Chapter 4The Classical Model

Aggregate SupplyThe distribution of output

The Equation of Exchange

• Irving Fisher divided nominal GDP by the money supply

Price Levelreal income

money supply

s

s

PyVM

Py

M

• Fisher thought that V (velocity) was constant.

• He thought up reasons why V might be constant– The technical pay structure of the economy

• Suppose V really is constant• The classical economists also believed y

was constant as well

1

s

s

s

PyVM

M V Py

M PyV

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

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.

• 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

dM kPy

• In equilibrium

s dM M kPy

Note simularity to1sM PyV

• Aggregate Demand.xls

• 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

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

The bond market

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

Bond supply: government bonds + corporate bonds

Bond demand: household savings S

B

B

S

D

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

For a consul that pay $50/Year

Price r (interest)

$250 20%

$500 10%

$1000 5%

• 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.

PB

SB

DB

B

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).

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).

Classical savings function

• 0

0r

r

s s s rs

r

s(r)=s0 +sr r

r1

s0 s

Classical investment function

• 0( )0

r

r

i r i i ri

r i(r)=i0 +ir r

r1

i1 i0 i

Interest rate determination in the classical model

• s(r)=i(r)

r i(r)=i0 +ir r s(r)=s0 +sr r

re

i=s i,s

Government budget deficit

• Government must borrow (g-t)

r

s(r)

re i(r)+(g- t)

i(r) s=i+(g-t) i+(g-t),s