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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**

Investment Government Taxes Imports Injections Savings Government Spending Exports

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**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

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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 ,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 %

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**Savings Positive Function of Real Interest Rate**

Increase in Real Interest Rate r0 Increase in Savings S0 S1

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**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

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**Savings - Investment Equilibrium**

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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**

B r1 C Investment

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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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