The classical model of macroeconomics assumes full flexibility of wages and prices and no
money illusion.
The ii schedule shows, under a policy of inflation targeting, how the central bank achieves
high interest rates when inflation is high and low interest rates when inflation is low. Central
banks set nominal not real interest rates, and hence must first forecast inflation in order to
calculate what nominal interest rate they wish to set.
The ii schedule shifts to the left, a higher real interest rate at each inflation rate, when
monetary policy is tightened, and to the right, a lower real interest rate at each inflation rate,
when monetary policy is loosened.
The macroeconomic demand schedule shows how higher inflation reduces aggregate
demand by inducing monetary policy to raise real interest rates.
The classical model always has full employment. The aggregate supply schedule is vertical
at potential output. Equilibrium inflation is at the intersection of the aggregate supply
schedule and the macroeconomic demand schedule. The markets for goods, money and
labour are all in equilibrium. Monetary policy is set to make the equilibrium inflation rate
coincide with the inflation target.
In the classical model, fiscal expansion cannot increase output. To continue to hit its inflation
target, the central bank must raise real interest rates to restore aggregate demand to the
level of potential output. Higher government spending crowds out an equal amount of
private spending, leaving demand and output unaltered.
Changing the target inflation rate leads to an equivalent change in the growth of wages and
nominal money in the classical model, but not to a change in output.
In practice, wages adjust slowly to shocks since job arrangements are long term. Wage
adjustment is sluggish not merely because wage bargaining is infrequent, but because
workers prefer their long-term employers to smooth wages.
Prices mainly reflect labour costs. The short-run aggregate supply schedule shows firms’
desired output, given the inherited growth of nominal wages. Output is temporarily
responsive to inflation, since nominal wages are already determined. As wage adjustment
occurs, the short-run supply schedule shifts.
The Keynesian model is a good guide to short-term behaviour but the classical model
describes behaviour in the long run.
Permanent supply shocks alter potential output. Temporary supply shocks merely alter the
short-run supply curve for a while.
If its effects were instant, monetary policy could completely offset demand shocks,
stabilizing both inflation and output. Temporary supply shocks force a trade-off between
output stability and inflation stability. The output effect of a permanent supply shocks cannot
be escaped indefinitely.
Flexible inflation targeting implies the central bank need not immediately hit its inflation
target, allowing some scope for temporary action to cushion output fluctuations.
