Let's look at classical economy and what that entails. Start with an economy in a recession, which is identified by price level one and quantity level one. According to a classical economist, with the unemployment in the economy, eventually wages – how much workers make – and prices of resources will decrease. Supply can then increase, because producers do not have to pay workers as much and because the cost of inputs is now less. The aggregate supply curve will shift to the right and achieve equilibrium again at a lower price and a higher output, with yf representing this higher output, therefore the recessionary gap is closed.
The principle of classical economics can also be illustrated when the economy is doing well. This graph represents the idea of a classical economists in a boom time. A booming economy and high inflation is represented by Price level one and quantity one. According to classical economist, with low unemployment and a higher price level, eventually the cost of wages and resources will increase. Why? Because workers are more scarce; therefore they can demand more money. With the cost of input also increasing, the aggregate supply curve will shift to the left and achieve a new equilibrium at a higher price level and a lower output.
