Lecture III Flashcards
This set also assumes the classical model.
Describe Fisher’s Quantity Theory.
Fisher greatly advanced the quantity theory by coupling it with the equation of exchange.
MV = PY
M is the money supply, V is the velocity of money, P is the price level, and Y is the real level of output. PY is of course nominal output.
What is velocity in the Fisher Model?
Velocity measures the turnover rate of money (money being currency and demand deposits) in the economy, i.e. how many times on average a pound coin changed hands in a year. For example, if nominal output PY was $100 and the money supply M was $20, it means that each dollar was used an average of 5 times.
In Fisher’s Model, does the quantity of money determine the price level?
Fisher’s quantity theory of money
(sometimes called the transactions quantity theory): the quantity of money determines the price level.
An increase in the money supply increases demand for goods, but does not increase the productive capacity of the economy to produce more goods—it is demand without
production to match it; prices simply increase.
How did the Cambridge Theory differ from the Fisher Theory?
Both believed that changes in the money
supply generate changes in prices, but the Cambridge economists developed a model of money demand to analyze how people decide how much money to hold, and therefore how changes in the money supply will affect their optimum money holdings.
Describe the Cambridge Model’s equation.
Since in equilibrium money demand must be equal to money supply (M), we have:
M = MD = kPY
Demand for money (MD) would be a
proportion, k, of nominal income (PY).
Marshall and Pigou also expected k and Y to be fixed exogenously.
Describe the Classical Aggregate Demand Curve.
MV = PY (or M = kPY)
the AD curve is derived by plotting different combinations of P and Y for a fixed money
supply (M). For example, if V is a constant 2.0 and M = 600, we know that PY = 1200.
we find a downward sloping AD curve: the
aggregate quantity demanded increases as the price level decreases for a given quantity of money–you demand more the cheaper goods are.
What are some of the major impacts on the AS and AD curves in the classical model?
The classical AD and AS curves determine output equilibrium independently of price level changes. Money supply shifts the AD curve, affecting prices. Real factors determine output equilibrium, shifting AS and influencing prices and output. The quantity of money shapes the AD curve, impacting the price level.
Explain why AD(bar) always equates to C + I + G in the classical model.
The classical model argued that any change in any component of aggregate demand—consumption, investment, and government
spending—would be matched by a counterbalancing change in one of the other components, and the interest rate was the mechanism that ensured this result.
Describe the supply and demand for loanable funds.
The demand for bonds is called supply of loanable funds in classical terminology.
Likewise, the supply of bonds by borrowers is termed demand for loanable funds.
The supply of loanable funds is expected to be a positive function of the interest rates. Recall that individuals can either consume or save their income.
At higher interest rates, the opportunity cost of consumption increases and people are more willing to forego current consumption to take advantage of higher interest rates. Therefore, the supply of loanable funds curve is upward sloping.
Further elaborate on the Demand for Loanable Funds and its components.
The demand for loanable funds comprises business investment and government borrowing (g-t). Investment rises as interest rates fall because lower rates make more projects profitable. Thus, the demand for loanable funds for investment decreases as interest rates decline. The government deficit (g-t) is presumed to be unaffected by interest rates, shifting the total demand for loanable funds curve to the right by the amount of g-t.
What is the equilibrium formula on the DLF and SLF curves?
Equilibrium is where the supply and demand of loanable funds curves intersect. At that intersection, the equilibrium interest rate is set, and demand and supply of loanable funds intersect, i.e. s = i + (g-t). (Recall that this is the same identity as the relationship derived in Topic I: I + G = S + T).
What is the importance of the interest rate (r) in the Loanable Funds Theory?
In the classical model, the interest rate maintains constant desired commodities demand (C+I+G). An increase in autonomous investment raises the demand for loanable funds, leading to higher interest rates and increased savings. This balance ensures that changes in investment and consumption offset each other, resulting in a net change of zero in C + I + G. Thus, the interest rate smooths out and eliminates changes in desired demand.
Is fiscal policy effective in changing aggregate demand?
Fiscal policy is generally ineffective even in adjusting AD, since only changes in the money supply shift AD. Monetary policy does not cause real changes; it only affects inflation and prices. The quantity theorists argued that any short run non-neutrality of money that caused a recession and potential use of a monetary
expansion was so short-term that it was not worth the long run cost of higher inflation.
What happens when there is an increase in government spending?
An increase in government spending raises the deficit (g-t), leading to borrowing and shifting the loanable funds demand curve rightward. Similar to increased investment, this causes the interest rate to rise, reducing profitability and decreasing investment. The rise in government spending is balanced by declines in consumption and investment, leaving C + I + G unchanged. Private expenditures are crowded out, rendering fiscal policy ineffective. In a bond-financed scenario, government spending doesn’t impact prices or output. Alternatively, printing more money increases the price level without affecting output.
What happens if the government issues a tax cut in the Loanable Funds Model?
A government tax cut aimed at expanding the economy initially stimulates consumer demand but may be offset by the sale of bonds, which increases the interest rate to maintain AD unchanged. The increased demand for loanable funds raises the interest rate, boosting savings and reducing the initial consumption increase. Higher interest rates also dampen investment, leaving C + I + G unchanged. Printing new money only escalates the price level, rendering tax policy ineffective in altering AD.
