The Classical model of the economy says that
all markets always clear. The labor

market failing to clear does not exist in
the Classical model because of

competitive exchange equilibrium in which
prices and quantities always adjust

perfectly. The Classical model is of a
closed economy and the variables are real

output, employment, real and
nominal wages, the price level, and the rate of

interest. It is easier to
understand the classical model using five diagrams

that are numbered one
through five in Appendix One, The Classical Model. These

diagrams represent
the separate parts of the model that together illustrate, for

the most part,
the entire Classical model. Diagram one represents the production

function,
which shows the assumption that real output, y, is determined by the

level of
employment, N. So y is a function of N and from the slope of the

function we
can see that output rises as employment is increased. But there is
a

diminishing marginal productivity of labor, which means that each
time

employment increases, the increase in output will get smaller and
smaller.

Diagram one illustrates the relationship between output and
employment in the

short run, but does not determine the level of output or
the level of

employment. But when used together with other diagrams of the
model, diagram one

can be used to figure these things out. Diagram two is the
labor market with the

real wage, w, on the vertical axis and employment, N,
on the horizontal axis. In

the classical model, the supply of labor depends
upon the real-wage level

because as the real wage rises, more people are
willing to work. The line SN

represents the labor supply function and the
line DN represents the demand for

labor. As the real wage increases so does
the labor supply function, but as the

labor supply function increases, the
demand for labor decreases. Because the

Classical model makes real wages
perfectly flexible and allows it to adjust to

the level that clears the labor
market, the real wage and the level of

employment can be figured out by using
diagram two. Once given the level of

employment determined from diagram two,
it is possible to use diagram one to

figure out the level of output. So
diagrams one and two, also know as the real

sector, can be used to determine
employment, real output, and the real wage

without any knowledge of the
monetary sector of the classical model. The

monetary sector, given the level
of real output, determines only the monetary or

nominal variables such as the
price level and the money wage. The separate

treatment of the monetary sector
and real sector is known as the 'Classical

dichotomy.' To complete the model,
diagrams three, four, and five are needed.

Diagram three represents the
Classical aggregate demand curve, which shows the

relationship between real
aggregate demand for output, y, on the horizontal

axis, and the price level
P, on the vertical axis. Real aggregate demand

represents the sum of the
demands for output of all the individuals in the

economy. The Classical
aggregate demand curve, AD, illustrates the level of

aggregate demand for a
given price level. Since the government or the central

bank can control the
quantity of money in circulation, it also controls the

position of the
Classical aggregate demand curve. But it can only control the

price level and
other nominal variables because it is independent of the

monetary sector. The
full understanding of the classical model comes with

diagrams four and five,
which consider money-wage determination and interest

rate determination
respectively. In diagram four, the real wage, w, is defined

as the money
wage, W, divided by the price level, P. For this reason there is
a

relationship between money wages and the price level which results in a
straight

line through the origin that corresponds to the real wage. The
higher the price

level, the higher the money wage must be to maintain any
given real wage.

Diagram five determines the interest rate, r, which is
expressed as a percentage

per period and depends upon the interaction of the
savings and investment

functions. The investment function, I, shows that the
lower the rate of

interest, the higher the amount of investment. The savings
function, S, shows

that the higher the rate of interest, the more will be
saved. Because of the

Classical dichotomy, diagram five is basically to
show the breakdown of the use

of income, or the demand for output, between
expenditure on consumption and new

capital goods. Like the Classical model,
the Keynes model can also be explained

by using five diagrams that are shown
in Appendix Two, Keynes model. This is

about the only similarity between the
two. In the Classical model, all markets

cleared. This is not true for the
Keynes model, where flexible wages and prices

do not bring about simultaneous
market clearing, which means its not inherently

self-regulating. The labor
market will not clear in the Keynes model, which can

be seen in Diagram five
that shows involuntary unemployment. Also, the arguments

are not connected to
wage and price rigidity as they are in the Classical model.

On the
subject of rigidities, Keynes also rejected Pigou's explanation
for

unemployment, which is basically the Classical models explanation. Keynes
said

that imperfections are not the source of unemployment, but other
policy

initiatives are required and not the removal of the imperfections.
Keynes

assumes there are only two assets households can hold, which are money
and

bonds. Bonds represent non-monetary options. Money has different effects
on the

economy in these models. Because of the Classical dichotomy, only the
nominal

sector is effected by money in the classical model. But in the Keynes
model,

many things are effected by money. First, the interest rate decreases,
which

causes an increase in bond prices. The decrease in interest rate causes
an

increase in investment and then this causes an increase in aggregate
demand,

which then causes income and employment to increase. This can be seen
in diagram

four, and then because of the increase in income, going back to
graph three, we

can see that this would cause an increase in consumption.
From diagram five, we

can see because of the increase in employment that this
would cause a decrease

in real wages. The decrease in real wages would then
cause involuntary

unemployment to decrease. Because of the different effects
that money has on the

economy in these models, they arrive at different
conclusions. The Classical

economy seems to be in favor of no policy since
everything works itself out and

ends up in equilibrium since all the markets
clear. The opposite is true for the

Keynes model, where they are in favor
of government intervention since it is not

inherently self-regulating and the
markets do not clear. The Keynes model needs

a little help from the
government, or the central bank, to achieve equilibrium,

where as the
Classical model, assuming all assumptions were realistic, is

self-regulating
and all markets clear.