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Lecture 2

Lecture 2. The Microfoundations of Money - Part 1. Lecture Structure. The foundations of Classical Monetary theory and the Classical dichotomy The invalidity of the Classical dichotomy neo-Classical monetary theory - the Real Balance Effect Evaluation of RBE The CIA model

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Lecture 2

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  1. Lecture 2 The Microfoundations of Money - Part 1

  2. Lecture Structure • The foundations of Classical Monetary theory and the Classical dichotomy • The invalidity of the Classical dichotomy • neo-Classical monetary theory - the Real Balance Effect • Evaluation of RBE • The CIA model • macro implications

  3. Classical Interpretation

  4. Cambridge ‘k’ • Where the Xs are initial endowments, and the Ps are market prices. • By aggregation we get (2). Valuing the initial endowments at market prices gives nominal income. • Dividing by the general price level P gives a measure of real income. • M is the n+1th good and y is real income.

  5. Invalid dichotomy • Let P rise, then Md > Ms • by Walras’ law good market must be in ES • by homogeneity postulate rise in P does not effect relative prices so goods market must be in equilibrium • thus Say’s law holds • by Walras’ law the money market is in equilibrium - contradiction!

  6. Real Balance Effect • A change in the price level affects goods markets inversely to the money market. • Inclusion of real balances destroys Say’s identity as all markets in the goods market are affected in the same direction. • Now there are n+1 equations plus the price equation = n+2 • By Walras’ law we have n+1 independent equations

  7. Internal consistency • Let all prices double, 2P, kPY>Ms = EDm • rise in P reduces real balances = ESg • ESg = EDm (Walras’ law) • ESg drives down P until real value of money restored • Sine Qua Non

  8. Cash - in - Advance

  9. C-I-A continued

  10. C-I-A

  11. Are government bonds net wealth?

  12. No-not if future tax liabilities are discounted at the same rate as the income from bonds!

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