Aggregate Demand and the Classical Theory of

the Price Level

Chapter 5

2

Introduction

• The classical theory of the price level is sometimes called the quantity theory of money or the classical theory of aggregate demand.

1. It works well in high-inflation countries.

2. It help us to understand how modern intertemporal equilibrium theories work.

3. It is incorporated into the neoclassical synthesis which was used to determine the economy’s long-run trend level of output.

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The Theory of the Demand for Money

• The classical theory of aggregate demand is a hybrid that adds a theory of money to the classical theory of aggregate supply.

• We begin with the budget constraint of a family in a static, one-period economy.

• Then we show how this constraint is altered when a family engages in repeated trade through time, using money as a medium of exchange.

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The Theory of the Demand for Money

• The classical theory of the demand for money argues: people ‘demand money’ up to the point where its marginal benefit equals its marginal cost.

• Money is a durable good and yields a flow of exchange services over time.

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The Theory of the Demand for Money

• The cost of holding money is the opportunity cost of forgoing consumption of some other commodity.

• The marginal benefit of holding money is the additional usefulness gained by having cash on hand to facilitate the process of exchange.

• The classical theorists assumed this benefit to be proportional to the volume of trade.

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Budget Constraints and Opportunity Cost

• Money imposes an opportunity cost because the decision to use money reduces the resources available for other goods.

• Assumption : Money is the only asset available to households as a store of wealth.

• Thus, if the household chooses not to hold money, it will be able to purchase additional commodities.

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Static Barter Economy

• The economy last for only one period of time: agents exchange labor for commodities they produce and consume, then the world ends.

• Money can be used as an accounting unit.

Demand for Commodities Profit Labor Income

D SP Y P w L

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Dynamic Monetary Economy

• The classical theorists argued that since the typical household does not buy commodities at the same time that it sells its labor, during an average week the household has a reserve of cash on hand to facilitate the uneven timing of purchases and sales.

• Consider a household that starts the week with some cash on hand, we call this the household’s supply of money.

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Dynamic Monetary Economy

• The household earns income each week and makes routine purchases.

• We call the cash held at the end of the week the household’s demand for money.

• Opportunity Cost

Demand for Demand for Profit Labor Income Supply of

Money Commodities Money

D D S SM P Y P w L M

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The Benefit of Holding Money

• To classical theorists, the benefit was the advantage that come from being more easily able to exchange commodities with other households – generally acceptable medium of exchange.

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The Benefit of Holding Money

• Classical theorists argued that the stock of money that the average household needs at any point in time is proportional to the dollar value of its demand for commodities.

• The constant k has units of time.

Demand for money Propensity to Nominal value of

hold money commodities demand

D DM k P Y

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From Money Demand to a Theory of the Price Level

• Assumption: the quantity of money demanded is always equal to the quantity of money supplied.

• The classical aggregate demand curve:

Supply of moneyPrice level

Propensity to hold money aggregate demand for commodities

=

S

D

MP

k Y

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From Money Demand to a Theory of the Price Level

• Each point along the aggregate demand curve is associated with the same demand for money.

• The aggregate demand curve slopes downward.

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The Classical Aggregate Demand Curve

Figure 5.1

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Irving Fisher and the Velocity of Circulation

• Fisher : the velocity of circulation

Average value value of transactionsVelocity of circulation

Nominal money supply=

S

PTV

M

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Irving Fisher and the Velocity of Circulation

• Assumption:

- T can be approximated by YD

- V is constant

- k = 1/V

Price level Aggregate DemandVelocity of circulation

Nominal money supply=

D

S

PYV

M

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The Classical Theory of the Price Level

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Figure 5.2

The Labor Demand and Supply Diagram

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Figure 5.3

The Production Function Diagram

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Figure 5.4

The Aggregate Supply Curve

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The Complete Classical Theory of Aggregate Demand and Supply

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Equilibrium in the Complete Classical System

Figure 5.5A

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Equilibrium in the Complete Classical System

Figure 5.5B

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Equilibrium in the Complete Classical System

Figure 5.5C

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Equilibrium in the Complete Classical System

Figure 5.5D

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Table 5.1

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The Neutrality of Money

• An important proposition logically follows from the classical assumption that all markets are in equilibrium.

• A vertical aggregate supply curve implies that a fall in aggregate demand will cause a fall in the price level and leave all real variables unaffected The Neutrality of Money.

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Figure 5.6A

The Response to a Reduction in the Money Supply Predicted by the Classical Model

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Figure 5.6B

The Response to a Reduction in the Money Supply Predicted by the Classical Model

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Figure 5.6C

The Response to a Reduction in the Money Supply Predicted by the Classical Model

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Figure 5.6D

The Response to a Reduction in the Money Supply Predicted by the Classical Model

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Table 5.2

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Figure 5.7A

Money Growth and Inflation in Three Low-Inflation Countries

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Figure 5.7B

Money Growth and Inflation in Three Low-Inflation Countries

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Figure 5.8A

Money Growth and Inflation in Three High-Inflation Countries

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Figure 5.8B

Money Growth and Inflation in Three High-Inflation Countries

37Figure 5.9©2002 South-Western College Publishing

The Propensity to Hold Money in the United States

END