20.2 Explaining Short-Run Economic Fluctuations

20.2 a. The Assumptions of Classical Economics

Classical economics focuses on the growth in the wealth of nations and promotes policies that create national economic expansion. Classical theory assumptions include the beliefs that markets self-regulate, prices are flexible for goods and wages, supply creates its own demand, and there is equality between savings and investments [6].

^{Classical Theory and Keynesian Theory [7]}

20.2 b. The Reality of Short-Run Fluctuations

Over the short-run, an outward shift in the aggregate supply curve would result in increased output and lower prices. An outward shift in the aggregate demand curve would also increase output and raise prices. Short-run nominal fluctuations result in a change in the output level. In the short-run an increase in money will increase production due to a shift in the aggregate supply. More goods are produced because the output is increased and more goods are bought because of the lower prices [6].

^{Short-Run Fluctuations [8]}

20.2 c. The Model of Aggregate Demand and Aggregate Supply

Aggregate supply is the total amount of goods and services that firms are willing to sell at a given price in an economy. The aggregate demand is the total amounts of goods and services that will be purchased at all possible price levels [6].

We use the model of aggregate supply and aggregate demand to explain economic fluctuations. This model can be graphed with the price level, measured by the CPI or the GDP deflator on the vertical axis and real GDP on the horizontal axis. The aggregate-demand curve shows the quantity of goods and services households, firms and government wish to buy at each price level. It slopes negatively. The aggregate-supply curve shows the quantity of goods and services that firms produce and sell at each price level. It slopes positively (in the short run) [1].

^{Aggregate Demand and Aggregate Supply [9]}