Topic 3: Classical Economics and Walras

Question 1

What is the classical view and dichotomy?

Answer 1

That real economic analysis can be seperated from monetary matters - the classical dichotomy is the idea that money is a veil.

Question 2

What are the forms of Walra’s model we consider?

Question 3

In Walras’s model, how is demand determined?

Answer 3

A function of the relative price of all goods, and inital endowement of goods.

Question 4

What is Say’s law?

Answer 4

Supply creates it’s own demand

Question 5

What is Walras’s law?

Answer 5

The sum of the numeraire value of demands and the sum of the numeraire value of supply are the equal. This tends to render the last equation of any set of excess demand functions unnecessary.

Question 6

How can we formalise Walras’s model?

Answer 6

Have n-1 goods.

Demand is a function of relative prices plus endowment.

Excess demand_i = f(1,p₂/p₁ … p_n-1/p_1, Σp_i/p₁S_i) - Si

All Si are known.

We have n-1 equations, p1 is the numeraire, so we only have n-2 unknowns.

Walras’s law means ΣP_iD_i = Σp_iS_i

So the n-1’th equation can be derived from the others, and there are only n-2 equations indepedent.

Question 7

What is Say’s identity?

Answer 7

When we look at a non-monetary system, Say’s law becomes a mathematical identity.

Question 8

What does Walras’s law imply?

Answer 8

That there can be no excess demand or supply across the entire market. Individual products might have excess demand, but there will be excess supply elsewhere that ‘cancells’ it out. The entire market can’t be in excess supply or excess demand in the walras model (without money).

Question 9

What is the fisher equation?

Answer 9

Fishers exchange circulation equation

MV = P_LT

M = Money

V = Velocity of money

T = index of real transactions (real expenditure)

P_L = nominal index of the price leves (CPI)

Fisher stresses that P_L Derives from M, V and T. Investigates circumstances where V is relatively constant.

Question 10

What is the classical quantity theory?

Answer 10

MV = Py

Question 11

What is the cash balances equation?

Answer 11

Also known as the cambridge equation, written up by Pigou in 1917

P_R = kY/M

where P_R = 1/P_L

Question 12

What was Pareto’s critique of Pigou’s paper?

Answer 12

Written in 1920.

Pareto’s criticism is there is a need to add economic growth and monetary growth, and conduct real analysis.

Determined that growth would have to be zero.

Question 13

What is the transmition mechanism for changes in the money stock to affect prices?

Answer 13

Direct mechanism:

i) Direct (ΔM -> ΔP)
ii) Indirect (ΔM -> Δi -> ΔLoanable funds -> ΔP)

Question 14

Show the graph for the direct mechanism. Explain it briefly.

Answer 14

Equates money demand and money supply per the cambridge equation. As the supply of money is fixed, demand adjusts so that the economy remains on it’s locus of monetary equilibria line.

Question 15

Show the graph for the indirect mechanism. Briefly explain it.

Answer 15

This looks at the flow of investment by examining the creation / excess of money, loanable funds and bonds.

• ~BS = ~I + ΔMD
• ~BD = ~S + ΔMS
• ~I + ΔMD = ~S + ΔMS

Question 16

Show an expansion of the money supply in the indirect money mechanism model.

Answer 16

• The change in the money supply causes a lower interest rate.
• This increases the demand for bonds. Hence there is an excess of investment. In the long run, this will increase demand for money, returning the system back to the level determined by the demand for invesment and savings.

Question 17

How do we add money to the walras system?

Answer 17

ED₁ = f(^p₁/p_n, ^p₂/p_n, p₃/p_n, … ^p_n-1/p_n, Σ^p_i/_pnSi) - S₁

CPI is defined as p_n = Σw_ip_i

n unknown variabels comprising n-1 relative prices and 1 price level variable

n-2 independent ED equations

1 equation for defining the price level

1 equation for the quantity level

Question 18

What are the implications of adding in money to the walras model?

Answer 18

The sum of real demand for goods and demand for money is equal to the sum of real supply of goods and supply of money.

There can be an excess supply of goods, and excess demand of money.

Says equality, not Says identity.

Question 19

What is Patinkin’s inconsistancy in the classical dichotomy?

Answer 19

When money is added, was variation in the absolute price level allowed to alter excess demand? Nope. Each price in the system is divided by p_n so there are no relative price changes.

It is relative price changes that influence excess demand.

Question 20

What is patinkins solution to the classical dichotomy?

Answer 20

Model money as a good which can be stockpiled. An increase in real cash balances can increase demand for goods, as there is an excess supply of money.

Question 21

Show Patnkin’s equation for excess demand

Answer 21

ED with real balances.

Where S_i/p_n represents the real money supply.

Money is no longer a veil.

Say’s identity is ruled out.

Question 22

Show the patinkin’s graph for real balances and goods

Answer 22

Patinkin’s model assumes real balances have utility

But prices will eventually increase, pulling the budget constraint back, as in the quantity theory, as argued by archibald and lipsey. This means the classical dichotomy holds in the long run. Patinkin argues this doesn’t even wash out in the long run.

Question 23

Constrast the excess demand equations for different versions of Walras’s models.

Answer 23