Question

4. The classical economists believed that our economy was always at full employment or tending toward full employment. If our economy were operating below full employment, what would happen, according to the classical, to move the economy back toward full employment?

Answer 1

Classical economists believe that the economy adjusts towards full employment and any deviation from the full employment level is only transitory and eventually the output adjusts to the long run full employment level. This happens through the adjustment in the wages of workers and the prices of the goods and services. When the employment is below the full employment level, the output falls below the long run equilibrium. This leads to a reduction in wages and prices, which brings back the output and employment to long run level. In an aggregate demand supply framework this happens through a shift in the demand curve towards the right that reduces the price (and wages) and brings output back to full employment level. This is shown in the figure below.