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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.