(Neo-)Classical Theory - AS & AD

We have seen that Classical economists had complete faith in markets. They believed that the economy would always settle - automatically - at the full employment equilibrium in the long-run. However, they did acknowledge that there might be a slightly different reaction in the short run as the economy adjusted to its new long-run equilibrium. We can illustrate these changes with AS & AD analysis:

Short-run

Any increase in aggregate demand in the short-run will lead to an increase in output (Q1 to Q2), but will also lead to prices increasing. This will happen as firms suffer from diminishing returns and are forced to increase the prices of their product to cover the higher level of costs. Increases in aggregate demand may come about for a variety of reasons including:

• Increases in the money supply
• Lower levels of taxation
• Increased government expenditure

Long-run

In the long-run, however, the situation will be different. The economy will have tended towards full employment on its own, and so any further increases in demand will simply be inflationary. The shape of the long-run aggregate supply curve will therefore be vertical:

The long-run aggregate supply curve is vertical at the full employment level of output (Qfe), and any increase in aggregate demand leads to prices increasing, but no increase in output.

Intro | Beliefs | Theories | AS & AD | Policies | VE Policies