Chapter 11, Problem 11.1LO

To determine

Short-run determination of equilibrium real GDP and the price-level in the classical model.

Explanation of Solution

According to Say's Law, when an economy produces a certain level of real GDP, it also generates the income needed to purchase that level of real GDP. In other words, the economy is always capable of demanding all of the output that its workers and firms choose to produce. Hence, the economy is always capable of achieving the natural level of real GDP.

While it is true that the income obtained from producing a certain level of real GDP must be sufficient to purchase that level of real GDP, there is no guarantee that all of this income will be spent. Some of this income will be saved. Income that is saved is not used to purchase consumption goods and services, implying that the demand for these goods and services will be less than the supply.

If aggregate demand falls below aggregate supply due to aggregate saving, suppliers will cut back on their production and reduce the number of resources that they employ. When employment of the economy's resources falls below the full employment level, the equilibrium level of real GDP also falls below its natural level.

Consequently, the economy may not achieve the natural level of real GDP if there is aggregate saving. The classical theorists' response is that the funds from aggregate saving are eventually borrowed and turned into investment expenditures, which are a component of real GDP. Hence, aggregate saving need not lead to a reduction in real GDP.

The classical theorists believed that Say’s law and flexible interest rates, prices and wages would always lead to full employment at real GDP of $18 trillion along the vertical aggregate supply curve, LRAS. With the aggregate demand, AD1, the price level is 110.

An increase in aggregate demand, shift AD1 to AD2. At the price level of 110, the quantity of real GDP demanded per year would be $18.5 trillion at point A on AD2. But, $18.5 trillion in real GDP per year is greater than Real GDP at full employment level. Price rise and the economy quickly move from E1 to E2, at higher price level of 120.

Economics Concept Introduction

Introduction:

The fundamental principle of the classical theory is that the economy is self-regulating. Classical economists maintain that the economy is always capable of achieving the natural level of real GDP or output, which is the level of real GDP that is obtained when the economy's resources are fully employed.  Self-adjustment mechanisms exist within the market system that works to bring the economy back to the natural level of real GDP. The classical doctrine—that the economy is always at or near the natural level of real GDP—is based on two firmly held beliefs: Say's Law and the belief that flexible interest rates, prices and wages would always lead to full employment at real GDP.