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The Role of Flexible Wages and Prices

The classical economists believed that Say's Law and the flexibility of interest rates would ensure that spending would be adequate to maintain full employment. But some critics were unconvinced. Suppose that households chose to "hoard" some of their income. (Hoarding money is the act of hiding it or storing it.) When people are concerned about the future, they may choose to hide money in a mattress or in a cookie jar so that they will have something to tide them over during hard times. (Households may prefer this form of saving if they lack confidence in the banking system—a situation that existed in the 1920s, when there were numerous bank failures.) This method of saving creates problems for Say's Law because it removes money from circulation. If households choose to hoard money in cookie jars, that money can't be borrowed by businesses and invested. As a consequence, spending may decline and unemployment may appear.

Although the classical economists admitted that hoarding could cause spending to decline, they did not believe that it would lead to unemployment. Full employment would be maintained because wage and price adjustments would compensate for any deficiency in total spending.

The existence of flexible wages and prices implies an AS curve that is vertical, not upward-sloping as in the initial section of this chapter. Recall that the upward slope of the earlier AS curve resulted from the assumption that wage rates and some other input prices remain fixed in the short run. Given these rigidities, an increase in the price level would allow businesses to profit by expanding output, thus producing the upward-sloping AS curve. But the classical economists believed that all prices—including wage rates (the price of labor) and other input prices—were highly flexible. An increase in product prices would therefore be quickly matched by higher costs, which would eliminate any incentive to expand output.

Thus, the existence of highly flexible wages and prices implies an AS curve that is vertical at the full-employment level of output (potential GDP), as represented in Exh. 2.

To illustrate how flexible wages and prices guarantee full employment, let us assume that the economy is operating at a price level of 100 and a real GDP of $1,000 billion, the intersection of AS and AD1. Now, suppose that consumers become pessimistic about the future and hide some of their income in cookie jars rather than spend it. What will happen? Aggregate demand will fall—the AD curve will shift from AD1 to AD2—because households are spending less and thus demanding less real output at any given price level. Reasoning from the assumptions of the classical economists, a reduction in aggregate demand leads quickly to falling prices. In our example the price level will not be maintained at 100; it will fall to 80. If that occurs, businesses will be able to sell the same amount of real output as before but at lower

EXHIBIT 2. The Classical Aggregate Supply Curve

The Classical Aggregate Supply Curve

prices. Wages will also decline because reductions in the demand for goods and services will be accompanied by falling demand for labor, which will lead to labor surpluses and wage reductions. Thus, employers will still be able to make a profit at the lower price level.

If AD were to increase (due to dishoarding—spending the money that had been hoarded—for example), this entire process would work in reverse. An increase in aggregate demand from AD1 to AD3 would quickly push up product prices. On the surface this would seem to make it attractive for businesses to increase output; if product prices rise while input prices remain stable, producers can make a profit by expanding output to satisfy the higher level of demand. But in the classical model, wage rates and other input prices are also highly flexible, and they would tend to rise because increases in the demand for goods and services would be accompanied by rising demand for labor and other inputs. Thus, businesses would have no incentive to expand output. The higher level of aggregate demand would lead to inflation, leaving output and employment unchanged.

In summary, the classical economists did not believe that changes in aggregate demand would have any impact on real GDP or employment; they maintained that only the price level would be affected.

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