Aggregate Demand and the Classical Theory of the Price Level Chapter 5
Dec 19, 2015
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.
Demand for Commodities Profit Labor Income
D SP Y P w L
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
Demand for Demand for Profit Labor Income Supply of
Money Commodities Money
D D S SM P Y P w L M
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.
Demand for money Propensity to Nominal value of
hold money commodities demand
D DM k P Y
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:
Supply of moneyPrice level
Propensity to hold money aggregate demand for commodities
=
S
D
MP
k Y
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.
15
Irving Fisher and the Velocity of Circulation
• Fisher : the velocity of circulation
Average value value of transactionsVelocity of circulation
Nominal money supply=
S
PTV
M
16
Irving Fisher and the Velocity of Circulation
• Assumption:
- T can be approximated by YD
- V is constant
- k = 1/V
Price level Aggregate DemandVelocity of circulation
Nominal money supply=
D
S
PYV
M
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
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
37Figure 5.9©2002 South-Western College Publishing
The Propensity to Hold Money in the United States