Classical Models - The Role of Aggregate Supply
The foundation for the Classical Model is three basic ideas:
1. Output is produced by capital and labor,
2. Capital is fixed in the short run, and
3. Supply and demand for labor determine the amount of labor hired.
The third point implies that there is no unemployment. This may or may not be a useful abstraction in normal times. The unemployment of the Great Depression certainly revealed this to be a weakness of the Classical Model in abnormal times. (*Many years later, the energy crises of the 1970's exposed the weakness of a Keynesian analysis with little emphasis on aggregate supply.)
We present two versions of the Classical Model. Both explore the properties of an economy where unemployment is assumed not to be an important economic issue.
A Simple Classical Model
The Simple Classical Model is formulated in the spirit of the Simple Keynesian Model in that it illustrates a central point in the simplest possible framework. In terms of the three points listed above, the simplification is an assumption that labor supply is fixed rather than a function of the wage rate.
The Classical Model
In the Classical Model, the supply of labor is an upward sloping, but not vertical function of the real wage rate. Added to the Simple Classical Model are also an aggregate supply and demand diagram and a loanable funds supply and demand diagram.
What about the role of aggregate demand?
The classical economists did not totally disregard the role of aggregate demand. In fact, Say's Law states that supply creates its own demand. Businesses distribute the proceeds from sales to their workers and owners who can then afford to buy the output.