Download Chapter 4 The Classical Model

Chapter 4
The Classical Model
Aggregate Supply
The distribution of output
The Equation of Exchange
• Irving Fisher divided nominal GDP by the
money supply
Py
V s
M
P  Price Level
y  real income
M  money supply
s
• Fisher thought that V (velocity) was
constant.
• He thought up reasons why V might be
constant
– The technical pay structure of the economy
• Suppose V really is constant
• The classical economists also believed y
was constant as well
Py
V s
M
M sV  Py
1
s
M  Py
V
• So if money supply doubles P must double
as well (V and y don’t change)
The Cambridge Equation
• Recall the functions of money
– Money is used as a medium of exchange
– Money is used as a store of wealth
• The classical economist did not believe
people held money as a store of wealth
• The opportunity cost of holding money is
foregone interest earnings.
• People held the bulk of their money in
bonds.
• People would hold a small amount of
wealth in the form of money to minimize
transactions costs.
• The number of transactions are
proportional to nominal income
M  kPy
d
• In equilibrium
M s  M d  kPy
Note simularity to
1
s
M  Py
V
• Aggregate Demand.xls
• The classical model is said to produce a
dichotomy
– The real economy (y is determined by real
factors – the labor market)
– The monetary economy that only affects the
price level but not the real economy
How output is distributed in the
classical model
•
•
•
•
•
Household get their income y
First they pay taxes T
Next they decide how much to save S
They consume what is left over
Y=C+S+T
The bond market
• Households save by purchasing bonds
• Firms borrow by selling bonds
• The government borrows by selling bonds.
Bond supply: S B  government bonds + corporate bonds
Bond demand: D B  household savings S
The bonds used in this class are called
consuls-they have no maturity date and
pay a fixed amount, say $50 each year.
The price of consuls is determined in the
bond market
For a consul that pay $50/Year
Price
r (interest)
$250
20%
$500
10%
$1000
5%
• Household (savers) will purchase more bonds
as the price falls (they get a higher interest
rate).
• Firms will supply more bonds as the price
rises (they pay lower interest rate).
• The government doesn’t care.
P
B
S
B
D
B
B
How savings and borrowing affect
bond prices
• If household buy more bonds (save more)
the demand curve for bonds will shift right
and bond prices will rise (interest rates fall)
• If the government or firms borrow more the
supply curve for bonds will shift to the right
and bond prices will fall (interest rates
rise).
Loanable funds market
• Economists prefer to use interest rates
rather than bond prices.
• Households are lenders. They will lend
(save) more if interest rates increase.
• Businesses borrow. The will borrow
(invest) more if interest rates fall.
• Government borrows (G-T).
Classical savings function
s  s0  sr r
•
sr  0
r
s(r)=s 0 +s r r
r1
s0
s
Classical investment function
i (r )  i0  ir r
•
ir  0
r
i(r)=i0 +ir r
r1
i1
i0
i
Interest rate determination in the
classical model
• s(r)=i(r)
r
i(r)=i0 +ir
r
s(r)=s 0 +s r r
re
i=s
i,s
Government budget deficit
• Government must
borrow (g-t)
r
s(r)
re
i(r)+(g- t)
i(r)
s=i+(g-t) i+(g-t),s