Hello bbshawn!
In order to answer your question, we must first compare the basic
assumptions of each model. Once we outlay the main features of the
models, the answer will be very clear.
Classical Model
The most important assumption of the classical model are:
-Fully flexible wages and prices: that is, they are left to be
determined by the equilibrium between supply and demand. This has the
important implication that in the long run, there is no involuntary
unemployment: the wages are set such that the number of people wanting
to work (labor supply) equals the number of people firms want to hire
(labor demand). Also, and of great importance to your question,
flexibility of prices implies that supply of real money balances can't
be changed by the government. That is, if the government decides to
raise the nominal money supply M (print currency), then prices (P)
will also rise, so that M/P is constant.
-Determination of Ouput: Since there is no long-term involuntary
unemployment, output in the long term will be the output that
corresponds to full employment, assuming that the capital level is
fixed. That is, output will be fixed at the full employment level.
This is a very important conclusion: it means that the output level of
an economy depends purely on supply shocks. Output can rise, for
example, if a rise in the technology level allows the same number of
workers to produce more goods. Output can fall, for example, if there
is an earthquake that destroys capital (e.g., factories). However
output will not change due to demand shocks. For example, an increase
in the government expenditure, which raises demand, will only have the
effect of an increase in the price level, while output will remain
fixed at the full employment level. Think of the classical model as a
model in which supply is a vertical line, and demand is
downward-sloping. Changes in demand will only change the price level,
but not the output level
-Classical Dichotomy: More about what affects the output and what
doesn't:
"Real variables, like the production of goods and services, are
determined by economic factors OTHER THAN the size of the money
supply. For example, the production of goods and services is dependent
on productivity and factor supplies. Economists do NOT expect that a
change in the money supply will at all affect the production of goods
and services."
This is also called "money neutrality"
Chapter Notes
http://www.lclark.edu/~bekar/Mankiw/ch28/notes.htm#aa1
By now it should be clear why in the classical model, the output level
is stable relative to demand shocks. Basically, the mechanism that
stabilizes the output at the full employment level is the price
flexibility.
Keynesian (IS-LM) model
-Rigid prices: The IS-LM model is usually referred to as a short-run
model. It assumes that, in the short term, neither prices nor wages
will change. This allows for the existence of unemployment or
overemployment. As the employment level can vary, there can also exist
variations in output. For example, since the wage level is also fixed,
firms can increase their ouput in response to a demand shock at a
constant cost (the fixed wage).
-Real Money Balances: Flexibility of prices implies that the
government can change the supply of real money balances, that is, it
can change M/P. This is crucial to explain your question. In the
liquidity prefernce framework, there is a demand for real balances
which depends on the interest rate. The interest rate is thus
determined by the equilibrium in the money market. In the classical
model, the gov't could not change the supply of M/P, so it could not
alter the equilbrium interest rate from thew money markey by changing
the money supply. However, in the IS-LM model, since prices are fixed,
the goverment can change the supply of M/P, which, in the liquidity
preference framework, causes the interest rate to fall. And here comes
the crucial difference between the 2 models:
* In the classical model, real variables cannot be affected by nominal
variables (for example, by the nominal supply of money)
* In the IS-LM model, since the gov't can change the interest rate by
increasgin the supply of money, it can also affect real variables.
Why? Recall that in the IS-LM model, we have that aggregate demand is
composed of consumption, investment and government expenditure. By
reducing the interest rate through a change in the money supply, the
gov't can increase the demand for investment and consumption (which
depend negatively on the interest rate). This rise in the aggregate
demand, insted of causing prices to rise (like in the classical model)
will cause in increase in output. Since the firms can sell more goods,
and can produce more by hiring more workers at a constant wage, they
will do so, there will be an increase in output.
Please see the folowing links for more information on the IS-LM model
THW's IS-LM model
http://www.sjsu.edu/faculty/watkins/islm1.htm
The IS-LM model
http://pages.stern.nyu.edu/~nroubini/NOTES/CHAP9.HTM#topic0
Summing up, what makes the equilibrium output stable in the classical
model? Basically, the fact that in this model, prices are assumed to
be flexible. Flexible prices translate into equilibrium in the labor
market, so there will be full employment, so output will fixed at the
full employment level. Thus, any shock (positive or negative) to the
aggregate demand curve, will result in a change in the price level,
that will be such that the demanded quantity is restored to the same
level as the fixed output. In contrast, in the IS-LM model, demand
shocks will cause the employment level (and thus the output level) to
vary. Since prices are assumed to be rigid, demanded quantity will not
be restored to the level previous to the demand shock.
To learn more about the differences between these 2 models, please
check the following pages.
The Extremes Critical Assumptions
http://www.wiwiss.fu-berlin.de/w3/w3collie/macro/PDFMACRO/AD_AS2.PDF
Classical and Keynesian Macro Analysis
http://www.gsu.edu/~ecomaa/Chapter11.pdf
Classical Model
http://instruct1.cit.cornell.edu/courses/econ302/overhead/2a.pdf
I hope this explanation was clear enough. If you have any doubts
regarding my answer, I will be more than happy to provide a
clarification on request. Otherwise, I await your rating and final
comments.
Best luck!
elmarto |
Clarification of Answer by
elmarto-ga
on
15 Jun 2003 19:01 PDT
Hi again!
First of all, you were right, there is a broken link. Apparently the
HTML version of the PDF is stored in Google cache, so I could see it,
but I didn't try to download it. This is the link to the HTML version
of the broken link.
Classical model
http://216.239.39.100/search?q=cache:zL5QWRv6cXwJ:instruct1.cit.cornell.edu/courses/econ302/overhead/2a.pdf+classical+model+overhead&hl=en&ie=UTF-8
Some graphs to support the answer are given in one of the links I
provided before. In case you didn't see it, I'm rewriting it here.
The Extremes Critical Assumptions
http://www.wiwiss.fu-berlin.de/w3/w3collie/macro/PDFMACRO/AD_AS2.PDF
The idea of the graphs that explain the difference between the 2
models is the following. I will also be talking about a graph that has
aggregate output (Y) in the x-axis and prices (P) in the y-axis.
As we have seen, in the classical model, output is assumed to be fixed
at the full employment level. Thus, we can imagine that the aggregate
supply curve is a vertical line at the full employment level, meaning
that firms will always supply the same quantity no matter what the
price is (this is because as prices rise, wages also rise, so it's not
profitable for firms to produce more). On the other hand, the
aggregate demand will be, as usually, downward-sloping. The
downward-sloping aggregate demand is usually explained using the
quantity theory of money:
M/P = k.Y
where M is the nominal money demand, P is the price level, Y is output
and k is (1/velocity of money) which is assumed to be a constant.
Therefore, if we hold M constant, we have that a higher P implies a
lower Y, hence the downward-sloping demand.
So, we have a vertical supply and downward-sloping demand. It's easy
to see that demand shocks cannot alter the equilibrium output level,
they can only alter the price.
In the Keynesian IS-LM model, the assumption is that prices and wages
are rigid. In a graph, this is usually shown as an *horizontal*
aggregate supply. It's horizontal at the current price level (which is
rigid), which means that at this price, firms are willing to produce
any number of goods; which in turn is because wages are rigid. Thus,
if demand rises, they can hire more workers at the same wage rate and
be able to produce and sell more.
So, we have that in the IS-LM model, demand is downward-sloping (same
as before) but supply is horizontal. This means that demand shocks can
change the equilibrium output level, but can't change prices. Thus, in
the classical model, equilibrium output is more "stable" than in the
IS-LM model.
We can also graph the relation of all this with the liquidity
preference theory. Recall that the liquidty preference theory states
that the demand for real balances of money decreases as the interest
rate increases. On the other hand, we have a that the nominal supply
of money is exogenous, given, for example by the Fed, or a Central
Bank.
We can then graph the equilibrium in the money market. We use a graph
that has the quantity of real balances of money (M/P) in the x-axis,
and the interest rate in the y-axis. Given a price level and the
nominal supply of money, we have that supply of real balances is a
vertical line (supply doesn't change with the interest rate). On the
other hand, we have that demand for real balances is downward-sloping.
The point at which they intersect is the equilibrium interest rate.
Now let's consider the difference between the 2 models. In the
classical model, if the government decides to increase the nominal
money supply, we will have that prices will also rise by the same
proportion, leaving real supply exactly as before. So there won't be
any effect on the interest rate.
On the other hand, in the IS-LM model, as prices are fixed, an
increase in the nominal money supply will effectively increase the
real money supply (move the vertical line to the right), thus lowering
the equilibrium interest rate. But lowering the interest rate in turn,
causes consumption and investment demand to rise, which causes
aggregate demand to rise, which leads, as we have seen, to an increase
in the equilibrium output, while leaving the price level unchanged.
These effects don't occur in the classical model. As we have seen,
interest rate does not change in the money graph. In the output-prices
graog, we do have in increase in aggregate demand (because more money
M corresponds to more output for every price level, as we see from
M/P=kY). However, this increase in aggregate demand only has the
effect of rising prices while leaving equilibrium output unchanged (of
course, because output supply is vertical).
I hope this made things more clear to you. If you still require
further clarification, please request it and I will answer it as soon
as possible.
Best luck!
elmarto
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