b)

How does the economy recover in a Recessionary Gap? (Slides 12 – 13)

Logic:

Q0 < Q N U > UN wages decrease cost of production decrease profit increase SRAS increases
(shifts to right)

Graphs: Slide 13. Graph (a) – before; Graph (b) – after

How does the economy recover in an Inflationary Gap? (Slides 14 – 15)

Logic:

Q0 > Q N U < UN wages increase cost of production increase profit decrease SRAS decrease
(shifts to left)

Graphs: Slide 15. Graph (a) – before; Graph (b) – after

Policy Implications:

 Laissez-faire: The economy can recover by itself. Government does not need to control the economy.

Applications of the Assumptions:

1. Interest rate flexibility – applied with Say’s Law (for money economy)
2. Wage rate flexibility – applied in the Labor market
3. Price Level flexibility – applied in Goods and Services market (AD-AS framework)