Download Chapter 23 The Classical Foundations

Chapter 23
The Classical Foundations
Monetary Theory and Policy
Classic System of Economics:
1.
Say’s Laws
“supply creates its own demand”
Total spending (demand) would always be sufficient to justify production
at full employment (supply).
Production function:
Potential output of economy determined by size of labor force available to
work with the existing stock of capital goods. Say argued that production
would always be at full employment. Prices and wages were flexible and
would adjust to assure that markets would clear.
Argument against Say by Malthus :
Nothing forcing spending to equal production: supply creates its own
purchasing power (income) but not its own demand (spending)
Key to Classical Economics:
Overall level of the interest in the market is the key—interest rates
fluctuate to make entrepreneurs want to invest and households want to
save.
Classical Interest Theory:
Increase rates result in more savings and less investments.
Determine rate where S=I
If savings >Investments then rates drop until S=I
If investments > savings then rates increase until S=I
2.
Quantity Theory
- Earliest Major Theory
- Composition of goods/services
- Equation of exchange:
MV = PQ
where
M= amount of money in the economy
V=velocity of money (average of times each dollar changes hands per year)
P= weighted average price of goods and services in the economy
Q=quantity of goods and services sold
PQ=total value of goods and services produced
-
Equation of exchange (if only consider new goods/services in their
final state):
MV y = Py y
where
M= amount of money in the economy
Vy = velocity of income
P= weighted average price of goods and services in the economy
y= real GNP
P y y = GNP
If V is constant then a change in M will result in a predictable change in PQ since Q was
assumed to be constant in the short run. This assumption was used in the creation of this
relationship--the time period was pre- industrial and much of the country’s livelihood was
rural. With these assumptions, if money supply increased then the average price level
increased since both quantity and velocity was assumed fixed in the short-run.
Money is primarily a medium of exchange. In the long -run, changes in velocity and
output are not a result of changes in money.
Since V and Q do not change, a change in M results in an equal change in P. Since
Govt contro lled M, the Govt controlled price stability.
Equation of exchange:
Transactions included not only total output of new goods and services but
purchases and sales of financial assets and of existing assets.
MVT = P T
Where P T represents total transactions in the economy
VT represents transaction velocity
Or
MVY = PYy
Where Py y represents GDP in current dollars
VY represents income velocity
Cambridge Approach (Cash-balance Approach)
M = k PY
Where k=(1/V)
Interpretation: demand for money equation
Example: If k=1/4 then if GDO increases by 400 then money increases by 100
According to Quantity Theory of Money a change in money supply produces a
proportionate change in price level based on the assumptions that: (1) Y is fixed at full
employment and V is fixed due to payment habits of the community.
Message of classical theory is that inflation is a monetary phenomenon
Monetarists focus on inflation--slow money growth will avoid the inflationary affects
Modern Quantity Theory of Money
Monetarists have revised this equation to allow quantity to fluctuate--call theory the
Modern Quantity Theory of Money. Velocity changes in a predictable manner and is
not related to fluctuations in the money supply. Therefore, the equation can still be
applied to assess how money can affect aggregate spending. Real output can deviate
temporarily from full employment. Monetarists advocate stable, low growth in the
money supply--allows economic problems to resolve themselves
Rational Expectations
People formulate expectations based upon all available information. Recognizing that
economy tends toward full employment implies an increase in the money supply to
decrease unemployment will only result in an increase in prices.
Keynesian Theory
Advocates active role of the federal government in correcting economic problems
Manipulate money supply to adjust interest rates to induce borrowing or decrease
borrowing
Looks at the short-run--sees immediate problem, fix it now, rather than let it fix
itself
Liquidity Preference Theory - Market rate of interest is determined by
demand/supply of money balances.
Demand of Money
Transaction
Precautionary
Speculative
+
f(y)
f(r)
Since:
+
−
D m = f (Y , r )
If MS increases then either income increases or interest rates drop.
Supply of Money
Fed basically determines supply
Few uncontrollable factors
(1) banks lending
(2) public's preference for cash
Letting D=S then solve for interest rate:
+
r= f (
Y
−
,M ,
•
+
P
)
e
Liquidity Trap: At some point rates will not drop further. At this point no one would
trade money for bonds.
Keynesian Focus
Focus on aggregate spending as the variable that must be adjusted through
adjusting interest rates:
ie. Excessive inflation--Keynesians see it as excessive spending (demandpull inflation) so they would manipulate money supply to raise interest
rates to decrease spending
Focus on ensuring low unemployment
Keynesians vs Monetarists
Break with Quantity Theory (Monetarists):
1. Since interest rattes change when MS change, the rigid proportinal link
between money and income is broken.
2. If the demand for money depends on interest rates, then velocity is a
function of interest rates which implies income no longer proportional
to change in money supply.
Reaction to Recession:
Keynesians immediately increase money supply to drive rates lower (later
inflation)
Monetarists allow lack of spending in economy to lower rates gradually
Keynesians assume that the quantity of loanable funds does not change when monetary
supply is adjusted (reduced/increased) Monetarists and Rational Expectations suggest
that when money supply is increased, inflationary expectations rise which cause a higher
demand for loanable funds This shifts the demand curve which could offset the shift in
the supply curve caused by the monetary policy decision. If both demand and supply
shift equally, no change occurs in the interest rate would occur and business investment
would not change
FOMC decision reflect both Monetarists and Keynesian viewpoints. In addition, their
political affiliation tends to be related to their viewpoints--those appointed by a
democratic president tend to favor loose monetary policy while those appointed by a
republican president tend to favor tighter monetary policies.
Classical interest theory
© 2000 Addison Wesley Longman
Figure 23.1
Increasedsavingcallsforthincreasedinvestment
©2000AddisonWesleyLongman
Figure23.2
The equilibrium price level
© 2000 Addison Wesley Longman
Figure 23.3
An increase in aggregate demand raises prices
© 2000 Addison Wesley Longman
Figure 23.4