**This one i wrote back in 2004 but never had an opportunity to revise. Now, everybody is talking about AS-AD models....
The classical denies the possibility of a deficiency of
aggregate-demand and of equilibrium below full-employment which is true. But
after that if demand increases it can not be fulfilled without raising the cost
of production and consequently prices.
But if at the same time government maintains a reserve
capacity for labour and capital within the economy through means of taxation,
together, they can help the economy raising output without a rise in cost of
production and inflation. Taking the globe, as one whole, there would be much
reserve capacity to offset an increase in demand in some region of the globe.
In short, the role of modern government and institutions is the one which
provides stability of prices, as have been emphasized. Generally, the government
and other institutions are not included in discussions in prior models. But
under disequilibrium government and other institutions should intervene and its
role must be the one which stabilizes the market and price-level.
Price-stability after full-employment can only be achieved
if government and its institutions maintain a reserve capacity for labor and
capital.
In the Classical theory, aggregate-demand is determined by
the supply of money and changes in money supply can be assumed constant if the
economy is in equilibrium. In the Classical-Theory the level of output is
determined solely by the aggregate supply of labor.
In the figure below, the intersection of the aggregate
demand, which slopes downward towards right, where the supply curve becomes
perfectly elastic, determines full-employment, which is actually not, since a
reserve capacity is maintained by the government and its institutions and at
this the total quantity of goods and services produced is completely sold-off.
The equilibrium established will be as follows;
Op* is the price level, Oq* quantity produced and q* and qg
is the reserve capacity maintained by the government.
To make it a dynamic model we can assume that in the next
period when population increases and money supply is expanded it would shift
the demand curve to the right and the new equilibrium will be as follows;
Op* is the price level (same),
Oq** quantity produced (more than before) and q** and qg (less than before) is
the reserve capacity maintained by the government.
We see that if the government maintains a reserve capacity
and uses it in times of crisis it can boost output and employment without
increasing prices…
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