Classical Adjustment

To understand classical adjustment to its fullest, you’ll need to know what short-run aggregate supply curves (SRAS), aggregate demand curves (AD), and long-run aggregate supply (LRAS) curves look like on your typical price-quantity graphs. If you’re not quite there yet, it’s okay...you can still understand the real-world effects of the classical adjustment (we’ve all been there, even if you're still not so sure).

Graphically, we start with the the AD and SRAS crossing, like your typical supply and demand graph. They cross at the vertical LRAS curve.

The main idea is that wages lag behind inflation as prices rise. Economists would say that wages are “stickier” than prices. When this happens, labor is cheap for a minute, since the real wage of workers has gone down. Think about it: if your income stays the same but everything around you just got more expensive, then your real income (buying power) just went down. Sad for you, but good for employers, because...cheap labor. On the graph, this means the AD curve moves to the right.

So firms might hire again for awhile, which can bring employment up. But eventually, wages will catch up with prices. On the graph, that means the SRAS curve will move to the left, bringing equilibrium back to the vertical LRAS (it’s long-run for a reason). We end up with higher prices than we started with, but at the same quantity produced. That’s inflation for you...basically temporarily lost income for workers because companies decided to raise prices. So it goes, round and round.