Question

Classical economists assumed that wage rates, prices, and interest rates are flexible and will adjust quickly. Consider an extreme case: Suppose classical economists believed that wage rates, prices, and interest rates would adjust instantaneously. What would the classical aggregate supply $(AS)$ curve look like? Explain your answer.

Short answer

The aggregate supply (AS) curve would be vertical, reflecting that the economy is always at its potential output irrespective of the price level. This is due to classical economists' assumption of instant adjustment of wage rates, prices, and interest rates to changes in economic conditions.

Step-by-step solution

Understanding Classical Economic Theory

According to classical economists, wage rates, prices, and interest rates would adjust quickly to changes in supply and demand. In an extreme case where these adjustments occur instantaneously, there would be no lags in the changes in these rates and prices.

Understanding the Aggregate Supply Curve

The aggregate supply (AS) curve is a graphical representation of the total quantity of goods and services that businesses are willing and able to produce, given the current price level. When wage rates, prices, and interest rates adjust instantly, businesses can swiftly adapt to any changes in the economy.

Formulating the Shape of the AS Curve

Given the assumptions of classical economists, particularly in the extreme case where wage rates, prices, and interest rates adjust instantaneously, the aggregate supply (AS) curve would be vertical. This is because in the classical model, the economy is always at its potential level of output, irrespective of the price level, reflecting the instant adjustment of wage rates, prices, and interest rates to any change in economic conditions. Therefore, the AS curve does not depend on the price level and is represented as a vertical line at the potential level of output.