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Classical Solution

Classical Solution - rates are downward sticky or rigid...

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Classical Solution The classical writers assert that if price level is lowered and if wage rates are cut the cost of production will reduce. Employers will be induced to invest more and employ the workers who are unemployed. This will bring about a downward shift in the aggregate supply curve which will now be SAS 2 . The new supply curve intersects AD 1 at point e 3 . This equilibrium point is on the long run supply curve and therefore ensures full employment. In this equilibrium position output level is Y 2 and price level is P 3 . It has become possible to attain the condition of full employment without any government spending , simply by cutting wage rate. This is the classical solution . Keynes rejects classical solution. For him such an equilibrium is unattainable . Laborers, with the backing of their trade unions, will not accept a cut in wages. The wage
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Unformatted text preview: rates are downward sticky or rigid . Therefore the supply curve cannot shift downwards. Yet unemployment can be cured. The only requirement here is to make adjustments on the demand side. If the government undertakes fiscal policy and increases public spending, effective demand will increase. This will cause aggregate demand curve to shift upwards as AD 2 . The new demand curve intersects both the old supply curve SAS 1 as well as the long run supply curve at point e 2 . Therefore this is the full employment equilibrium . At this point output and employment levels are Y 2 and price level is P 2 . Therefore though the price level P 2 is somewhat higher, the problem of unemployment has been solved immediately....
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