Download Lecture Five: The Classical Money Market and Aggregate Demand

Lecture Five: The Classical Aggregate Demand Curve and the Classical Money Market
{Money Demand, Money Market Equilibrium, Implicit Aggregate Demand, Interest Rate
Determination, loanable funds market, autonomous changes, induced changes}
Classical Macroeconomic III
10
5
Quantity Theory of Money: shows a relationship between the exogenous supply
of money and the aggregate price level.
1.
Role of money is an essential determinant of the price level in the classical
system.
2.
Reasons for holding money:
i.
money will be held for the convenience it serves in exchange
transactions.
ii.
money will be held for security due to one’s risk of not being able
to meet obligations.
iii.
since holding money provides no income, individuals will
necessarily use other stores of value.
iv.
Optimal Holding: money will be held only insofar as its yield in
terms of convenience and security outweighs the lost income from not
storing in productive activity or the lost satisfaction from using the money
to consume.
3.
Demand for Money: will be proportional to the level of nominal income:
MD=kPY
i.
in this, k is the proportion of nominal income that is estimated to
be the optimal level of money to hold.
ii.
in the short run, k is assumed to be stable and determined by the
payment habits of society. That is, how often are individuals paid for their
labor time (the shorter the pay period, the less need be held in between pay
checks); the use of credit also affects k.
4.
Equilibrium requires the exogenous supply of money to equal the demand
for money: M = MD = kPY
i.
now, k is fixed in the short run and Y is determined by supply
conditions, so the market for money simply determines the price level.
Aggregate Demand Curve: the quantity theory implicitly is the theory of
aggregate demand in the classical system (money needed for consumer and
investment demand).
1.
To do so, lets use an example:
i.
k=1/4 M=300  P*Y=1,200
ii.
thus, the AD curve associated with an exogenous supply of money
of 300, then, is constructed as all the points at which real income times the
price level is 1200.
15
2.
The AD curve, in the short run, shifts only if M is changed since k is
fixed.
i.
if M=400 then P*Y=1600
3.
Now, we can determine the aggregate price level in the classical system.
i.
and the result from the quantity theory of money, is that changes in
the money supply will only effect the price level.
4.
This AD theory is implicit, not explicit, because it does not explicitly
consider the determinants of the components of aggregate demand,
namely: C, I, and G.
The Interest Rate is endogenously determined by the components of
aggregate demand.
1.
In fact, the interest rate functions to ensure that exogenous changes in
any one component of aggregate demand will not affect the total level
of aggregate demand.
2.
The equilibrium interest rate in classical theory is the rate at which the
amount of funds desired to be lent equals the amount of funds desired
to be borrowed.
i.
we consider bonds for simplicity  borrowing is selling a bond &
lending is buying a bond.
[[[[[[[[[[ii.
consider only bonds that provide a perpetual stream of
interest to the buyer without a repayment of the principal.]]]]]]]]]]]]
[[[[[[[[[iii.
also ignore the secondary market.]]]]]]]]]]]]]
iv.
the interest rate measures the return to holding (buying) bonds and
the cost of borrowing (selling bonds); and is determined by the levels of
bond demand (loanable fund suppliers) and bond supply (loanable
fund demanders).
3.
Bond Suppliers: firms and government
4.
Firms: finance all investment spending by selling bonds.
i.
The level of investment spending is a determined by the interest
rate and the expected level of profitability of an investment project.
ii.
We assume the expected level of profitability to be exogenously
determined and vary due to changes in product demand  we assume this
expectation to be given.
iii.
Given a level of expected profitability, investment spending varies
inversely with the interest rate. I=i(r), i’<0
iv.
Since the interest rate represents the cost of borrowing to firms, as
it increases, the cost of investment increases, thus the level of investment
decreases.
5.
Government: finances deficit from either printing money or selling
bonds.
i.
We take both the level of government deficit, and that proportion
that is financed by selling bonds as given.
ii.
For now, assume the entire deficit is financed by selling bonds.
iii.
Then, the demand of loanable funds = I + (G-T).
6.
Bond Demanders: individuals who are savers.
i.
S=s(r), s’>0
ii.
The act of saving is the acting for foregoing current
consumption for future consumption. If the interest rate is higher, then
it becomes more beneficial to forego current consumption.
iii.
Since money is only held for convenience in exchange transactions
and security against not meeting obligations, all purchasing power being
stored for future consumption will be in the form of bond demand.
iv.
That is, saving = bond demand = supply of loanable funds.
7.
Equilibrium: the interest rate is the price in the market for loanable funds,
as it adjusts to equilibrate the supply of and demand for loanable funds.
8.
Lets assume for the time being that the government budget is balanced.
i.
Suppose for some reason firms believe a decline in product
demand is coming and thus lower their level of expected profitability from
investment.
ii.
Then, at every level of the interest rate, firms would demand to
borrow fewer funds
iii.
Thus, the I schedule will shift left putting downward pressure on
the interest rate.
iv.
As the interest rate decreases S declines  C increases and there
is an induced increase in I
v.
At the new equilibrium, the induced increase in investment
spending plus the induced increase in consumer spending is equal to the
autonomous decline in investment spending  aggregate demand
doesn’t change.