Question

Describe Classical Theory. To do so, begin by describing its approach to the circular flow model and indicate its assumption about employment and output in the economy. Close with a description of the aggregate demand curve, aggregate supply curve used to find equilibrium in this model.

Answer 1

Answer and Explanation:

Classical Theory:

Classical theory states that the economy is free flowing and that there should be no outside intervention. It states that the prices and wages move up and down freely. During good times the prices and wages tend to increase and during bad times or recession the prices and wages are adjusted accordingly to downwards.

Another vital information pertaining to classical theory is that it states: economy is always at full employment level of output. Which means that the aggregate supply curve is vertical and this implies that the increase in aggregate demand or a decrease in aggregate demand will lead to increase or decrease respectively. However, the output will remain same in the economy when it comes to the classical approach.