Introduction to Macroeconomics Chapter 21 Classical Macroeconomic Theory

Introduction to Macroeconomics Chapter 21. Classical Macroeconomic Theory

Chapter 21. Classical Macroeconomics • Cornerstones of Classical Theory – – Say’s Law Interest Rate flexibility Price-Wage flexibility Aggregate Supply • Classical Theory and Policy – Fiscal Policy – Monetary Policy and the quantity theory of money

Leakages and Injections • Leakages – Investment – Government Taxes – Imports • Injections – Savings – Government Spending – Exports

Say’s Law Supply Creates Its Own Demand From circular flow: income = expenditures if leakages = injections Economy will operate at full employment if real interest rate, prices and wages are flexible

Interest Rate Flexibility • Real Interest Rate, Savings and Investment • Savings - Investment Equilibrium • Role of Interest Rate Flexibility

Real Interest Rate = Nominal Interest Rate - Expected Inflation Purchase 1 -year T-bill Earn 6% per year nominal interest Sell T-bill 1 year from now $100, 000 6, 000 $106, 000 If expected inflation is 4%, goods that cost $100, 000 today will cost $104, 000 one year from now Net profit 1 year from now Real rate of return $2, 000 2%

Savings Positive Function of Real Interest Rate r 1 Increase in Real Interest Rate r 0 Increase in Savings S 0 S 1

Investment Negative Function of Real Interest Rate r 1 Increase in Real Interest Rate r 0 Decrease in Investment I 0 I 1

Savings - Investment Equilibrium Savings Investment

Savings - Investment Equilibrium » AD = C + I + G + NX • Assume no government (G = 0) no foreign trade (NX = 0) » AD = Consumption + Investment • Income = Consumption + Savings Substitute for Consumption: » AD = (Income - Savings) + Investment • Assume in equilibrium (Say’s Law): » AD = Income • Then in equilibrium: » Savings = Investment

Role of Interest Rate Flexibility • Unexpected reduction in Consumption expenditures (Savings increase) • AD less than AS at full-employment output • Interest rate declines – Investment increases – Savings decline -> Consumption increases (but not by as much as the original change) • AD returns to original level – Full-employment output maintained – Composition of AD has changed

Increase in Savings Rate Lower Real Interest Rate Increase in Investment Savings r 0 r 1 A B C Investment

Price - Wage Flexibility • Unexpected decline in AD • Prices fall (supply chasing fewer buyers) • Purchasing power of money increases • AD returns to original level – full-employment output maintained – composition of AD unchanged – only thing that has changed are prices

Aggregate Supply and Demand Classical Aggregate Supply Aggregate Demand Full-employment output

Classical Theory and Government Policy • Balance the Budget - deficit spending crowds out investment spending • Keep Government Small - high taxes reduce incentive to work • Laissez Faire - no government interference in economy • Free Foreign Trade

Quantity Theory of Money and Monetary Policy M • V=P • Y M = money supply V = “velocity” of money P = average price level Y = real output Assume V is constant. Since Y is always at full-employment output, a change in M only changes P Monetary Policy ineffective in changing output