Model Answer
0 min readIntroduction
The Aggregate Supply (AS) curve illustrates the relationship between the price level and the quantity of output supplied in an economy. It’s a fundamental component of the Aggregate Demand-Aggregate Supply (AD-AS) model used to analyze macroeconomic equilibrium. While both Classical and Keynesian economists recognize the AS curve, their interpretations differ significantly, stemming from contrasting views on how expectations about future prices and wages influence current economic behavior. The Classical school assumes perfect flexibility, while Keynesians emphasize ‘sticky’ prices and wages, leading to distinct AS curves with varying implications for macroeconomic policy.
Understanding the Aggregate Supply Curve
The Aggregate Supply (AS) curve can be divided into three ranges: the horizontal (Keynesian) range, the upward-sloping range, and the vertical (Classical) range. The shape of the AS curve is determined by the responsiveness of output to changes in the price level, which, in turn, is heavily influenced by expectations.
Classical Aggregate Supply Curve
The Classical school, rooted in the ideas of Adam Smith and David Ricardo, believes in the self-correcting nature of markets. Key assumptions include:
- Price and Wage Flexibility: Prices and wages adjust quickly and completely to changes in supply and demand.
- Rational Expectations: Economic agents form expectations about the future based on all available information and use this information rationally. They anticipate government policies and their effects.
- Full Employment: The economy naturally tends towards full employment of resources.
Because of these assumptions, the Classical AS curve is vertical at the level of potential output (Y*). This implies that changes in aggregate demand only affect the price level, not real output. If workers and firms anticipate inflation, they will immediately adjust wages and prices accordingly, preventing any increase in real output. The vertical shape signifies that the economy’s productive capacity is fixed in the short run.
Keynesian Aggregate Supply Curve
John Maynard Keynes challenged the Classical assumptions during the Great Depression. The Keynesian school emphasizes:
- Sticky Prices and Wages: Prices and wages are slow to adjust, particularly downwards, due to factors like menu costs, long-term contracts, and imperfect information.
- Adaptive Expectations: Expectations are formed based on past experiences and are adjusted gradually as new information becomes available. Individuals don’t necessarily anticipate policy changes perfectly.
- Underemployment Equilibrium: The economy can remain in equilibrium below full employment for extended periods.
Due to these factors, the Keynesian AS curve is relatively flat at low levels of output. This means that changes in aggregate demand can lead to significant changes in real output with little impact on the price level. As the economy approaches full employment, the AS curve becomes steeper, reflecting increasing resource constraints. Because wages and prices are sticky, an increase in aggregate demand can lead to increased output and employment before causing significant inflation.
Differences in Expectations and their Impact
The core difference lies in how expectations are formed and incorporated into economic decisions.
| Feature | Classical | Keynesian |
|---|---|---|
| Expectations | Rational, forward-looking | Adaptive, backward-looking |
| Price/Wage Flexibility | Perfectly flexible | Sticky |
| AS Curve | Vertical | Upward-sloping (flat at low output) |
| Impact of AD Changes | Price level changes only | Output and price level changes |
For example, if the government announces an increase in spending, Classical economists believe that individuals will anticipate the resulting inflation and immediately demand higher wages, neutralizing the stimulative effect on output. Keynesians, however, argue that wages and prices adjust slowly, allowing the increased spending to boost output and employment in the short run before inflation becomes a concern.
Short-Run vs. Long-Run AS Curves
It’s important to note that both schools recognize a distinction between short-run and long-run AS curves. In the long run, even Keynesians acknowledge that wages and prices become more flexible, leading to a vertical AS curve at potential output. However, the key difference remains in the speed of adjustment and the role of expectations in the short run.
Conclusion
In conclusion, the contrasting shapes of the Classical and Keynesian aggregate supply curves are fundamentally rooted in differing assumptions about expectations and the flexibility of prices and wages. The Classical view, with its emphasis on rational expectations and perfect flexibility, leads to a vertical AS curve, suggesting that monetary and fiscal policy are ineffective in influencing real output. Conversely, the Keynesian view, with its focus on sticky prices and adaptive expectations, results in an upward-sloping AS curve, implying that government intervention can play a crucial role in stabilizing the economy, particularly during periods of recession. Understanding these differences is vital for formulating effective macroeconomic policies.
Answer Length
This is a comprehensive model answer for learning purposes and may exceed the word limit. In the exam, always adhere to the prescribed word count.