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# NoteClassical-more - Supplemental Notes on Classical...

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1 Supplemental Notes on Classical Macroeconomic Theory [For further reading: Optional] A Quantitative Perspective on Velocity and Interest Rates In the Lecture Note, we assumed that velocity V=V(i) is an increasing function of the interest rate without saying much about the strength of this link. For this reason, we could give only qualitative answers to questions that involved endogenous changes in velocity. This Note introduces more specific assumptions about the shape of the V(i) function that will yield quantitative answers. The linkage between interest rates and velocity is well approximated by an exponential relationship of the form V(i) = exp{v 1 * i + v 0 (time)}. The parameter v 1 is a positive constant that captures the responsiveness of velocity to interest changes. If i changes by an amount Δ i, v 1 is the percentage increase in velocity. Empirical estimates suggest a numerical value of about v 1 =0.5, That is, an increase in interest rates by one percentage point raises velocity by about 0.5%. Because f(i,Y)=Y/V(i), money demand is reduced by 0.5%. The exponential relationship is convenient because it yields a linear relationship for growth. The v 0 -term is a function of time that can be used to capture other changes in velocity. This may include slow-moving trends—e.g., due to innovations in payment technology—and unexpected

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## This note was uploaded on 12/26/2011 for the course ECON 135 taught by Professor Bohn,h during the Fall '08 term at UCSB.

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NoteClassical-more - Supplemental Notes on Classical...

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