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The Classical model of the economy says that all markets always clear. The labor market failing to clear does not exist in the Classical model because of competitive exchange equilibrium in which prices and quantities always adjust perfectly. The Classical model is of a closed economy and the variables are real output, employment, real and nominal wages, the price level, and the rate of interest. It is easier to understand the classical model using five diagrams that are numbered one through five in Appendix One, The Classical Model.
These diagrams represent the separate parts of the model that together illustrate, for the most part, the entire Classical model. Diagram one represents the production function, which shows the assumption that real output, y, is determined by the level of employment, N. So y is a function of N and from the slope of the function we can see that output rises as employment is increased. But there is a diminishing marginal productivity of labor, which means that each time employment increases, the increase in output will get smaller and smaller. Diagram one illustrates the relationship between output and employment in the short run, but does not determine the level of output or the level of employment. But when used together with other diagrams of the model, diagram one can be used to figure these things out.
Diagram two is the labor market with the real wage, w, on the vertical axis and employment, N, on the horizontal axis. In the classical model, the supply of labor depends upon the real-wage level because as the real wage rises, more people are willing to work. The line SN represents the labor supply function and the line DN represents the demand for labor. As the real wage increases so does the labor supply function, but as the labor supply function increases, the demand for labor decreases. Because the Classical model makes real wages perfectly flexible and allows it to adjust to the level that clears the labor market, the real wage and the level of employment can be figured out by using diagram two. Once given the level of employment determined from diagram two, it is possible to use diagram one to figure out the level of output.
So diagrams one and two, also know as the real sector, can be used to determine employment, real output, and the real wage without any knowledge of the monetary sector of the classical model. The monetary sector, given the level of real output, determines only the monetary or nominal variables such as the price level and the money wage. The separate treatment of the monetary sector and real sector is known as the Classical dichotomy. To complete the model, diagrams three, four, and five are needed.
Diagram three represents the Classical aggregate demand curve, which shows the relationship between real aggregate demand for output, y, on the horizontal axis, and the price level P, on the vertical axis. Real aggregate demand represents the sum of the demands for output of all the individuals in the economy. The Classical aggregate demand curve, AD, illustrates the level of aggregate demand for a given price level. Since the government or the central bank can control the quantity of money in circulation, it also controls the position of the Classical aggregate demand curve.
But it can only control the price level and other nominal variables because it is independent of the monetary sector. The full understanding of the classical model comes with diagrams four and five, which consider money-wage determination and interest rate determination respectively. In diagram four, the real wage, w, is defined as the money wage, W, divided by the price level, P. For this reason there is a relationship between money wages and the price level which results in a straight line through the origin that corresponds to the real wage. The higher the price level, the higher the money wage must be to maintain any given real wage. Diagram five determines the interest rate, r, which is expressed as a percentage per period and depends upon the interaction of the savings and investment functions.
The investment function, I, shows that the lower the rate of interest, the higher the amount of investment. The savings function, S, shows that the higher the rate of interest, the more will be saved. Because of the Classical dichotomy, diagram five is basically to show the breakdown of the use of income, or the demand for output, between expenditure on consumption and new capital goods. Like the Classical model, the Keynes model can also be explained by using five diagrams that are shown in Appendix Two, Keynes model. This is about the only similarity between the two.
In the Classical model, all markets cleared. This is not true for the Keynes model, where flexible wages and prices do not bring about simultaneous market clearing, which means its not inherently self-regulating. The labor market will not clear in the Keynes model, which can be seen in Diagram five that shows involuntary unemployment. Also, the arguments are not connected to wage and price rigidity as they are in the Classical model. On the subject of rigidities, Keynes also rejected Pigous explanation for unemployment, which is basically the Classical models explanation. Keynes said that imperfections are not the source of unemployment, but other policy initiatives are required and not the removal of the imperfections.
Keynes assumes there are only two assets households can hold, which are money and bonds. Bonds represent non-monetary options. Money has different effects on the economy in these models. Because of the Classical dichotomy, only the nominal sector is effected by money in the classical model. But in the Keynes model, many things are effected by money. First, the interest rate decreases, which causes an increase in bond prices.
The decrease in interest rate causes an increase in investment and then this causes an increase in aggregate demand, which then causes income and employment to increase. This can be seen in diagram four, and then because of the increase in income, going back to graph three, we can see that this would cause an increase in consumption. From diagram five, we can see because of the increase in employment that this would cause a decrease in real wages. The decrease in real wages would then cause involuntary unemployment to decrease. Because of the different effects that money has on the economy in these models, they arrive at different conclusions.
The Classical economy seems to be in favor of no policy since everything works itself out and ends up in equilibrium since all the markets clear. The opposite is true for the Keynes model, where they are in favor of government intervention since it is not inherently self-regulating and the markets do not clear. The Keynes model needs a little help from the government, or the central bank, to achieve equilibrium, where as the Classical model, assuming all assumptions were realistic, is self-regulating and all markets clear.
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