Classical Model of Price Level

Classical Model and Keynesian Model

The classical model of the price level looks different than other approaches, such as the Keynesian model. Classical economics considers the long-run aggregate supply curve as inelastic, so any variance of the output is short-term. The classical model focuses on the efficient and self-regulatory nature of the free market. It also emphasizes that government intervention should be limited in order for the market to operate freely. The Keynesian model, on the other hand, assumes that the economy can withstand being below full capacity of output for some time since there are imperfect markets. Keynesian economics views government intervention, through fiscal policy, as a helpful tool to survive difficult times in the market.

Figure 2. Classical Model with Output Gaps, StudySmarter Originals

Take a look at Figure 2. Here is an example of the classical model. Note how the LRAS curve is completely inelastic. Because short-term changes are not highlighted in this model, the long-term effects are important to show the change in the price level and output.

Figure 2 contains other illustrations in its graph, which are called output gaps. These gaps can either be positive or negative. A positive output gap takes place when the level of output is greater than the level of output that will be reached in the long run. This is why output gaps only apply in the short run. A negative output gap is when output in the short run is at a lower level than it will be in the long run.

Figure 3. Keynesian Model, StudySmarter Originals

In comparison to Figure 2, we see a different representation of the price level and national output shown by the Keynesian model in Figure 3. The long-run aggregate supply curve is upward sloping and elastic, unlike the inelastic curve in the classical model. It is argued that the economy in the Keynesian model can be below the full national output, or employment level, even in the long run. This points out the impact aggregate demand (AD) has in causing and overcoming a recession. You can see shifts from AD₁ to AD₂ that increase the price but do not affect the national output. This is due to the nature of the long-run aggregate supply curve.

On the topic of output gaps, economists who use the Keynesian model state that there will never be a positive output gap, there will only be negative output gaps. A negative output gap on the Keynesian diagram above would be the difference between Y and a point to the left of Y, and it would be located on the LRAS curve. We see above that going from point A to point B will not result in any higher output, only a higher price level. The national output Y is the maximum amount of output that the economy can produce, otherwise known as potential output.

Classical Model of the Price Level and Inflation

The two main types of inflation are called cost-push inflation and demand-pull inflation. Below are illustrations that depict how both are portrayed using the classical model of the price level.

Figure 4. Cost-push Inflation, StudySmarter Originals

In Figure 4, we see cost-push inflation in practice. Cost-push inflation takes place when overall prices increase as a direct result of increases in the cost of wages and raw materials. This type of inflation can occur when higher costs of production decrease the aggregate supply in the economy. Because the short-run aggregate supply has changed, but the demand for goods has not, the price increases of production affect the consumer. We see that as SRAS₁ shifts to SRAS₂, the price level increases from P₁ to P₂.

Figure 5. Demand-pull Inflation, StudySmarter Originals

Now let's take a look at how demand-pull inflation is different. Demand-pull inflation occurs when there is an increase in demand, putting upward pressure on prices. In the Keynesian model of economics, for example, an increase in employment would lead to an increase in aggregate demand for goods. Following this increase in aggregate demand, firms would likely hire more people in order to increase their output. Eventually, the demand for goods will outpace the ability to manufacture and supply them; thus, causing this type of inflation.

Figure 5 exhibits what this would look like as aggregate demand shifts to the right, increasing real GDP and the price level.

Classical Model of the Price Level Examples

Let's go over a couple of examples using the classical model of the price level. One case where we see this model implemented is through cost-push inflation. Cost-push inflation occurs when there is an increase in the cost of wages and materials, leading to an increase in overall prices. In 2008, for instance, government subsidies for the production of ethanol caused food prices to increase.¹ Because of these subsidies, farmers were encouraged to grow corn for ethanol, which in turn created a shortage of corn grown for food. Since the supply of corn for food decreased, corn prices for consumers soared, as did the prices of crops that were substituted by corn in the fields the supply of those crops declined.

Another example where we would use the classical model of the price level would be demand-pull inflation. Now, this takes place when there is an increase in demand which would then put upward pressure on prices. The use of subprime mortgages in the 2008 financial crisis is an example that shows how demand-pull inflation can be connected to an increase in aggregate demand. As mortgage-backed securities were becoming more popular prior to 2008, the demand for these securities also increased.² Because of this, home prices then increased as well, which can be ascribed to demand-pull inflation. This produced years of disruption in the mortgage market.