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Introduction to Macroeconomics Chapter 21. Classical Macroeconomic Theory

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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

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Leakages and Injections Leakages –Investment –Government Taxes –Imports Injections –Savings –Government Spending –Exports

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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

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

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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%

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Savings Positive Function of Real Interest Rate r0r0 r1r1 S0S0 S1S1 Increase in Real Interest Rate Increase in Savings

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Investment Negative Function of Real Interest Rate r0r0 r1r1 I0I0 I1I1 Increase in Real Interest Rate Decrease in Investment

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Savings - Investment Equilibrium Investment Savings

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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

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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

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Increase in Savings Rate Lower Real Interest Rate Increase in Investment r0r0 r1r1 Savings Investment A B C

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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

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

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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

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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

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