assign10 - 1 Intro Macro N Sheflin Assignment 10 NOTES...

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1 I n t r o M a c r o N . S h e f l i n Assignment 10 NOTES Classical Long-Run Inflation, the LR Aggregate Supply curve, the LR Phillips Curve and fiscal and monetary policy in the long run. KEY POINTS (some review) QUANTITY THEORY OF MONEY – explains the role of money in the long-run Classical model which is ONLY to determine the price level and nominal values. o Start with the equation of exchange: MxV=Pxy (or PQ) where M=money supply, V=velocity, P=price level and y=real gdp. ± Note that Velocity=Py/M (nomGDP/Money) i.e. , how many times the stock of money changes hands each year ± REMEMBER – money (or the quantity or supply or stock of money) refers to the ‘pile’ of currency and checking accounts in the economy controlled by the Fed. NOT the same as income (although bot are measured in dollars). o Assume that velocity is roughly constant (reflecting peoples payment and income receipt patterns) and that output is at full employment level according to Say’s law and flexible wages and prices and loanable funds theory. o Then, the quantity theory implies that changes in the Money Supply ONLY affects the level of Price, not output or other real variables. i.e. M x V = P x y and with V and y ‘fixed’ (unchanging) then changes in M can only change P. o The neutrality of money or Classical Dichotomy refers to the fact that the quantity of money ONLY affects prices and other nominal ($) variables, not real variables REAL INTEREST RATE i real = i nominal expected inflation or i nominal = i real + expected inflation o Nominal interest is the $ you receive for lending or pay for borrowing o Real interest is the amount you receive for lending or pay for borrowing in terms ofwhat you can buy with it o Real interest rate is the key variable in determining investment and savings Loanable Funds Theory (we’ll focus on this in assignment 10 ) explains why Saving equals Investment in the long-run and thus why Says law always holds. The supply and demand for ‘loanable funds’ – i.e., funds that can be loaned or borrowed (= saving and investment) determines the real interest rate and in equilibrium makes sure that S=I and hence the economy tends towards full employment equilibrium. The
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assign10 - 1 Intro Macro N Sheflin Assignment 10 NOTES...

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