Classical AD/AS model - Short-run and Long-Run

hi everyone when it comes to aggregate

demand and aggregate supply there are

two different major schools of thought

on this topic you have a classical

school of thought which has a very

unique interpretation of what aggregate

supply it looks like and you have the

Keynesian school of thought which has

its own interpretation of aggregate

supply both schools into an aggregate

demand because of this vast difference

between aggregate supply you have

different ideas as to how the macro

economy needs to be managed

let's here look at the classical model

start with some assumptions first in the

classical model there is a big

difference an important difference

between the short run and the long run

and that is taken in two different

interpretations of aggregate supply as

well so we have a short-run aggregate

supply curve whose position is

determined by costs of production in the

economy so if cost of production rides

maybe that's because of an increase in

wages maybe that's because of an

increase in the price of raw materials

or commodities all the factors that are

talked about on my previous video on the

causes of inflation that sres will shift

to the left and the SR ax curve is very

simply upward sloping and we call it s

ra s so the classical's I believe in

this short-run aggregate supply curve

but also a long-run aggregate supply

curve this position is determined by the

quantity equality and factors of

production it's vertical because it

represents the level of full employment

in the economy the maximum output that

can be produced by using all factors of

production to their maximum potential

sustainably so that is vertical because

it represents one value of AB of the

full employment level of output however

if the quantity and quality of factors

of production increased then the curve

could shift downwards okay so that's the

long-run aggregate supply curve and

therefore there are two different

equilibrium we can equilibrium or ad

equals s ras that's the short-run

equilibrium and we have a long-run

equilibrium why ad equals L RS that's

important both schools of thought do not

different ad

it's just seedless like this G plus X

minus M downward sloping as we've learnt

it no problems there the difference

comes at the aggregate supply curve so

short-run equilibrium and long-run and

Gudrun straight away Keynes we disagree

with all of that no difference in

aggregate supply no difference between

short and long run he would argue that's

a lot of Tosh letter rubbish basically

but fundamental assumptions in the

classical model how the classical

economist defines a short-run in the

long run well the short-run is where

wages are fit more generally that's what

resource prices are fixed but to

understand our model where wages are fit

around the map and the long-run is where

wages are our variable importantly there

are no time frames put on the shorter in

the long run we don't know when the long

run will happen all we know is that when

wages become variable and when workers

accept higher or lower wages that's when

we hit the long run in this one no time

frame on that and the final thing here

this is the conclusion of the model

basically in the long run classical

economists believe that an economy will

always move back to or be at the full

employment level of output there is no

need for government intervention there

is no need for excessive management in

the economy the economy will self heal

and return back to full employment on

its own let's look how that happens

we'll take two examples of an economy an

economy in recession and an economy

that's overheating in a boom and we'll

see how in the classical model the

economy will self heal and return to

full employment let's take an economy

here with a short for an equilibrium

where 80 has SRS which happens to be at

the full employment level of output so I

could draw LRS going through the

because we're making the assumption that

that is the full employment level of

output with a price level of p1 let's

say for some reason aggregate demand

shifts to the left from 81 to 82 that

could be because of a sudden fall in

investment that's it any component of AD

may have suddenly fallen taping the

economy into recession now the new

short-term equilibria would be here

where ad cuts

SROs the newest ras curve and that will

lead to a reduction in output and a

lower price level but before that

happens firms have got to think to

themselves initially they were producing

at full employment of wire thiol firms

in the economy were getting together

producing a maximum level rapper but

that were the recession basically taking

place with lower levels of demand in the

economy firms have got to make a

decision they can accept this lower

level of output and produce less but now

in sacking workers that will mean

reducing the size of their workforce

which maybe they don't really want to do

so therefore if they want to continue

producing at their full employment

levels that maximum production levels

well the only way to do that is to

reduce their costs somehow demand is

lower in the economy at 82 if they want

to get back to wifey the only thing in

that control is to reduce costs and to

shift sres back here to the right to cut

ad at this point which takes us back to

the wifey level of output and why would

they want to maybe continue producing

their well they don't want to reduce the

size of their workforce maybe because

the workers they've got a skill they're

trained a lot of money has been spent on

actually getting them to a decent level

of training getting into a productive

part of the production process in which

case getting rid of them is a bit of a

waste so those are other key work is in

set

that's the case so they would like to

continue operating or yov so what is in

their control to shift SRS to the right

what costs of production can they lower

which can take them there

well wages wages is a major cost for

firms and that's something that

employers have control over so they want

to reduce their costs well they can cut

wages by cutting wages sres can shift to

the right

taking the economy back to why I fee but

that's not a viable option in the short

run in the classical model

why because wages are fixed in the short

run for three main reasons one it could

be that minimum wages are high in the

economy which prevents by law weight is

falling below it could be that

unemployment benefits are quite high and

generous in the economy whereby cutting

wages might not make sense the incentive

might then not be to continue working it

might be just to accept employment and

tape unemployment benefits but I think

probably the biggest reason especially

in advanced nations is a strength of

trade unions with strong trade unions it

becomes very difficult to cut wages

trade unions fight against that in fact

they fight for high wages they will

never really accept lower wages which

makes it very difficult firms to cut

wages even in times of very low demand

of recession so for that reason wages

tend to be fixed in the short run and

firms have got to accept its new

equilibrium of lower output and

therefore higher unemployment this is

known as a deflationary gap or a

recessionary gap so in the classical

model this is a recession taking place

right here and with it lower levels of

inflation which is why to them is a

deflationary gap who knows that could

well be deflation in the inflation rate

going negative and one of the

characteristics here we see lower output

and we see higher unemployment levels

characteristics of a recessionary gap or

deflation gap but keeping it in the

classical model this will not be

sustained in the long run in the long

run wages become variable there is no

we put on that but eventually wages book

a variable why because with persistent

unemployment what is revised down there

wait expectations then you realize that

the reason they're not getting work is

because their wait expectations are too

high and maybe that's stopping them

actually get a job getting a job

so eventually work is not to revise down

on the way to expectations they accept

lower wages which for firms reduces

their cost of production and shifts sres

to the right to SRS

due and that takes the economy back to

the full employment level of output but

now I don't even lower price level P

three and that's the key adjustment at a

texas-based matter in the economy waste

is become variable way to start the for

reducing costs of production ticking and

the economy back to why if he and wages

become very well very simply because

workers start to realize that maybe the

high wages of the reason why they're

stuck in in unemployment here the only

way to solve that is to revise that wage

expectations so in this model here

whenever there is a recession it's okay

because in the long term the economy

yourself here what we do see a slight

index lower demand pull inflation from

p1 to p2 initiative and also lower cost

push inflation p2 to p3 so the economy

will South we're back to white feed but

just with lower levels of inflation in

the economy what about if the economy is

only eating how does the classical model

explain adjustments in the economy as a

result of that in place well let's again

redraw our axis where we'll show the

price level and real GDP let's again

take an economy with a short-run

equilibrium which happens to be our full

employment so the economy yet is settled

and a full employment level a birth of

YF e with a price level P wants the

economy right now is in long term

equilibria let's now say for some reason

just to the right this time from 81 to

82 right really the short-term

equilibria is going to be here at y2

with a higher price level hind amount of

invasion and p2 now firms like this

equilibrium a lot they like it because

wages are still fixed in the short-run

bear this in mind as I go through the

explanation here so this new shorts

manubrium implies that output can

increase beyond the full employment

level of output now that seems

ridiculous how did that happen well

remember full employment the

unemployment rate is not 0% there is

still some unemployment out there the

frictional employed the structural

employee are seasonally unemployed so

that unemployed or it can be in advanced

economies around 5% so therefore it is

possible in the short-run to employ some

of those people able to produce more

than the full employment level of output

maybe it's not employing fresh people

that takes us to y2 maybe it's just

existing workers working harder working

overtime because remember again the way

I feel a bit about that represents

maximum use of factors of production at

sustainable levels or maybe in the short

so we can use our factors of production

unsustainably maybe that's using workers

to work instead of nine-hour days work

12-hour days unsustainable you're going

to wear your workers out but in the

short term it's possible to do that but

the key thing is firms can produce a way

to paying workers whether it's existing

workers whether it's new workers they

can pay them the same wage rate and why

is that wait is the fix in the short run

because what is a slow to adapt the slow

to realize that either they're in scarce

supply therefore they can drive up their

wages they're slow to realize that oh

they're working so much more they're

working so much hard about the same wage

rate and therefore I'm on they can

actually bargain higher wages that they

did if they wanted to and this led to

realize that with inflation

economy their bargaining power actually

increases they can ask for higher wages

and most likely will be given to them so

in the short run they're slow to adapt

which means the economy settles in the

short run of this separate Librium

producing more than wifey but classical

economist argue now if you shift it into

the right in a period of initiative full

employment all that's going to happen is

you see inflation this equilibrium here

higher growth it's not going to be

sustained

eventually workers will change their

wage expectations wages become variable

in the long run and workers realize that

oh I can demand high wages for the

reasons I've said before and as soon as

all workers start to do that and demand

higher wages that increases costs of

production the firm's shifting sres to

the left from SRA x12 sres to taking the

economy back to y fe but now with just a

higher rate of inflation so initially we

had demand-pull inflation from p1 to p2

and then we saw cost-push inflation it's

wages increased this camp here is known

as an inflationary gap for that reason

and characteristics of an inflationary

gap while you tend to see higher output

beyond so greater than the full

employment level of output and in

tendency lower unemployment lower than

the natural rate of unemployment

characteristics then but not sustained

not sustained or not sustainable in the

long run as wages become variable bet

all you see is that inflation increases

which is why classical economists are

known as supply-side economist they say

that if the economy's at full employment

which you will always be in the long run

the only way to reduce the natural rate

of unemployment to grow sustainably is

through use of supply-side policies to

ship long-run aggregate supply to the

right demand side management

expansionary demands our policies are

not going to be useful at all all you're

going to see is an increase in

and no increase in full employment

levels of output all right so that's the

classical model of aggregate aggregate

supply let's now compare that to the

Keynesian model