Aggregate Demand and the Classical Theory of the Price Level Chapter 5

2 Introduction The classical theory of the price level is sometimes called the quantity theory of money or the classical theory of aggregate demand. 1. It works well in high-inflation countries. 2. It help us to understand how modern intertemporal equilibrium theories work. 3. It is incorporated into the neoclassical synthesis which was used to determine the economy’s long-run trend level of output.

3 The Theory of the Demand for Money The classical theory of aggregate demand is a hybrid that adds a theory of money to the classical theory of aggregate supply. We begin with the budget constraint of a family in a static, one-period economy. Then we show how this constraint is altered when a family engages in repeated trade through time, using money as a medium of exchange.

4 The Theory of the Demand for Money The classical theory of the demand for money argues: people ‘demand money’ up to the point where its marginal benefit equals its marginal cost. Money is a durable good and yields a flow of exchange services over time.

5 The Theory of the Demand for Money The cost of holding money is the opportunity cost of forgoing consumption of some other commodity. The marginal benefit of holding money is the additional usefulness gained by having cash on hand to facilitate the process of exchange. The classical theorists assumed this benefit to be proportional to the volume of trade.

6 Budget Constraints and Opportunity Cost Money imposes an opportunity cost because the decision to use money reduces the resources available for other goods. Assumption : Money is the only asset available to households as a store of wealth. Thus, if the household chooses not to hold money, it will be able to purchase additional commodities.

7 Static Barter Economy The economy last for only one period of time: agents exchange labor for commodities they produce and consume, then the world ends. Money can be used as an accounting unit.

8 Dynamic Monetary Economy The classical theorists argued that since the typical household does not buy commodities at the same time that it sells its labor, during an average week the household has a reserve of cash on hand to facilitate the uneven timing of purchases and sales. Consider a household that starts the week with some cash on hand, we call this the household’s supply of money.

9 Dynamic Monetary Economy The household earns income each week and makes routine purchases. We call the cash held at the end of the week the household’s demand for money. Opportunity Cost

10 The Benefit of Holding Money To classical theorists, the benefit was the advantage that come from being more easily able to exchange commodities with other households – generally acceptable medium of exchange.

11 The Benefit of Holding Money Classical theorists argued that the stock of money that the average household needs at any point in time is proportional to the dollar value of its demand for commodities. The constant k has units of time.

12 From Money Demand to a Theory of the Price Level Assumption: the quantity of money demanded is always equal to the quantity of money supplied. The classical aggregate demand curve:

13 From Money Demand to a Theory of the Price Level Each point along the aggregate demand curve is associated with the same demand for money. The aggregate demand curve slopes downward.

14 ©2002 South-Western College Publishing The Classical Aggregate Demand Curve Figure 5.1

15 Irving Fisher and the Velocity of Circulation Fisher : the velocity of circulation

16 Irving Fisher and the Velocity of Circulation Assumption: -T can be approximated by Y D -V is constant -k = 1/V

17 The Classical Theory of the Price Level

18 ©2002 South-Western College Publishing Figure 5.2 The Labor Demand and Supply Diagram

19 ©2002 South-Western College Publishing Figure 5.3 The Production Function Diagram

20 ©2002 South-Western College Publishing Figure 5.4 The Aggregate Supply Curve

21 The Complete Classical Theory of Aggregate Demand and Supply

22 ©2002 South-Western College Publishing Equilibrium in the Complete Classical System Figure 5.5A

23 ©2002 South-Western College Publishing Equilibrium in the Complete Classical System Figure 5.5B

24 ©2002 South-Western College Publishing Equilibrium in the Complete Classical System Figure 5.5C

25 ©2002 South-Western College Publishing Equilibrium in the Complete Classical System Figure 5.5D

26 ©2002 South-Western College Publishing Table 5.1

27 The Neutrality of Money An important proposition logically follows from the classical assumption that all markets are in equilibrium. A vertical aggregate supply curve implies that a fall in aggregate demand will cause a fall in the price level and leave all real variables unaffected  The Neutrality of Money.

28 ©2002 South-Western College Publishing Figure 5.6A The Response to a Reduction in the Money Supply Predicted by the Classical Model

29 ©2002 South-Western College Publishing Figure 5.6B The Response to a Reduction in the Money Supply Predicted by the Classical Model

30 ©2002 South-Western College Publishing Figure 5.6C The Response to a Reduction in the Money Supply Predicted by the Classical Model

31 ©2002 South-Western College Publishing Figure 5.6D The Response to a Reduction in the Money Supply Predicted by the Classical Model

32 ©2002 South-Western College Publishing Table 5.2

33 ©2002 South-Western College Publishing Figure 5.7A Money Growth and Inflation in Three Low-Inflation Countries

34 ©2002 South-Western College Publishing Figure 5.7B Money Growth and Inflation in Three Low-Inflation Countries

35 ©2002 South-Western College Publishing Figure 5.8A Money Growth and Inflation in Three High-Inflation Countries

36 ©2002 South-Western College Publishing Figure 5.8B Money Growth and Inflation in Three High-Inflation Countries

37 Figure 5.9 ©2002 South-Western College Publishing The Propensity to Hold Money in the United States

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