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Chapter 22
The Classical
Foundations
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Learning Objectives
• Define Say’s law and the classical understanding of
aggregate supply
• Understand the supply of saving and demand for
investment that leads to the equilibrium interest rate
• Explain the quantity theory of money and its
implication for the aggregate demand curve
• Differentiate between nominal and real rate of interest
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Introduction
• Origins of monetary theory lie in Classical Economics,
starting with the works of Adam Smith (1723–1790)
• Two cornerstones of classical economics
– Say’s Law—deals with interest rates, employment and
production
– Quantity Theory of Money—examines the role of money in
the economy
• Focused on long-term view of the economy
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Introduction (Cont.)
• Classical economics was attacked by John Maynard
Keynes during the Great Depression
• Theory was resurrected and refined by modern
monetarists and new classical macroeconomics
beginning in the 1970s
• The starting point of classical theory is what determines
gross domestic product (GDP)—total value of goods
and services produced domestically
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Classical Economics
• “Supply creates its own demand”
• The economy could never suffer from
underemployment
• Total spending (demand) would always be
sufficient to justify production at full
employment (supply)
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Classical Economics (Cont.)
• Potential output of an economy
– Determined by the size of the labor force to work
with existing capital stock and level of technology
(real factors in the economy)
– Production function defines the total supply of goods
and services that can be produced
– Because of interplay of market forces (an
invisible hand), production will always be at the
full employment level
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Classical Economics (Cont.)
• Potential output of an economy (Cont.)
– Flexible wages and prices would assure that all markets
would clear—all goods sold and all people employed
– If the economy deviated from full employment, this
flexibility would bring all markets back into equilibrium at
the full employment level
– Laissez-faire—government intervention was not required
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Classical Economics (Cont.)
• The economist Reverend Thomas Malthus (1766–1834)
attacked the classical assumption of full employment:
– While production of output generates income in the amount
of total production, there is nothing to force spending to
equal total production
– If spending in the economy is less than income (due to
increased savings), part of the goods produced will not be
sold resulting in reduced production and unemployment
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Classical Economics (Cont.)
• However, classical economists countered Malthus’s
criticism:
– Individuals save, but such funds do not disappear
– Savings are diverted from the spending stream, but flow to
entrepreneurs to use for capital investment projects
– Savers receive interest on funds and borrowers are willing to
pay as long as expected return on their investment exceeds
the rate of interest
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Classical Economics (Cont.)
• However, classical economists countered
Malthus’s criticism: (Cont.)
– Flexibility in the rate of interest causes savings to be
equal to investment spending, thereby flow back into
the economy
– Therefore, interest rates fluctuate to make
entrepreneurs want to invest what households want
to save
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Classical Interest Theory
• Overall level of interest rates is determined by
supply and demand for loanable funds (Figure
22.1)
• However, classical economics focused on
savings and investment, the two factors that
underlie the long-run supply and demand for
loanable funds
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FIGURE 22.1 Classical interest theory.
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Classical Interest Theory (Cont.)
• Savings (Figure 22.1)
– Function of interest rates—the higher the rate of
interest, the more will be saved (positive or direct
relation)
– Interest earned on savings is a reward for delaying
consumption in favor of future consumption
– At higher interest rates people will be more willing
to forgo present consumption
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Classical Interest Theory (Cont.)
• Investment (Figure 22.1)
– Also a function of interest rates—the lower the rate of
interest, the more entrepreneurs will borrow and invest
(negative or indirect relation)
– Investment in physical capital is undertaken because capital
goods produce output in the future
– The firm will undertake the investment if the rate of return
exceeds the cost of borrowing
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Classical Interest Theory (Cont.)
• Investment (Figure 22.1)
– The return on investments is subject to diminishing
returns, each successive project earns a lower return
on investment
– Therefore, a lower rate of interest induces
entrepreneurs to undertake more and more
investments
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Classical Interest Theory (Cont.)
• Equilibrium rate of interest (Figure 22.1)
– Represented by the intersection of the supply/demand curve
for loanable funds
– Total savings is equal to total investment
– That portion of income that was diverted from spending to
savings flows back into the spending stream in the form of
investment
– As long as the supply or demand for loanable funds do not
shift, this equilibrium rate of interest will not change
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Classical Interest Theory (Cont.)
• Shifts in supply or demand
(Figure 22.2)
– Any shift in the supply or demand for loanable funds
will cause market forces to drive the rate of interest
back into equilibrium at a different level
– This flexibility in the rate of interest will ensure that
the amount of savings is always equal to investment
and total income will always equal total spending
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FIGURE 22.2 Increased saving
calls forth increased investment.
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Classical Interest Theory (Cont.)
• Role of money in determining interest rate
– Rate of interest is influenced in the long run by the savings of
the public (personal preferences) and investment of
entrepreneurs (productivity of capital)
– Money plays no role in determining real factors in the
classical system
– Real factors are determined by the supply of capital, the labor
force, and existing technology
– Interest rates are determined by the thriftiness of the public
and the productivity of capital
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Quantity Theory of Money
• In classical economics, money is strictly a veil—
it affects the price level, but not the real factors
in the economy
• Increase in money will lead only to increase in
prices, but not output or employment
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Quantity Theory of Money (Cont.)
• Equation of Exchange
– MV=PY
•
•
•
•
Where: M = money supply
V = Income velocity (rate of turnover)
P = price level
Y = real income (GDP)
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Quantity Theory of Money (Cont.)
• Equation of Exchange (Cont.)
– This expression is a truism—true by definition
– Generally, “Y” is referred to as real gross domestic product
(GDP)
– The price level “P” is an index of the current prices of all
goods (CPI)
– The product of “Y  P” represents the nominal level of GDP
– This equation equates total spending (left hand) with total
purchases (right hand)
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Quantity Theory of Money (Cont.)
• Equation of Exchange (Cont.)
– Originally this equation was expressed in terms of
“T”, the total level of transactions
– Includes both real and financial assets
– In this expression, “V” is called the transactions
velocity
– The remainder of this discussion will be in terms of
the income velocity
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Quantity Theory of Money (Cont.)
• The Cambridge Approach
– Restates equation of exchange to focus on fraction of total
expenditure people hold as money
– Manipulation of the equation of exchange results in the
Cambridge cash-balance approach or the demand-formoney equation
• M = kPY
– Where: k = fraction of spending that people have command over in the
form of money balances
– Since “k” = 1/V, both the equation of exchange and the cash-balance
approach are identical
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Quantity Theory of Money (Cont.)
• Quantity Theory of Money
– Re-interprets equation of exchange as a behavioral
relationship—an increase in quantity of money (M)
causes what changes in other variables
– According to the quantity theory of money, a
change in the money supply leads to a
proportionate change in the price level (causeand-effect conclusion)
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Quantity Theory of Money (Cont.)
• Quantity Theory of Money (Cont.)
– The above is based on two propositions:
• “Y” is assumed fixed at full employment levels
• “V” is assumed fixed by payment habits of the population
– The transmission mechanism of an increase in the money
supply is as follows:
•
•
•
•
Money supply increases
Individuals now hold larger cash balances
Reduce cash balances by spending on goods/services
Since output (Y) [real GDP] is fixed, the increased demand drives up
prices with no increase in real output
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Quantity Theory of Money (Cont.)
• Quantity Theory of Money (Cont.)
– Therefore, a change in the money supply leaves the
real amount of goods and services produced (real
GDP) unchanged, but increases the dollar value of
GDP (nominal GDP)
– Money is a veil in the economy and has no effect on
real output or employment levels
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Money Demand and the Quantity
Theory
• When explaining transmission mechanism, cashbalance version (M = kPY) is superior
• The fraction of nominal GDP (PY) people want to
hold in the form of money, k, is determined by many
forces
– It is essentially a transactions demand for money
– Since money is a medium of exchange, the value of k is
influenced by the frequency of receipts and expenditures
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Money Demand and the Quantity
Theory (Cont.)
• Fraction of nominal GDP held as cash (Cont.)
– The ease you can buy on credit also influences k by
permitting people to reduce the average balances in their
checking accounts
– Money is used as a temporary abode of purchasing power—
waiting until an individual wants to spend on real goods or
services
– Although the value of k may vary by individuals, for the
population as a whole it appears to be rather stable
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Money Demand and the Quantity
Theory (Cont.)
• If the money supply increases:
– Individuals hold larger cash balances and spend it on real
goods and services
– Spending will stop when nominal balances have increased
proportionately through price increases
– Therefore, the real value of money (M/P) held is the same in
both the initial and final position
– The increase in money must result in an equal percentage in
prices for the real value of money to be in equilibrium
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Aggregate Demand and Supply: A
Summary
• Figure 22.3
– Price (index of all prices) is measured on the vertical and
quantity (real aggregate output) is on the horizontal
– Since output and income are identical in the classical theory,
the terms income and output are interchangeable
– Aggregate supply curve
• Perfectly vertical at the full employment level of output
• Does not vary with the price level
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FIGURE 22.3 The equilibrium price
level.
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Aggregate Demand and Supply:
A Summary (Cont.)
• Figure 22.3 (Cont.)
– Aggregate demand curve
• Downward sloping
• Drawn for a given level of the money supply (M)
• Hence, a lower price level means that the amount of goods and
services demanded is greater
– Intersection of the supply and demand curve
• Indicates the equilibrium price level
• Flexibility of prices means that a change in aggregate demand will
result in only a change of price at a constant level of output
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Aggregate Demand and Supply:
A Summary (Cont.)
• Figure 22.4
– This shows the effect of shifting the demand curve to
the right by an increase in the money supply
– Before the increase of M, individuals held the right
amount of real cash balances at price P
– However, when the money supply increases, people
now hold too large real cash balances
– They spend until the price increases to P’ and
equilibrium of real cash balances has been restored
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Figure 22.4 An increase in
aggregate demand raises prices
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Aggregate Demand and Supply:
A Summary (Cont.)
• Figure 22.4 (Cont.)
– Continued expansion of the money supply results in
increasing prices (inflation), but not in increased
real output
– Therefore, in classic economic theory, inflation is
a monetary phenomenon and only supported by
ever increasing money supply
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Real Versus Nominal Rates
of Interest
• With the possibility of inflation, it is necessary
to make a distinction between the real rate of
interest and the nominal rate
• Inflation erodes the real purchasing power of
income earned at a given nominal rate of interest
• Real interest = nominal interest – anticipated
inflation
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Real Versus Nominal Rates
of Interest (Cont.)
• Savers and investors will factor inflation when
considering whether to save/invest at a given level of
nominal interest
• Increasing expectations of inflation will drive the
nominal interest rate up until the real interest rate is at
the level determined by savings and investment
• Therefore, inflation will not cause the real rate of
interest to change
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Modern Modifications: Monetarists
and New Classicists
• Modifications to the classical economic theory
were developed at the University of Chicago
starting in the late 1940s
• Monetarists
– Adhere to virtually all tenets of classical economics
– However, they have made some modifications
– They focus on the relationship between M and PY
rather than just M and P
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Modern Modifications: Monetarists
and New Classicists (Cont.)
• Monetarists (Cont.)
– Recognizes the fact that real output may deviate temporarily
from full employment, however, eventually the economy will
tend toward the full employment level of output
– In the 1950s, Milton Friedman replaced the idea of the
stability of velocity with a less restrictive notion that it varies
in a predictable manner
– Money demand may not be a fixed fraction of total spending,
but is related to PY in a close and predictable way
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Modern Modifications: Monetarists
and New Classicists (Cont.)
• Monetarists (Cont.)
– Therefore, in the short run an increase in M might lead to
temporary higher real output, but eventually is reflected just
in higher prices
– Since the monetarists upheld the classical tradition of inherent
stability of the economy at full employment, they rejected
governmental attempts to fine-tune the economy
– Governmental intervention is unnecessary to regulate the
economy and may be potentially damaging
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Modern Modifications: Monetarists
and New Classicists (Cont.)
• New Classical Macroeconomists
– Added another reason for futility of government efforts at
fine-tuning the economy
– Rational Expectations
• People formulate expectations based on all available information and
recognize that the economy will always tend toward full employment
• Therefore, attempts to reduce unemployment by increasing the money
supply will not be successful since people will immediately drive up
prices
• No real effect on economy, just higher prices
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EQUATION 1
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EQUATION 2
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EQUATION 3
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Appendix
GDP DEFINITIONS
AND
RELATIONSHIPS
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APPENDIX—GDP DEFINITIONS
AND RELATIONSHIPS
• Divide the economy into two groups—firms and households
• Gross domestic product (GDP)—total value of goods and
services produced within the United States
• GDP can be measured in two ways
– The total output sold by firms
– The total income received by households
• Figure 22A.1 summarizes these relationships
–
–
–
–
Inner circle records the flows of real things
Outer circle records the associated money flows
Assumes all income (Y) is spent on consumption (C): Y = C
Does not allow for savings
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APPENDIX—GDP DEFINITIONS
AND RELATIONSHIPS (Cont.)
• Saving (S)
– Typically households don’t spend all their income, save some fraction
– This represents a leakage in the circular flow
– Therefore: S = Y - C
• Investment (I)
– Firms want to add to their stock or production facilities
– If firms want to invest exactly what households want to save, equilibrium
has been reached: S = I
– Therefore, the injections into the circular flow by business investment
equals the leakage from saving
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APPENDIX—GDP DEFINITIONS
AND RELATIONSHIPS (Cont.)
• Figure 22A.2 shows the connecting link between saving and
investment in the financial markets
– In the classical model, changes in interest rates would bring desired saving
and investment together
• Role of the government
– Taxes (T) represents a leakage from the circular flow
– Government expenditures (G) represent an injection into the circular flow
• Equilibrium occurs when the total leakages from the spending
stream (S + T) equals total spending injections (I + G): S + T = I
+G
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FIGURE 22A.1 The circular flow of
spending, income, and output.
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FIGURE 22A.2 The circular flow
including saving and investment.
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