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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. Fisher thought that V (velocity) was constant. He thought up reasons why V might be constant

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Chapter 4 The Classical Model

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  1. Chapter 4The Classical Model Aggregate Supply The distribution of output

  2. The Equation of Exchange • Irving Fisher divided nominal GDP by the money supply

  3. Fisher thought that V (velocity) was constant. • He thought up reasons why V might be constant • The technical pay structure of the economy

  4. Suppose V really is constant • The classical economists also believed y was constant as well

  5. So if money supply doubles P must double as well (V and y don’t change)

  6. 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.

  7. 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

  8. In equilibrium

  9. Aggregate Demand.xls

  10. 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

  11. 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

  12. The bond market • Households save by purchasing bonds • Firms borrow by selling bonds • The government borrows by selling bonds.

  13. 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

  14. For a consul that pay $50/Year

  15. 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.

  16. 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).

  17. 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).

  18. Classical savings function

  19. Classical investment function

  20. Interest rate determination in the classical model • s(r)=i(r)

  21. Government budget deficit • Government must borrow (g-t)

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