Question

We examined the (classical) aggregate supply/aggregate demand model.  Explain in your own words how the economy would adjust to LR equilibrium automatically from being in a recession.

Answer 1

In Classical theory, the economy is self-regulating. Classical economists say the economy is always at or near the natural level of real GDP. They believe in say's law: supply creates its own demand. And they believe price-wage and interest rates are flexible.

In the time of recession, aggregate demand falls so AD1 curve shifts to the left to AD2. So price level falls from P1 to P2. And the economy's real GDP falls below the natural level from Y1 to Y2, that is now the economy's resource is not fully employed. When there are unemployed resources classical theory predicts that paying the wage to these resources will fall. that is suppliers now able to supply more goods at lower cost, it shifts SRAS1 curve to the right SRAS2. In the end, equilibrium price falls further to P3 and the economy returns to the natural level of real GDP

LAS SRAS SP A S 2 Aeal