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 we will review is the classical price level model. We will review some definitions 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 Price Level Classical Model of Price Level

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Table of contents

    Classical Model of the Price Level Definition

    The classical model of the price level, often associated with pre-Keynesian "classical" economists, implies that the real quantity of money, represented as M/P (money supply/price level), is always at its long-run equilibrium level. In other words, it suggests that adjustments in the money supply have no long-term impact on real economic variables, and primarily affect the price level. This model becomes especially useful in situations of high inflation, where understanding the relationship between money supply and price level becomes crucial.

    The classical model of the price level is defined by the belief that the economy is always at its long-run equilibrium, where the real quantity of money (M/P) is stable. According to this model, changes in the nominal supply of money lead to proportional changes in the price level in the long run, leaving real variables unaffected - a principle known as monetary neutrality.

    Consider, for example, an economy experiencing high inflation due to an excessive increase in the nominal money supply. According to the classical model, this increase would not affect real economic variables like output or employment in the long run. Instead, it would cause a proportional increase in the price level, resulting in inflation. Once the economy adjusts to this change, the real quantity of money (M/P) would return to its long-run equilibrium level, signifying the monetary neutrality principle inherent in the classical model of the price 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.

    Classical Model of the Price Level StudySmarter OriginalsFigure 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.

    Classical Model of the Price Level Classical Model with Output Gaps StudySmarter OriginalsFigure 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.


    Classical Model of the Price Level Keynesian Model StudySmarter OriginalsFigure 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.

    Classical Model of the Price Level Cost push Inflation StudySmarter OriginalsFigure 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.

    Classical Model of the Price Level Demand pull Inflation StudySmarter OriginalsFigure 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
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    Frequently Asked Questions about Classical Model of Price Level

    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.

    What is the classical model of the price level?

    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.

    How are output and price determined in classical model?

    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.

    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.

    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. Thus, the stability of the money supply is important for ensuring price level stability.

    Test your knowledge with multiple choice flashcards

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

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

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

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