Chapter 4 - Classical Macroeconomics (II) - complete and notes

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Chapter 4
Classical Macroeconomics (II):
Money, Prices and Interest
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Main Goals of this Chapter
1. Develop the Classical Model’s theory of price determination;
2. Develop the Classical Theory of the Rate of Interest:
Loanable Funds Theory.
3. Integrate Chapters 3 & 4 to arrive at an integrated “Classical Model”;
4. Discuss the policy conclusions that emerge from the Classical Model.
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Determining the Price Level
The Classical Model relies on the “Equation of Exchange” to determine the aggregate price level;
Equation of Exchange:
 
M x V ≡ P x Y
Where:
M = money stock
V = velocity of money (turnover rate)
P = price level (the price index for current output)
Y = real output
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The Equation of Exchange
The equation of exchange is an identity not a theory!
Measured ex post, velocity of money is calculated so that MV is always equal to PY.
Classical economists made certain assumptions to turn this identity into a theory.
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Velocity of Money
In order to calculate the turnover rate of each dollar in the economy (i.e. the velocity of money) one simply applies the formula: V = (P.Y)/M
		V is the value that makes the equality hold!
For instance, if the volume of total transactions in a period at current price (nominal income) is $3,600 billion and the money stock is $300 billion, each dollar must have been used, on average, 12 times in the given period:
	
		V = (P.Y)/M = 3,600/300 = 12
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Classical Assumptions and the Equation of Exchange
The Equation of Exchange (Fisher’s version): 
M.V ≡ P.Y
Classical Assumptions:
Velocity is relatively stable;
Y is completely determined by supply-side factors; 
Causality runs from money to prices.
Classical Price Theory says that variations in the money supply (∆M) will cause proportional change in the price level (∆P): M.Vo = P.Yo 
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But What Determines the Price Level?
The price level is determined via the Equation of Exchange
In an equation with four variables, we can solve for any one variable by “plugging in” the values for the other three
To solve for P, we must know the values of M, V and Y 
Classical economists considered the money supply to be fixed in the short-run, so we can take the value of M as given
They also considered V to be known and stable, so we can treat V as a known value
All we need, then, is to determine a value for Y and we can solve for P
We have already seen how Y* is determined according to the Classical Model.
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The Implicit Aggregate Demand Curve
Each curve gives us combinations of price and real output that generate the same nominal value equal to the product Mi.V 
If V is stable and Y is given, the supply of money (M) is the only variable that affects aggregate demand and generates a new price level.
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Determining P* Requires Y* (cont.)
To determine the equilibrium price level, we must have a Y* 
As seen in Chap. 3, the value of Y* is determined via the production function, where K & T are considered fixed
We must know N* in order to determine Y*
The Classical Model is an integrated story, where one piece of the puzzle is used to solve another piece, and so on
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The Integrated Story
As noted before, according to (Neo)Classical Macroeconomic Theory, only supply-side factors will affect the equilibrium level of output and employment.
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The Neutrality of Money
With velocity (V) stable and the economy operating at full-employment (Y = YFE) , prices can change only if there is a change in the money supply (M)
Importantly, the Classical Model assumes that ∆M will have no effect on real variables
According to the Classical Model, any ∆M will simply lead to a direct, proportionate change in all nominal values (i.e. nominal prices, nominal wages, nominal interest rates, etc.)
Real variables, such as output, employment, real wages, and real interest rates will be unaffected
This means that the monetary authority has no power to influence production or employment
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Deflation
Question: What must happen to bring about deflation?
Answer: The money supply must contract, shifting MV inward.
Question: What will happen to output and employment as firms discover that they can only sell their output at lower prices?
Answer: Nothing. Money is neutral and money determines prices, therefore prices are neutral as well. Changes in the money supply do not affect output or employment. As prices fall, firms pay lower costs for their factors of production. So, even though TR falls, TC fall too, leaving profits unaffected. 
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The Classical Theory of the 
Rate of Interest
	From the Saver’s Perspective:
Classical economists considered interest to be the reward for saving (i.e. not spending)
Households might abstain from current consumption (which yields utility) if the “reward for waiting” (i.e. the interest rate) was sufficiently attractive
If a portion of household income is saved rather than spent, it will earn interest and the saver will be able to increase his future consumption 
	From the Borrower’s Perspective:
Interest is the cost of borrowing funds
Borrowing is done by business for the purpose of acquiring funds to purchase plant & equipment (invest)
The demand for household savings is referred to as a demand for “loanable funds”
The firm borrows savings from households and pays the household back, with interest
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The Loanable Funds Market
SLF = ƒ (i)
DLF = ƒ (i)
The interest rate is determined in the Market for Loanable Funds
The forces of Supply and Demand cause the interest rate to adjust whenever there is an imbalance
The Loanable Funds Market ensures that aggregate demand doesn’t decline simply because households decide to save rather than spend
↓C → ↑ S → ↑I → ∆Y = 0
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The Loanable Funds Market (cont.)
But what if Households decide to save more than Businesses want to borrow at the current rate of interest?
An increase in Household saving shifts the SLF curve outward
The immediate effect is excess supply
An excess supply of LF, like an excess supply of any good, puts downward pressure on the price of LF
As the interest rate begins to fall, businesses find that they can borrow at a lower cost
The interest rate continues to fall until businesses have borrowed all of the additional income that households chose not to spend
At the new equilibrium, S=I at a new, higher level and aggregate output and employment remain unchanged (though composition of output has changed)
What about a change in the marginal productivity of capital (rate of return on of investment)?
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The Loanable Funds Market and 
Say’s Law
The strongest version of Say’s Law holds that there cannot be a deficiency of demand in the aggregate
All of the income generated in the process of production will be spent buying back the G&S that are produced
Changes in “i” guarantee that changes in components of AD will not affect the aggregate level of AD. 
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The Effect of an Increase in Government Spending: Crowding-Out
Now suppose we have a government that wants to increase its spending by tapping the LF Market (i.e. borrowing from Households)
The Classical Model assumes that the government must “compete” with business when it borrows 
The additional demand for funds shifts the DLF curve outward and creates excess demand in the LF Market
The market returns to equilibrium as the interest rate adjusts (rises) 
At the new equilibrium, S = I + (G-T)
↑ G-T → ↑i → ↓I and ↓C → ∆Y = 0
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The Effect of Reduced Income Tax Rates
If the government reduced marginal income tax rates from 35% to 25%, there would be an incentive effect on labor supply
The change would affect workers’ willingness to supply labor (since they will keep more real income for every hour worked)
The labor supply curve will shift
outward, increasing the level of employment and, hence, the level of output
Remember! Only changes on the supply-side can affect Y and N in the CM
What happens to prices? 
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Putting it all Together
1. Suppose that instead of issuing bonds, the government prints money to finance its deficit. Show what will happen to output, employment, prices and the rate of interest.
2. Suppose a hurricane wipes out half of the nation’s capital stock. Show what will happen to output, employment, prices and the rate of interest.
3. Suppose households decide to save less (i.e. increase current consumption). Show what will happen to output, employment, prices and the rate of interest.
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