Download The Theory of the Demand for Money

Chapter 5
Aggregate Demand and
the Classical Theory of
the Price Level
Introduction
• The classical theory of the price level is
sometimes called the quantity theory of money
or the classical theory of aggregate demand.
1. It works well in high-inflation countries.
2. It help us to understand how modern
intertemporal equilibrium theories work.
3. It is incorporated into the neoclassical
synthesis which was used to determine the
economy’s long-run trend level of output.
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The Theory of the Demand for Money
• The classical theory of aggregate demand is
a hybrid that adds a theory of money to the
classical theory of aggregate supply.
• We begin with the budget constraint of a
family in a static, one-period economy.
• Then we show how this constraint is altered
when a family engages in repeated trade
through time, using money as a medium of
exchange.
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The Theory of the Demand for Money
• The classical theory of the demand for money
argues: people ‘demand money’ up to the point
where its marginal benefit equals its marginal
cost.
• Money is a durable good and yields a flow of
exchange services over time.
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The Theory of the Demand for Money
• The cost of holding money is the opportunity
cost of forgoing consumption of some other
commodity.
• The marginal benefit of holding money is the
additional usefulness gained by having cash on
hand to facilitate the process of exchange.
• The classical theorists assumed this benefit to
be proportional to the volume of trade.
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Budget Constraints and Opportunity Cost
• Money imposes an opportunity cost because
the decision to use money reduces the
resources available for other goods.
• Assumption : Money is the only asset
available to households as a store of wealth.
• Thus, if the household chooses not to hold
money, it will be able to purchase additional
commodities.
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Static Barter Economy
• The economy last for only one period of time:
agents exchange labor for commodities they
produce and consume, then the world ends.
PYD

Demand for Commodities
P
Profit
 w LS
Labor Income
• Money can be used as an accounting unit.
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Dynamic Monetary Economy
• The classical theorists argued that since the
typical household does not buy commodities at
the same time that it sells its labor, during an
average week the household has a reserve of
cash on hand to facilitate the uneven timing of
purchases and sales.
• Consider a household that starts the week with
some cash on hand, we call this the
household’s supply of money.
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Dynamic Monetary Economy
• The household earns income each week and
makes routine purchases.
• We call the cash held at the end of the week the
household’s demand for money.
MD
 PYD
 P
Demand for Demand for
Money
Commodities
Profit
 w LS
 MS
Labor Income
Supply of
Money
• Opportunity Cost
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The Benefit of Holding Money
• To classical theorists, the benefit was the
advantage that come from being more easily
able to exchange commodities with other
households – generally acceptable medium of
exchange.
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The Benefit of Holding Money
• Classical theorists argued that the stock of
money that the average household needs at any
point in time is proportional to the dollar value
of its demand for commodities.
MD
Demand for money

k
Propensity to
hold money

PYD
Nominal value of
commodities demand
• The constant k has units of time.
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From Money Demand to a Theory of
the Price Level
• Assumption: the quantity of money demanded
is always equal to the quantity of money
supplied.
• The classical aggregate demand curve:
P
Price level

=
S
M
D
k Y
Supply of money
Propensity to hold money 
aggregate demand for commodities
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From Money Demand to a Theory of
the Price Level
• Each point along the aggregate demand curve
is associated with the same demand for money.
• The aggregate demand curve slopes downward.
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The Classical Aggregate Demand Curve
Figure 5.1
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Irving Fisher and the Velocity of
Circulation
• Fisher : the velocity of circulation
V

Velocity of circulation
=
PT
MS
Average value value of transactions
Nominal money supply
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Irving Fisher and the Velocity of
Circulation
• Assumption:
- T can be approximated by YD
- V is constant
V

PY D
MS
Velocity of circulation
=
Price level  Aggregate Demand
Nominal money supply
- k = 1/V
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The Classical Theory of the Price Level
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The Labor Demand and Supply Diagram
Figure 5.2
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The Production Function Diagram
Figure 5.3
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The Aggregate Supply Curve
Figure 5.4
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The Complete Classical Theory of
Aggregate Demand and Supply
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Equilibrium in the Complete Classical System
Figure 5.5A
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Equilibrium in the Complete Classical System
Figure 5.5B
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Equilibrium in the Complete Classical System
Figure 5.5C
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Equilibrium in the Complete Classical System
Figure 5.5D
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Table 5.1
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The Neutrality of Money
• An important proposition logically follows
from the classical assumption that all markets
are in equilibrium.
• A vertical aggregate supply curve implies that a
fall in aggregate demand will cause a fall in the
price level and leave all real variables
unaffected  The Neutrality of Money.
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The Response to a Reduction in the Money
Supply Predicted by the Classical Model
Figure 5.6A
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The Response to a Reduction in the Money
Supply Predicted by the Classical Model
Figure 5.6B
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The Response to a Reduction in the Money
Supply Predicted by the Classical Model
Figure 5.6C
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The Response to a Reduction in the Money
Supply Predicted by the Classical Model
Figure 5.6D
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Table 5.2
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Money Growth and Inflation
in Three Low-Inflation Countries
Figure 5.7A
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Money Growth and Inflation
in Three Low-Inflation Countries
Figure 5.7B
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Money Growth and Inflation
in Three High-Inflation Countries
Figure 5.8A
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Money Growth and Inflation
in Three High-Inflation Countries
Figure 5.8B
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The Propensity to Hold Money in the
United States
Figure 5.9
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END