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

Real Interest Rate = Nominal Interest Rate - Expected Inflation

Purchase 1-year T-bill $100,000

Earn 6% per year nominal interest 6,000

Sell T-bill 1 year from now $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 $2,000

Real rate of return 2%

Savings Positive Function of Real Interest Rate

Savings

Rea

l In

tere

st R

ate

r0

r1

S0 S1

Increase in RealInterest Rate

Increase inSavings

Investment Negative Function ofReal Interest Rate

Investment

Rea

l In

tere

st R

ate

r0

r1

I0 I1

Increase in RealInterest Rate

Decrease inInvestment

Savings - Investment Equilibrium

Savings or Investment

Rea

l In

tere

st R

ate

Investment

Savings

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 and Investment

Rea

l In

tere

st R

ate

r0

r1

Savings

Investment

AB

C

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

0

0

Output

Av

erag

e P

rice

Lev

elClassical Aggregate Supply

AggregateDemand

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 Moneyand 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