The classical LRAS curve Flashcards
When did classical economic school begin?
An approach to managing the economy which started in the 1700s.
Who is the classical school associated with?
1) Adam Smith
2) Friedrich Hayek.
Who has since developed classical economics?
Neo-classical economists and monetarist economists: Milton Friedman.
What are the central beliefs of classical economists?
The power of market forces (the free market) to manage the economy.
What does the classical LRAS curve show?
The classical LRAS curve shows the relationship between the price level and the output of goods and services in the economy in the long run.
Explain the shape of the curve?
The LRAS curve is perfectly inelastic. This means that changes in the prices level have no impact on the output of goods and services in the economy.
What are the assumptions behind the classical LRAS curve?
The curve is drawn on the assumption that all businesses are making the level of output which maximises their profit.
What are the reasons for the shape of the classical LRAS curve?
1) The LRAS curve is vertical because the cost per unit of the factors of production are variable. This means that if the price level increases (business can raise their prices) then the unit costs will also increase. Businesses have no incentive to increase their output because the profit per unit will remain exactly the same.
What effect does increasing the price level have on the classical LRAS curve?
An increase in the price level would cause an upward movement along the LRAS curve, as the price level moves from P1 to P2. However, output would remain at Y1 because the economy is operating at its full employment level of output, which is determined by factors like technology and resources, not the price level.
At P1, the economy is already at Y1. An attempt to increase the price level would lead to higher business costs, but since output is already at its natural level, there is no incentive for firms to increase production. This is because the higher prices would not lead to higher profits in the long run. Therefore, output stays the same at Y1.
What effect does decreasing the price level have on the classical LRAS curve?
An decrease in the price level would cause an downward movement along the LRAS curve, as the price level moves from P1 to P2. However, output would remain at Y1 because the economy is operating at its full employment level of output, which is determined by factors like technology and resources, not the price level.
At P1, the economy is already at Y1. An attempt to decrease the price level would lead to lower business costs, but since output is already at its natural level, there is no incentive for firms to increase production. This is because the higher prices would not lead to higher profits in the long run. Therefore, output stays the same at Y1.
What is the classical view of an economy going into a recession?
The economy starts at full employment output Yfe and the price level of P1.
As the economy goes into recession, the price level fails to P2 but the output remains at Yfe.
Wages have been high, so workers are prepared to accept lower wage rises so that they stay in employment.
As the economy continues to go into recession, the price level falls to P3 and P4. However, the output remains at Yfe.
This is because workers are prepared to continue to accept lower and lower wages so that they don’t lose their jobs and they stay in employment.
For the reasons, output will not fall below Yfe.
In the classical view why can wages continue to fall but employment stay the same?
1) No minimum wage to stop wages reaching a wage floor.
2) Limited trade union power to prevent wages from falling.
3) Minimum benefits system so that workers will continue working.
