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 permanent supply shocks cannot
be escaped indefinitely.
Flexible inflationtargeting implies
the central bank need not immediately hit its inflation target, allowing some
scope for temporary action to cushion output fluctuations.
