Classical View of Aggregate Supply

Meet the Economist -Fredrick Hayek

Fredrick Hayek was an Austrian Economist who believed the economy should be left alone without governments intervening through Government Spending (Fiscal Policy) or Central Bank (Monetary Policy). This was the stance taken by many Classical Economists, especially when dealing with Economic Downturns. In fact, Hayek would argue that it is this very intervention in the Economy that causes the resulting downturn in Macroeconomic activity. Instead, classical economists believe that because prices are flexible (meaning they can increase or decrease, based on free markets and laws of demand and supply) and that any change in economic activity will correct itself in the Long Run as individuals respond to changes in the market.

In one of his most famous books, The Road to Serfdom, Hayek claimed that government intervention eventually leads to a loss of freedoms and eventually tyranny. Below we will look into more detail as to the assumptions underpinning Hayeks and other new classical/monetarists economists view of the Macroeconomy.

Assumptions of the New Classical/Monetarist View

The New Classical/Monetarist view is based on the ideas of competitive free markets and the role of the Price Mechanism in allocating and reallocating resources efficiently in these competitive markets. This forms the basis for the assumption of Price/Wage Flexibility within the Economy. This assumption basically means that prices and wages are able to both increase and decrease in line with changes in the economy. This is explained in more detail in the final video below.

They also view the economy as an organic system, meaning it automatically tends to achieve full employment (or reach its Potential Output) in the Long Run and that the economy will always achieve full employment in the Long Run and any cyclical unemployment will correct itself in the Long Run. (Remember that Full Employment means that there still exists the Natural Rate of Unemployment (NRU) in the economy but these types of unemployment (seasonal, frictional & structural) all naturally occur in the economy)

All of these assumptions are important for understanding why, from the New Classical/Monetarist perspective, recessions and inflationary gaps will automatically be corrected in the long run and that governments should not intervene to try to correct an economic recession or inflationary gap. In fact, some classical economists would argue that it is government intervention in the first that causes recessionary or inflationary gaps, by governments using policies such as Monetary policy (manipulating interest rates) or Fiscal policy (manipulating government spending and taxation) to try to steer the economy.

Short Run Aggregate Supply

Classical SRAS.mov

The above video will discuss:

Definition of the Short Run in Macroeconomics
Why the SRAS is an upward sloping curve
What causes a shift in the SRAS
The Short-Run Macroeconomic Equilibrium (Actual Output)

Long Run Aggregate Supply

Classical LRAS.mov

The above video will discuss:

Why the LRAS represents to potential output
How changes in AD can cause inflationary and deflationary/recessionary gaps based on actual v potential output
How changes in the SRAS can cause stagflation or higher real GDP with lower prices
What causes a shift in the LRAS

Whiteboard 13 copy 3.mov

This final video will discuss:

Why in the classical view, the economy will automatically close any recessionary/inflationary gaps caused by an increase or decrease in Aggregate Demand, based on the assumptions of price/wage flexibility.

This assumption essentially means that prices/wages can both increase or decrease easily and therefore the economy is able to return by to the full potential in the Long Run.

Classical/Monetarist View of the Business Cycle

As we have seen above, Classical Economists focus on the idea that Government Intervention should be kept to a minimum. Monetarists, such as Milton Friedman, would argue that Central Banks should focus on allowing the growth of the money supply in line with the growth of an Economy. If the money supply does not grow in line with economic growth, then this will lead to inflation. In the classical view, with inflation, the economy will self-regulate through increased prices/wages and a decrease in output (decrease in SRAS) and any inflationary gap will return back to the potential, at a new higher average price level (inflation). Similarly, any downturn in economic activity or recession will be correct as price/wages adjust to changes in demand and supply, leading to a decrease in prices/wages and therefore an increase in SRAS, returning the economy to its full potential and closing the recessionary gap.

Essentially, Classical Economists believe that Inflationary and Deflationary (recessionary) gaps happen in the short run but the economy will self regulate and return to its full potential in the Long Run.

It is for these reasons that many classical economist favour policies that promote freer markets, such as:

Labour Market Reforms to encourage Price/Wage Flexibility
Tax cuts for households and firms
Free Trade
Deregulation
Privatisation

All of these policies are examples of Market Based Supply-Side Policies and focus on increasing the potential output of the economy. They are discussed in more detail here.

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