Chapter 23 the Classical Foundations

Chapter 23 The Classical Foundations

Monetary Theory and Policy

Classic System of Economics: 1. Say’s Laws “supply creates its own demand”

Total spending (demand) would always be sufficient to justify production at full employment (supply).

Production function: Potential output of economy determined by size of labor force available to work with the existing stock of capital goods. Say argued that production would always be at full employment. Prices and wages were flexible and would adjust to assure that markets would clear.

Argument against Say by Malthus: Nothing forcing spending to equal production: supply creates its own purchasing power (income) but not its own demand (spending)

Key to Classical Economics: Overall level of the interest in the market is the key—interest rates fluctuate to make entrepreneurs want to invest and households want to save.

Classical Interest Theory: Increase rates result in more savings and less investments. Determine rate where S=I If savings >Investments then rates drop until S=I If investments > savings then rates increase until S=I

2. Quantity Theory - Earliest Major Theory - Composition of goods/services - Equation of exchange:

MV = PQ

where M= amount of money in the economy V=velocity of money (average of times each dollar changes hands per year) P= weighted average price of goods and services in the economy Q=quantity of goods and services sold PQ=total value of goods and services produced

- Equation of exchange (if only consider new goods/services in their final state):

MV y = Py y

where M= amount of money in the economy Vy= velocity of income P= weighted average price of goods and services in the economy y= real GNP P y y = GNP

If V is constant then a change in M will result in a predictable change in PQ since Q was assumed to be constant in the short run. This assumption was used in the creation of this relationship--the time period was pre-industrial and much of the country’s livelihood was rural. With these assumptions, if money supply increased then the average price level increased since both quantity and velocity was assumed fixed in the short-run. Money is primarily a medium of exchange. In the long-run, changes in velocity and output are not a result of changes in money.

Since V and Q do not change, a change in M results in an equal change in P. Since Govt controlled M, the Govt controlled price stability.

Equation of exchange: Transactions included not only total output of new goods and services but purchases and sales of financial assets and of existing assets. MVT = P T Where P T represents total transactions in the economy VT represents transaction velocity Or MVY = PYy Where Pyy represents GDP in current dollars VY represents income velocity

Cambridge Approach (Cash-balance Approach)

M = k P Y Where k=(1/V) Interpretation: demand for money equation Example: If k=1/4 then if GDO increases by 400 then money increases by 100

According to Quantity Theory of Money a change in money supply produces a proportionate change in price level based on the assumptions that: (1) Y is fixed at full employment and V is fixed due to payment habits of the community.

Message of classical theory is that inflation is a monetary phenomenon Monetarists focus on inflation--slow money growth will avoid the inflationary affects

Modern Quantity Theory of Money

Monetarists have revised this equation to allow quantity to fluctuate--call theory the Modern Quantity Theory of Money. Velocity changes in a predictable manner and is not related to fluctuations in the money supply. Therefore, the equation can still be applied to assess how money can affect aggregate spending. Real output can deviate temporarily from full employment. Monetarists advocate stable, low growth in the money supply--allows economic problems to resolve themselves

Rational Expectations

People formulate expectations based upon all available information. Recognizing that economy tends toward full employment implies an increase in the money supply to decrease unemployment will only result in an increase in prices.

Keynesian Theory Advocates active role of the federal government in correcting economic problems Manipulate money supply to adjust interest rates to induce borrowing or decrease borrowing Looks at the short-run--sees immediate problem, fix it now, rather than let it fix itself

Liquidity Preference Theory - Market rate of interest is determined by demand/supply of money balances.

Demand of Money + Transaction f(y) Precautionary - Speculative f(r)

Since:

+ - D m = f (Y , r )

If MS increases then either income increases or interest rates drop.

Supply of Money Fed basically determines supply

Few uncontrollable factors (1) banks lending (2) public's preference for cash

Letting D=S then solve for interest rate:

· + - + r = f ( Y , M , P ) e

Liquidity Trap: At some point rates will not drop further. At this point no one would trade money for bonds.

Keynesian Focus Focus on aggregate spending as the variable that must be adjusted through adjusting interest rates: ie. Excessive inflation--Keynesians see it as excessive spending (demand- pull inflation) so they would manipulate money supply to raise interest rates to decrease spending Focus on ensuring low unemployment

Keynesians vs Monetarists Break with Quantity Theory (Monetarists): 1. Since interest rattes change when MS change, the rigid proportinal link between money and income is broken. 2. If the demand for money depends on interest rates, then velocity is a function of interest rates which implies income no longer proportional to change in money supply.

Reaction to Recession: Keynesians immediately increase money supply to drive rates lower (later inflation) Monetarists allow lack of spending in economy to lower rates gradually

Keynesians assume that the quantity of loanable funds does not change when monetary supply is adjusted (reduced/increased) Monetarists and Rational Expectations suggest that when money supply is increased, inflationary expectations rise which cause a higher demand for loanable funds This shifts the demand curve which could offset the shift in the supply curve caused by the monetary policy decision. If both demand and supply shift equally, no change occurs in the interest rate would occur and business investment would not change

FOMC decision reflect both Monetarists and Keynesian viewpoints. In addition, their political affiliation tends to be related to their viewpoints--those appointed by a democratic president tend to favor loose monetary policy while those appointed by a republican president tend to favor tighter monetary policies. Classical interest theory

Increased saving calls forth increased investment