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Introduction to Macroeconomics

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

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Introduction to Macroeconomics

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  1. Introduction to Macroeconomics Chapter 21. Classical Macroeconomic Theory

  2. 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

  3. Leakages and Injections • Leakages • Investment • Government Taxes • Imports • Injections • Savings • Government Spending • Exports

  4. 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

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

  6. 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%

  7. Savings Positive Function of Real Interest Rate r1 Increase in Real Interest Rate r0 Increase in Savings S0 S1

  8. Investment Negative Function ofReal Interest Rate r1 Increase in Real Interest Rate r0 Decrease in Investment I0 I1

  9. Savings - Investment Equilibrium Savings Investment

  10. 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

  11. 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

  12. Increase in Savings Rate Lower Real Interest Rate Increase in Investment Savings A r0 B r1 C Investment

  13. 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

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

  15. 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

  16. 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

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