Microsoft PowerPoint - 110.1_CH04.pptxand QTM
factor markets (supply, demand, price) determination of output/income
Demand side money market equilibrium
Equilibrium AS=AD
loanable funds market/goods market
We need to discuss ……
Say’s law implies goods market is in equilibrium.
Aggregate demand is derived from the condition of money market equilibrium.
With the loanable fund market equilibrium, Classical model is complete.
Money demand: transaction demand for money
where k = how much money people wish to hold for each dollar of
income. (k is exogenous, a constant)
Money Market
This equation is also called Cambridge equation
Money demand is assumed to be a proportion (k) of nominal income, the price level (P) times the level of real income (Y).
dM kPY
Money Market
Money market equilibrium:
dM M kPY With k fixed and real output ( ) determined, the Cambridge equation also reduces to a proportional relationship between the price level and the money supply.
Y
constantMPY k

An increase in the money supply shifts the aggregate demand curve to the right.
AD ( )
P
derive a negatively sloped AD curve.
The Classical Aggregate Demand Curve
What happens to the aggregate demand curve, if the proportion of nominal income holding money, k,
increases?
Nominal variables are determined: * and *P W
*N Y
( )*, *, *W N Y P
Real Sector Nominal Sector
1. Classical Dichotomy
Real variables are independent to any change in the nominal sector.
Production function Labor market
( )*, *, *W N Y P
Real Sector Nominal Sector
1. Classical Dichotomy
Changes in the real sector can affect both the real variables and nominal variables.
Production function Labor market
( )*, *, *W N Y P
Real Sector Nominal Sector
Real variables: Nominal variables:
* and *P W
Changes in the nominal sector can NOT affect the real variables, only affect the nominal variables.
You just saw two examples!
Properties of the Classical Model 2. Full employment
Assume money wage adjusts instantaneously, labor market is always in equilibrium.
• Full-employment level of employment • No “involuntary” unemployment • Natural rate of unemployment
Properties of the Classical Model 3. Money Neutrality
An increase (a decrease) in the quantity of money does not affect the real variables.
• Think about “Classical dichotomy” • Consistent with the result of Quantity Theory of
Money (QTM) • What is QTM?
Preview
To understand the relationship between saving and investment
To understand how changes in saving and investment affect a closed economy

Private Saving Private saving equals private disposable income minus consumption expenditure
Private disposable income:
Y = GDP
T = net taxes (i.e., taxes – government transfers – interest payments on debt)
DY Y T
C = consumption expenditure
Private saving rate is the proportion of private disposable income that is saved :
S Y T C - -
Government saving:
Budget surplus occurs if T > G, and budget deficit (dissaving) occurs if T < G
National saving is the sum of private saving and government saving:
National saving rate:
GS T G
GS S Y T C T G Y C G ( ) ( )
GS S Y( ) /



( ) = ( ) =
Uses of Saving
(1) Household saving
I S T G IM EX = ( ) ( )
Saving, Investment, and Goods Market Equilibrium in a Closed Economy To further understand the link between saving and investment in the long run when all prices are flexible, we first assume:
–The goods market is in equilibrium –A closed economy (NX=0)
Y C I G
Subtracting C and G from both sides of the above equation, then:
Saving = Investment
The real interest rate keeps the market for saving and investment in equilibrium
S T G Y C G I ( )
Saving, Investment, and Goods Market Equilibrium in a Closed Economy (cont’d)

1
2


supply of loanable funds demand for loanable funds

C = consumer demand for goods & services
I = demand for investment goods
G = government demand for goods & services
(closed economy: no NX )
Consumption, C
Def: Disposable income is total income minus total taxes: Y – T.
Consumption depends on disposable income and real interest rates
(Y – T ) C
r C Why?
Investment, I
The investment function is I = I (r ), where r denotes the real interest rate, the nominal interest rate corrected for inflation.
The real interest rate is – the cost of borrowing – the opportunity cost of using one’s own funds
to finance investment spending
So, r I
The investment function r
I (r )
Spending on investment goods depends negatively on the real interest rate.
Government spending, G G = gov’t spending on goods and services. G excludes transfer payments
(e.g., social security benefits, unemployment insurance benefits).
Assume government spending and total taxes are exogenous:
and G G T T
1
Aggregate demand:
Aggregate supply:
The real interest rate adjusts to equate demand with supply.
Y C I G
Y F K N( , )

S T G I ( ) S I G T ( )

One asset: “loanable funds”
–demand for funds: investment, gov’t deficit –supply of funds: saving –“price” of funds: real interest rate
Demand for funds: Investment, Gov’t deficit
The demand for loanable funds…
–comes from investment: Firms borrow to finance spending on plant & equipment, new office buildings, etc.
– comes from gov’t deficit: Gov’t deficit is exogenous.
–depends negatively on r, the “price” of loanable funds (cost of borrowing).
Loanable funds demand curve r
I
I (r )+
The loanable funds demand curve is the investment curve plus a given gov’t deficit
The loanable funds demand curve is the investment curve plus a given gov’t deficit
G T
The supply of loanable funds comes from saving:
– Households use their saving to make bank deposits, purchase bonds and other assets. These funds become available to firms to borrow to finance investment spending.
Types of saving
Savings depend positively on real interest ratesWhy?
r adjusts to equilibrate the goods market and the loanable funds market simultaneously:
If L.F. market in equilibrium, then Y – T – C = I + G - T Y = C + I + G (goods market eq’m) Thus,
The special role of r
Eq’m in L.F. market
Eq’m in goods market
FIGURE The Saving-Investment Diagram: Equilibrium in the Goods Market
Goods Market Equilibrium
In the saving-investment diagram, r* keeps the goods market in equilibrium
If r > r*, then desired investment is less than desired saving
If r < r*, then desired investment is greater than desired saving
Changes in Saving: Autonomous Consumption
A rise in autonomous consumption causes saving and
investment to fall and the real interest rate to rise in the
long run, while a fall in autonomous consumption causes
saving and investment to rise and the real interest rate to
fall