The price level is relationship between the level of output and the quantity of money o We need to add money to the model

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1 LECTURE NOTES Chapter 4: Mney, Prices, and Interest 1. The Quantity Thery f Mney The price level is relatinship between the level f utput and the quantity f mney We need t add mney t the mdel The equatin f exchange Fcuses n mney supply All transactins M: quantity f mney V T : mney velcity f all transactins (mney turnver) P T : Price level f all transactins T: Ttal transactins in the ecnmy Incme transactins M: quantity f mney V: incme velcity f mney (purchase f currently prduced final gds and services) P: Price index (nt price level) fr currently prduced final gds and services Y: Real utput (GDP) Remember that Therefre: If, then P is the price vectr f all gds included in the vectr Q Cambridge apprach Fcuses n mney demand ( ) M d : Mney demand k: Prprtin f nminal incme (PY) that is demanded as cash-hlding P: Price index Y: Real utput Page 1 f 9

2 In equilibrium mney supply equals mney demand, then Mney velcity is the inverse f mney demand Quantity thery f mney Add t the equatin f exchange the fllwing assumptins: Mney demand, and therefre V, are cnstant Output (Y) cannt change fast in the shrt run Then, because M is exgenus, P depends n mney supply (dn t frget: assuming mney demand is cnstant) Imprtant: Mnetary equilibrium depends n all transactin that take place in the ecnmy, nt nly purchases f final gds and services: is mre accurate If during a cycle is nt cnstant then t fllw Y rather than T can underestimate mnetary disequilibrium Because T was nt bservable but Y was, quantity thery f mney uses Y rather than T. Sme cuntries, such as the U.S., prvide measures that track mre clsely all transactins Grss Output: ( ) Grss Dmestic Expenditures: ( ) Accrding t GDP, cnsumptin is the variable that drives the ecnmy Accrding t GO, investment is the variable that drives the ecnmy The Classical Aggregate Demand (AD) Curve The quantity thery f mney is the implicit thery f aggregate demand AD = MV (ttal nminal spending) With a given level f utput, AS and AD determine the price level Page 2 f 9

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4 2. The Classical Thery f the Interest Rate Equilibrium interest rate: rate at which desire t lend and desire t brrw are equal The interest rate is the cst f brrwing Investment depends n expected prfits and the rate f interest All else equal, investment varies inversely with interest rates (cst f brrwing t invest) Credit/lan market Demand side: firms and gvernment (inverse relatinship with interest rate) Supply side: savers (psitive relatinship with interest rates) Assume interest rate r falls because investment falls (demand shifts t the left): Quantity f savings decrease and therefre cnsumptin increases Investment quantity increases due t the fall in the interest rate Tw reasns why there is full emplyment in Classical macrecnmics AS is vertical (see previus chapter) Because the interest rate makes S = I What is nt saved/invested is cnsumed Page 4 f 9

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6 3. Plicy Implicatins f the Classical Equilibrium Mdel Fiscal plicy (changes in G). Assume the budget is in equilibrium (n deficit nr surplus) Gvernment spending Three surces t finance a deficit: (1) taxes, (2) debt, (3) mney creatin The mdel assumes perfect Ricardian equivalence: If gvernment cut taxes permanently then cnsumers knw that in the future they will have t pay taxes t pay-ff the new debt. Therefre cnsumptin falls tday by the same present value than the debt and there is n effect in AD If gvernment cut taxes and is expected that spending will fall accrdingly in the near future then cnsumptin falls less and there is an effect in AD because Y D is expected t raise It is a fall in G, nt a fall in taxes, what increases real incme in the private sectr Debt increase If gvernment debt increases, it still the case that S = I and then utput desn t change. There is a change in the cmpnents f GDP, nt in the level f GDP Because utput des nt change, the price level des nt change Crwding ut effect: The deficits crwds ut the same amunt f resurces frm the private sectr (cnsumptin and investment.) Private investment falls even if ttal savings increase when the gvernment deficit increases See figure 4-5 belw Tax plicy Effects n demand d nt affect the price level (remember AS is vertical) Effects n supply affects the price level because utput changes [( ) ] See figure 4-6 belw Mney creatin P changes in the same prprtin than M It des nt matter (fr P) where des the mney enter the market Mnetary plicy (changes in M) Imprtant: M defines P and the level f nminal incme (subject t Y and mney demand) Nt imprtant: The level f utput and emplyment des nt depend n the quantity f mney. Mney is neutral in the sense that equilibrium real values [ ( ) ] d nt depend n M Page 6 f 9

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9 4. Mdel example See the Macrecnmic Mdels spreadsheet in Blackbard Mdel functins ( ) ( ) Labr demand depends n the firm maximizing prfits ( ) ( ) ( ) ( ) [ ( ) ( ) ] ( ) Labr market equilibrium cnditin ( ) [ ( ) ( ) ] d sme math. ( ) [( ) ] [( ) ] Assume: A = 100 K = 1 α = 0.5 c = 0 d = 3.5 Then: ( ) Use the spreadsheet t apply shcks t the mdel Can yu predict the results? Can yu explain the ecnmic intuitin behind the shck effect? Page 9 f 9