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 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.
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
- 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
- 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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