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 Pigou's 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.