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Lecture 2 The Microfoundations of Money - Part 1

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Lecture Structure The foundations of Classical Monetary theory and the Classical dichotomy The invalidity of the Classical dichotomy neo-Classical monetary theory - the Real Balance Effect Evaluation of RBE The CIA model macro implications

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Classical Interpretation

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Cambridge k Where the Xs are initial endowments, and the Ps are market prices. By aggregation we get (2). Valuing the initial endowments at market prices gives nominal income. Dividing by the general price level P gives a measure of real income. M is the n+1 th good and y is real income.

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Invalid dichotomy Let P rise, then M d > M s by Walras law good market must be in ES by homogeneity postulate rise in P does not effect relative prices so goods market must be in equilibrium thus Says law holds by Walras law the money market is in equilibrium - contradiction!

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Real Balance Effect A change in the price level affects goods markets inversely to the money market. Inclusion of real balances destroys Says identity as all markets in the goods market are affected in the same direction. Now there are n+1 equations plus the price equation = n+2 By Walras law we have n+1 independent equations

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Internal consistency Let all prices double, 2P, kPY>M s = ED m rise in P reduces real balances = ES g ES g = ED m (Walras law) ES g drives down P until real value of money restored Sine Qua Non

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Cash - in - Advance

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C-I-A continued

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C-I-A

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Are government bonds net wealth?

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No-not if future tax liabilities are discounted at the same rate as the income from bonds!

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