Classical Approach to Output and Price Determination:

Among economists there is no agreement on how adjustments  in equilibrium levels  of output, prices and employment take place. There are also differences in views oil the sources of economic fluctuations. Basically  there  are  two  important schools  of thought: classical  and Keynesian. Classical approach is a term coined  by John Maynard keynes to reflect  the ideas presented by economists prior  to him. Prominent among  classical economists  Adam Smith, David Ricardo, Thomas Malthus  and John Stuart Mill. The classical and Keynesian  economists  differ on:

i)  the relative roles  played  by supply  and demand  in determination  of output, employment  and prices, 

ii)  the flexibility of  prices and wage  rate  in  the economy, and 

iii) the dichotomy between  real sector and monetary sector.

The  mainstay of  classical economics  has been  the basic  assumption  that 'supply creates  its own demand; often  referred to as  'Say's law', named after J. B. Say. The Keynesian  economists  rule out such  a  possibility, particularly  during  periods  of  recession.  

The classical economists believed in free trade and minimum intervertion by thle government on economic activities. They suggested  a  'laissez-faire' (French  for 'leave us alone') economy where government should confine itself to law, defence and
governance.  In such  an  economy 'market forces' will determine  real variables such as output, employment  and prices. This  is made possible by flexibility  in price and wage levels. The classical economists  believed  that the aggregate supply  curve  is  vertical, so that  there  is no change in equilibrium level of output  and  employment.

For example, suppose  there  is a downward shift  in  aggregate  demand  from AD₁ to AD₂, due to reduced consemptin  expenditure  by households. This will result  in  excess  supply at the prevailing price P₁. Consequently,  prices will decline  to P₂  while  there will be n$ decline  in output level, and market gets cleared. In the factor market, wage rate will decline  so  that  lll  employment  is maintained. According  to  classical economists there  iS a 'self-correcting mechanism  behind  the 'market clearing model of  the economy. The process of change  in wage rate  and  prices are achieved instantaneously. The classic economists also assume dichotomy between  real variables  (such as output and employment)  and nominal variables (such  as money supply  and prices).  Thus  changes  irb money supply  (M) do not influence output  or employment.  If there  is a decrease  in money supply,  levels  of prices and wage  rate will decline.

The Keynesian approach,  however, does  not subscribe  to  the vertical AS curve.  Keynes points out  that  in the short run there are  price and wage 'rigidities'  so  that prices and wage  rate do not decline when there  is a downward  shift  in  aggregate  demand. Wag rigidities arise because  of various contracts and  labour  legislation. Due  to wage rigidity, wage rate is maintained at a higher level, Consequently, the output  level  declines  and there  is  'recession' in  the economy.  In the short-run  the  AS curve  is  either  horizontal ot upward sloping (in Fig. we have presented an upward sloping  AS curve so  that downward  shift  in AD  results  in  decline  in  both output and  price levels).  In  the Keynesim model, however, the AS curve  is  assumed  to be vertical  in  the long run  so that output supplied  is  fixed. Thus we can say  that  the classical model explains  the  long run  while  the Keynesian model explains the short  run.

In response  to  the Keynesian economics  the 'neoclassical economists' (John Hicks, Paul Sarnuelson,  Robert  Solow  among others) attempted  to  imbibe  the  important ideas of Keynesian  economics  in a classical  framework. The pioneering efforts  by Sir John Hicks paved the way for  the synthesis of classical and Keynesian ideas  on real and nominal macro-variables, popdarly  known  as  IS-LM model. The neoclassical growth model by Solow  helped  in  analysis  of long run  growth  of  an  economy. The 'new classical  economics'  is a  term broadly used  to describe the challenges  posed to  the Keynesian orthodoxy.  This  school of thought suggests  that economic fluctuations can be explained while maintainjng  classical assumptions.