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# Classical Model of Price Level

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Classical Model of Price Level

Understanding different economic models can help us learn what might happen in the future. Whether it is on the topic of inflation or GDP, these models can give us an idea about how to prepare for uncertainties in the market. One such model that we will review is the classical model of the price level. We will go over some uses of the classical model, how it compares to the Keynesian model, and how it relates to inflation. Keep reading to find out more.

## Classical Model of the Price Level Definition

In order to understand inflation and what causes it, we need to look at the effect of changes in the money supply on the price level.

We know that in the short run an increase in the money supply increases real GDP by dropping the interest rate and encouraging investment spending and consumer spending. However, in the long run, nominal wages rise, and an increase in the money supply does not change real GDP at all. Rather, it leads to a similar percentage rise in the overall price level.

In other words, the prices of all goods and services increase by about the same percentage as the money supply. We see that in the long run, a change in the nominal money supply (M) causes a change in the aggregate price level (P), leaving the real quantity of money (M/P) at its original level. This results in no long-run effect on aggregate demand or real GDP.

When observing changes in the aggregate price level, some macroeconomists find it useful to temporarily overlook the difference between short-run and long-run effects, and instead, use a simplified model. This model shows the effect of a change in the money supply on the aggregate price level occurring suddenly, as opposed to over a long period of time. This model in which the real quantity of money (M/P) is always at its long-run equilibrium is called the classical model of the price level.

The classical model of the price level illustrates the real quantity of money always being at a long-run equilibrium level.

## Uses of Classical Theory of Price Level

The classical model can be used to observe what markets might look like from a perspective of less government intervention, more concentration on managing the money supply, and the allowance of markets to operate freely.

Figure 1 below represents the classical model of the price level when there is an increase in the money supply. Using the axes of the aggregate price level and real GDP, we will look at how aggregate demand (AD), short-run aggregate supply (SRAS), and long-run aggregate supply (LRAS) play a role in the classical model of the price level. In this model, different price levels are indicated by P1, P2, and P3. Y1 and Y2 are potential outputs of real GDP.

Figure 1. Classical Model of the Price Level, StudySmarter Originals

First, let's look at the point of P1 and Y1. We see that an increase in the money supply shifts the aggregate demand curve to the right, going from AD1 to AD2. There is a new short-run macroeconomic equilibrium at the second dot where the price level is P2 and real GDP is Y2. Therefore, in the long run, nominal wages calibrate upward and move the SRAS1 curve to the left to SRAS2. The total percent increase in the price level from P1 to P3 is close to the percent increase in the money supply. We disregard the short transition and imagine the price going directly from P1 to P3. This is a fair estimation under the conditions of high inflation.

## 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.

Third type of inflation

There is a third type of inflation known as built-in inflation, in which past events affect present-day prices. This typically occurs when the price of a product rises. When this happens, workers demand an increase in wages to keep up with the high prices. However, firms that choose to pay their workers higher wages have to compensate with higher prices on their products in order to cover the firm's costs.

## 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.

## Classical Model of the Price Level - Key takeaways

• The classical model of the price level illustrates the real quantity of money always at a long-run equilibrium level.
• The classical model can be used to observe what markets might look like from a perspective of less government intervention, more concentration on managing the money supply, and the allowance of markets to operate freely.
• The classical model focuses on the efficient and self-regulatory nature of the free market, and it emphasizes that government intervention should be limited in order for markets to operate freely. The Keynesian model, on the other hand, views government intervention, through fiscal policy, as a helpful tool to survive difficult times in the market.
• A positive output gap takes place when the level of output in the short run is greater than the level of output that will be reached in the long 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.
• Cost-push inflation takes place when overall prices increase as a direct result of increases in the cost of wages and raw materials. Demand-pull inflation occurs when there is an increase in demand, putting upward pressure on prices.

## References

1. Congressional Budget Office, The Impact of Ethanol Use on Food Prices and Greenhouse-Gas Emissions, April 2009, https://www.cbo.gov/sites/default/files/111th-congress-2009-2010/reports/04-08-ethanol.pdf
2. Martin Neil Baily, Robert E. Litan, and Matthew S. Johnson, The Origins of the Financial Crisis, November 2008, https://www.brookings.edu/wp-content/uploads/2016/06/11_origins_crisis_baily_litan.pdf

In the classical model, the levels of output and employment are determined solely by supply factors. In this model, output is not a function of price. As price changes, the nominal wage changes proportionately. The real wage does not change.

In the classical model, the equilibrium level of output is determined by the employment of labor. The level of output is therefore established in the market by the demand for and supply of labor.

In the classical model, money is neutral. An increase in the money supply raises the overall price level by the same percentage. It has no effect on the real variables of quantities and prices.

In the classical system, the quantity of money dictates the general price level. Thus, the stability of the money supply is important for ensuring price level stability.

The classical model is used to observe what markets might look like from a perspective of less government intervention, more concentration on managing the money supply, and the allowance of markets to operate freely.

## Final Classical Model of Price Level Quiz

Question

In the classical model of the price level…

…the levels of output and employment are determined solely by supply factors. In this model, output is not a function of price. As price changes, the nominal wage changes proportionately. The real wage does not change.

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Question

What are the four assumptions of the classical model?

Classical theory assumptions include the beliefs that markets self-regulate, prices are flexible for goods and labor, supply creates its own demand, and there is equality between savings and investments.

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Question

How are output and price determined in classical model?

In the classical model, equilibrium level of output is determined by the employment of labor. The level of output is therefore established in the market by the demand for and supply of labor.

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Question

How does the classical model deal with money?

In the classical model, money is neutral. An increase in the money supply raises the overall price level by the same percentage. It has no effect on the real variables of quantities and prices in the long run.

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What is the importance of the classical model on the price level?

In the classical system, the quantity of money dictates the general price level. For a given income, it dictates the price level. Thus, the stability of the money supply is important for ensuring price level stability.

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Question

What is the classical model used for?

The classical model is used to observe what markets might look like from a perspective of less government intervention, more concentration on managing the money supply, and the allowance of markets to operate freely.

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Question

What are two major types of inflation?

Two major types of inflation are cost-push and demand-pull.

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What is an example of cost-push inflation?

The Organization of Petroleum Exporting Countries (OPEC), which controls the majority of the world’s oil reserves, restricting oil production in order to increase prices.

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What is an example of demand-pull inflation?

Technological innovations, such as those in the electric vehicle industry, would be an example. Early on, the number of electric vehicle manufacturers was small, meaning that the demand typically outweighed the supply. So people paid more than they might be willing to pay today.

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What is a third type of inflation?

Built-in inflation is a third type. It typically happens when workers demand higher wages to keep up with the rising cost of living.

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What is the quantity theory of money?

The quantity theory of money is the hypothesis that changes in prices correspond with changes in the money supply.

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What are two beliefs upon which the classical model of the price level is based?

Say’s Law and the flexibility of prices, wages, and interest rates.

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What is Say’s Law?

According to Say's Law, when an economy generates a certain level of real GDP, it also produces the income needed to purchase that level of real GDP. This way, the economy may always achieve the natural level of real GDP.

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What is an output gap?

An output gap is a measure of the difference between the actual quantity produced in an economy and the potential output.

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True or false:

According to the Keynesian model, there will never be a positive output gap, there will only be negative output gaps.

True

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Question

In the long-run, nominal wages rise, leading to ______ change in GDP.

no

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Question

In the long-run, an increase in the money supply leads to:

a similar percentage change in prices

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Question

in the long run, a change in the nominal money supply causes a change in the:

aggregate price level

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Question

According to the classical model of price level, an increase in aggregate demand will cause:

short-run aggregate supply to shift to the left

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Question

The percentage increase in price is similar to:

the percentage increase in the money supply

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Keynesian economics views government intervention as:

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In the ______ model, the long-run aggregate supply curve is upward sloping and elastic

Keynesian

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It is argued that the economy in the Keynesian model can be below the employment level even in the:

long-run

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Demand-pull inflation occurs when...

there is an increase in demand

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Cost-push inflation occurs when...

there is a decrease short-run aggregate supply

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Cost-push inflation can happen due to:

increasing wages and materials

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Demand-pull inflation can happen due to:

an increase in the demand for goods

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Question

The classical model of the price level illustrates:

the real quantity of money is always at a long-run equilibrium level.

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Question

A positive output gap takes place when:

the level of output in the short run is greater than the level of output that will be reached in the long run.

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A negative output gap is when:

output in the short run is at a lower level than it will be in the long run.

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True or False: there is no difference between the Keynesian model and the Classical model.

False

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Question

True or False: Cost-push inflation is rare and almost never happens.

False

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