Session 3-Classical Model (1).pptx

Session-3
Monetary Theory: The Classical
Model
Lectures:3 hrs
Sources:
1. Chapter 2, Meenai and Ansari
2. CHAPTER 4 Classical Macroeconomics (II): Money,
Prices, and Interest, Richard T Froyen

Understanding the economic models for
effective monetary policy implentation
• The goal of monetary policy is to regulate and
determine the optimal level of money and credit in
order to get the desired affect on major
macroeconomics variables.
• A successful MP requires Atleast following two
elements:
1. A theory or Model of how the economy works and
how the major macroeconomics variables are related
to each other.
2. Secondly, a theory that explains the role of money in
connection major macroeconomics variables.

The mainstream Macroeconomics schools
of thoughts for Monetary Theory
1. Classicals
2. Keynesian economics
3. Monetaris
4. New classical economics, and supply-side
economics
5. New Keynesian
All these theories are based, in varying degrees, on
the classical economics that preceded the advent
of Keynesian economics in the 1930s

Introduction of the Classicals
• Classical model was the first systematic and rigorous
attempt to explain the determinants of such economy
wide or aggregate economic variables as the Price
level, national income, employment and expenditures
• The CM also attempted to show how these variables
were interrelated and how and where money fits in
• Classical economics was the predominant school of
thought from 1770s until the 1930s
• Some of th main Classical Economists were Adam
Smith, David Ricardo, Thomas Malthus, A C Pigou,
• Neo Classicals: Irving Fisher, Alfred Marshall , Walras
etc.

Fundamental Issues
1. What are the key assumptions of classical monetary
theory?
2. How are the aggregate levels of labor employment and real
output of goods and services determined in the classical
theory?
3. What factors determine the price level in the classical
framework?
4. How are interest rates determined in classical monetary
theory?
Copyright © 2004 South-Western. All rights
reserved.
22–5

Fundamental Classical Assumptions
1. Workers, consumers, and businesspersons are motivated by rational self-
interest.
2. Prices and wages are fully flexible
3. Pure competition prevails in the markets for goods and services and for factors
of production.
4. People do not experience money illusion (Money neutrality, Classical
Dichotomy)
5. Economy is always at full employment level (AD=AS, I=S)-'Supply creates its own
demand”- Say’s Law
6. Motive of holding Money: only transactional
7. QTM (Quantity Theory of Money)- basis of determining:
– Nominal income
– Money Demand
– Aggregate Demand
– Price level in the economy
Copyright © 2004 South-Western. All rights
reserved.
22–6

Copyright © 2004 South-
Western. All rights reserved.
22–7
Key Terms
• Money illusion:
– A situation that exists when economic agents change their behavior in response to changes in
nominal values, even if there are no changes in real (price-level-adjusted) values.
• Nominal vs Real values:
– nominal value is measured in terms of money, whereas real value is measured against goods or
services. A real value is one which has been adjusted for inflation, enabling comparison of quantities as
if the prices of goods had not changed on average.
• Money neutrality
Neutrality of money is an important idea in classical economics and is related to the classical dichotomy.
It implies that the central bank does not affect the real economy (e.g., the number of jobs, the size of real
GDP, the amount of real investment) by creating money
• Classical Dichotomy
– Nominal and real variables are independent
• Pure competition:
– There are enough buyers and sellers of a typical good, service, or factor of production that no
single buyer or seller can affect the market prices of these items.

22–8
The Production Function and the determination
of AS in the Classical Model
Production function:
A central relationship in the classical model is the aggregate
production function . The production function, which is based on
the technology of individual firms, is a relationship between the
level of output and the level of factor inputs. For each level of
inputs, the production function shows the resulting level of output
and is written as

22–9
The Aggregate Production Function and the Marginal-Product-of-
Labor (MPN) Schedule
Figure 22–1

22–10
The Marginal Product Of Labor
• Marginal product of labor:
– The change in total output resulting from a one-
unit increase in the quantity of labor employed in
production.
• Law of diminishing marginal returns:
– The law that states that each successive addition
of a unit of a factor of production, such as labor,
eventually produces a smaller gain in real output
produced, other factors held constant.

• MPN decreases with the increase in labor
• this Mpn curve is downward sloping
• A profit maximizing firm will only pay labor
equal to his productivity or contribution in
output and NEVER greater than it
• Thus real wage rate = MP of labor (MPN)

22–12
Labor Demand
• Profit-maximization of labor:
– A firm produces output to the point at which its
marginal revenue (MR), or additional revenue
generated by producing and selling an additional unit
of output, equals its marginal cost (MC), or the
additional cost that it incurs in this activity.
• Because labor is the only variable factor of
production, the marginal cost of each additional
unit of output is the marginal labor cost.
• Marginal labor cost equals the money wage divided
by the number of units of output produced by the
additional unit of labor. employed as the MPN

• The condition for short-run profit
maximization in the perfectly competitive
market is

22–14
The Demand for Labor
Figure 22–2

22–15
Changes in the Real Wage and Labor Supply
Figure 22–3

22–17
The Effects of a Doubling of the
Price Level on the Equilibrium
Nominal Wage, Employment,
and Real Output
Figure 22–5

Effect of change in P on real output, u,
and AS
• When P increases Real wage will decrease and there
will be voluntary unemployment but in the Classical
Model there is no voluntary unemployment because
firm’s know that the productivity of the worker is
actually higher so they are willing to increase the
nominal wage till it again becomes equal to Real wage
rate equivalent to their MPN .
• Thus with the increase in price level there will be no
change in the employment level, real wage rate and
actual output.
• The impact of change in price level will be on nominal
wage rate & nominal income

Effect of change in P on real output, u,
and AS
• Economic agents respond to real changes.
• They have no money illusion
• Nominal variables only affects nominal variables ( P, W)
and they do not affect the real variables (w, Y)
• Y only changes in response to change in Labor (Ns),
Capital or technology.
• Actual output is always equal to potential output and
variation in price have no impact on production
• In the Classical Model, AS is perctly inelastic because ?

22–20
Determination of AD and P in the Classical
Model
• The basis of Price determination, Money demand and
Aggregate Demand in the Classical Model is the QTM
(Quantity Theory of Money).
• To understand the determination of the price level in
the classical system, we analyze the role of money.
• According to Classical Economists the main function of
money is to make transactions or to buy good and
services produced in the economy
• In the classical theory, the quantity of money
determines aggregate demand, which in turn
determines the price level.

Equation of Exchange
• The starting point for the classical quantity
theory of money is the equation of exchange,
an identity relating the volume of transactions
at current prices to the supply of money times
the turnover rate of each dollar.
• This turnover rate for money, which measures
the average number of times each dollar is
used in transactions during the period, is
called the velocity of money .

Equation of Exchange
• where M is the quantity of money, VT is the
transactions velocity of money, PT is the price
index for the items traded, and T is the
volume of transactions.
• T was later replaced by Y (income) and VT by V
• M is again the quantity of money, and V is
now the income velocity of money, the
number of times the average dollar is used in
a transaction involving current output.

Equation of exchange:
– An accounting identity that states that the
nominal value of all monetary transactions for
final goods and services is equal to the nominal
value of the output of goods and services
purchased.
LHS
Value of current dollar
Monetary paymnts on buying
Final goods and services
produced in the economy
RHS
Nominal value of goods and
services produced in the
economy
Ad = AS
EOE is an identity,
that’s it’s true by
definition

From EOE to QTM
The EOE does not tell us anything about the direction of relationship among the variables
It only becomes the QTM or a theory for price determination when the equilibrium values of the
elements in the equation of exchange, with the exception of the price level, are determined by other
forces.
The equation of exchange determines the price level when under the conditions assumed, the price
level varies
(1) directly as the quantity of money in circulation ( M ),
(2) directly as the velocity of its circulation ( V ),
(3) inversely as the volume of trade done by it ( T ).
The first of these three relations constitutes the “quantity theory of money
The EOE turns into QTM with the imposition of two important classical assumptions:
• Full employment/constant real output level (output is supply determined)
• Constant velocity of money in the short run
Money is used mainly for transaction purpose and is controlled by the monetary authority

• According to Fisher and other quantity theorists, the
equilibrium level of velocity was determined by such
institutional factors as payment habits and payment
technology of society and could be regarded as fixed
for the short run .
• If velocity is predetermined and not simply defined
residually to equate MV and PY , the equation of
exchange is not merely a definition.
• With output fixed from the supply side, the equation of
exchange now expresses a relationship of
proportionality between the exogenously given money
supply and the price level:

Quantity Theory of Money (cont’d)
• From the equation of exchange to the
quantity theory of money
– Fisher’s view that velocity is fairly constant in the
short run, so that , transforms the equation of
exchange into the quantity theory of money,
which states that nominal income (spending) is
determined solely by movements in the quantity
of money M
P Y M V
  

Quantity Theory of Money
(Cambridge Equation)
• Demand for money: To interpret Fisher’s quantity theory in terms of the
demand for money…
Divide both sides by V
When the money market is in equilibrium
M = Md
Let
Because k is constant, the level of transactions generated by a fixed level of
PY determines the quantity of Md.
The demand for money is not affected by interest rates
PY
V
M 

1
V
k
1

PY
k
M d



THE CLASSICAL AGGREGATE DEMAND
CURVE
• The quantity theory is the implicit theory of
the aggregate demand for output within the
classical system.
• We can use the quantity theory to construct
the classical aggregate demand curve

22–29
Aggregate Demand Calculation

• Aggregate demand schedule (yd):
– The combinations of various price levels and levels of
real output at which individuals are satisfied with their
consumption of output and their holdings of money.
– As price level increases, the quantity of real output
that HHs desire to purchase declines because as price
level increases the nominal income inreases and HHs
desire to hold more money balances. There will be
leftward movement along the AD curve
– In the classical model the main determinant of AD is
the money supply.

22–31
The Classical Aggregate Demand Schedule
Figure 22–7

• The classical theory of aggregate demand has been termed an implicit
theory.
• The theory is not explicit in the sense that it focuses on the components of
aggregate demand and explains the factors that determine their level.
• Instead, in the classical theory, a given value of MV [or M (1> k )] implies
the level of P * Y that is required for equilibrium in the money market—for
money demand to equal the existing money supply.
• If money demand exceeds (falls short of) money supply, there will be a
spillover to the commodity market as individuals try to reduce (increase)
their expenditures
• on commodities. Points along the Yd schedule are points at which firms
and households
• are in equilibrium with regard to their money holdings and, therefore, are
also at
• equilibrium rates of expenditures on commoditi

22–33
Output Market Equilibrium in the
Classical Model
Figure 22–8

• For a given supply of money, we trace out a downward-sloping
aggregate demand curve that can be put together with the vertical
aggregate supply curve to illustrate the determination of price and
output in the classical model.
• Increasing the money supply shifts the aggregate demand curve
upward to the right.
• Because the supply curve is vertical, increases in demand do not
affect output. Only the price level increases.
• For a given value of k (or V ), a change in the quantity of money is
the only factor that shifts the aggregate demand curve .
• Because the equilibrium value of k (or V ) was considered to be
stable in the short run, aggregate demand varied only with the
supply of money.

Quantity Theory of Money (cont’d)
• Velocity fairly constant in short run
• Aggregate output at full-employment level
• Changes in money supply affect only the price
level
• Movement in the price level results solely from
change in the quantity of money

22–36
The Income Velocity of Money in the United States
Figure 22–9
SOURCES: Economic Report of the President, 2002;
Economic Indicators; Federal Reserve Bulletin, various issues.

• In the classical system, the components of
aggregate demand—consumption,
investment, and government spending—play
their explicit role in determining the interest
rate.
• It is, in fact, the interest rate that guarantees
that exogenous changes in the particular
components of demand do not affect
aggregate demand.

22–38
The Classical Market for
Loanable Funds
Figure 22–10

• This stabilizing role of the interest rate is important to the
classical system.
• The interest-rate adjustment is the first line of defense for
full employment. Shocks that affect consumption demand,
investment demand, or government demand will not affect
the demand for output as a whole.
• These shocks will not shift the aggregate demand curve in
• Even if they did, there would be no effect on output or
employment because of the self-adjusting properties of the
classical labor market as reflected in the vertical aggregate
supply curve—the second line of defense for full
employment

The Classical Theory of the Interest
Rate
• The equilibrium interest rate in the classical theory was
the rate at which the amount of funds individuals
desired to lend was just equal to the amount others
desired to borrow.
• For simplicity, we assume that borrowing consists of
selling a standard bond, The simplest assumption is
that the standard bond is a perpetuity, a bond that
pays a perpetual stream of interest payments with no
return of principal.
• The interest rate depends on the factors that
determine the levels of bond supply (borrowing) and
bond demand (lending).

The Classical Theory of the Interest
Rate
• There are two agents which required funds i.e
Firms and Govt
• In the classical model, the level of business
investment was a function of the expected
profitability of investment projects and the rate
of interest.
• Classical term the saving as supply of loanable
funds and Investment is the demand for loanable
funds.
• Using these information we can formulate the
following equilibrium

The equilibrium interest rate r0 is the rate that equates the supply of loanable funds, which consists of saving ( S),
with the demand for loanable funds, which consists of investment ( I) plus the bond- financed government deficit
(G-T) .

A Declined in Autonomous
investment:
An autonomous decline in investment
shifts the investment schedule to the
left from I0 to I1
—the distance ΔI.The equilibrium
interest rate declines from r0 to r1.
As the interest rate falls, there is an
interest-rate–induced increase in
investment—distance B.
There is also an interest-rate–induced
decline in saving, which is an equal
increase in consumption—distance A.
The interest rate–induced increases in
consumption and investment just
balance the autonomous decline in
investment.

Role of interest rate in classical System
• This stabilizing role of the interest rate is important to
the classical system.
• The interest-rate adjustment is the first line of defense
for full employment. Shocks that affect consumption
demand, investment demand, or government demand
will not affect the demand for output as a whole.
• Even if they did, there would be no effect on output or
employment because of the self-adjusting properties
of the classical labor market as reflected in the vertical
aggregate supply curve—the second line of defense for
full employment.

Policy Implications of the Classical
Equilibrium Model( Effect of
Fiscal/Monetray Policy) on output
employment

Govt. Policy Options Summary
Govt. Policies Tools Types
Method to
conduct
Expansionary
Policy
Method to
conduct
Contractionary
Policy
Objectives of
Expansionary
Policy
Objectives of
Contractionary
Policy
Fiscal Policy
1. Govt. Spending (G)
2. Taxes (T)
1. Expensionary
2. Contractionary
G- Increased
T- decreased
G- Decreased
T- Increased
1. Unemployment
2. GDP Growth
1. Inflation
2. Current A/C
Balance
Monetary
Policy
1. Money Supply (M)
2. Discount Rate (I)
1. Expensionary
2. Contractionary
M- Increased
I- decreased
M- Decreased
I- Increased
1. Unemployment
2. GDP Growth
1. Inflation
2. Current A/C
Balance

Fiscal Policy Effects: An Expansionary
Policy
• Govt spending(Increased); possible sources of finance are taxation,
borrowing and money printing.
• Fiscal policy tool of govt spending will affect the S & I. The effect in the
loanable funds market of an increase in government spending
financed by a sale of bonds to the public is mentioned bellow.

Crowding Out
• The increase in government spending financed
by selling bonds to the public pushes the
interest rate up by enough to “crowd out” an
equal amount of private expenditure
(consumption plus investment).

MONETARY POLICY
• In the classical system, the quantity of money
determines the price level and the level of
nominal income. In this sense, monetary policy
was quite important to classical economists.
Stable money was a requirement for stable
prices.
• In another sense, money was not important. The
quantity of money did not affect the equilibrium
values of the real variables in the system: output,
employment, and the interest rate.

22–50
Possible Factors in a Leftward Shift of
the Aggregate Supply Schedule
• Lower labor force participation
• A decline in labor productivity
• Higher marginal tax rates on wages
• Provision of government benefits that give
households incentives not to supply labor
services to firms.

Summary/Key conclusion of the
Classical Model
• Classical theory assumptions include the beliefs that:
– markets self-regulate
– prices are flexible for goods and wages
– supply creates its own demand (Y=full employment level=potential level)
– and there is equality between savings and investments. (I=S)
– Real interest rate ensures S=I because I and S are very responsive to changes in interest rate and there
is no concept of hoarding money. If people don’t consume, they save. And demand and supply of
loanable funds (S, I) due vto their responsiveness to changes the n interest rate always become equal at
the equilibrium real interest rate.
– Md =kPy (Md is only a function of mom nominal income and is NOT affected by changes in interest rate)
– Real variables like real output or AS, real wage rate, employment level and real interest rate are not
affected by changes in Money or prices (nominal variables)- There is no Money illusion, Money is neutral
– Classical Dichotomy
• Prices are mainly a function of supply of money in the economy (MV=Py) or
M V
P
Y



Classical Model in a nutshell
• Say’s Law:In the classical model supply creates its own demand-SAY’S
LAW-because : markets are perfect and self regulatory and resources are
always fully utilized –all the leakages (e.g: S) gets back into the economy
(e.g:in shape of I).
• Interest rate is determined in the loanable fund market Investment is very
elastic to changes in interest rate while money demand is perfectly
inelastic to changes in interest rate (no speculative money demand)
• Velocity and output are constant (stable). Thus for a given change in
money supply, there will be proportional change in the price level-Quantity
Theory of Money
• Classical Dichotomy: Changes in nominal variables (Money Supply) do not
change the real variables (real output, real wage, real interest rate or
employment level) but only affect the nominal variables (nominal income,
prices, nominal wages and nominal interest rate) as people are rational
and have no Money illusion
• Money is neutral and monetary policy can is ineffective in changing the
real output but should be used to stabilize the price level

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