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
Investment
Government Taxes
Imports
Injections
Savings
Government Spending
Exports

4. 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

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 ,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 %

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

8. 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

9. Savings - Investment Equilibrium

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 InvestmentB 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 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