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 Investment Government Taxes Imports Injections Savings Government Spending Exports

Supply Creates Its Own Demand 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 Increase in Real Interest Rate r0 Increase in Savings S0 S1

Investment Negative Function of Real Interest Rate Increase in Real Interest Rate r0 Lower real interest rate makes more investment projects profitable and hence undertaken. Decrease in Investment I0 I1

Savings - Investment Equilibrium

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 B r1 C Investment

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 Classical Aggregate Supply Aggregate Demand 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 Money and 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