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ECON 1110 Lecture Notes 03

ECON 1110 Lecture Notes 03 - ECON 1110 Lecture Notes 3 ECON...

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ECON 1110 Lecture Notes 3 ECON 1110 Intermediate Macroeconomics James R. Maloy Spring 2011 Lecture Notes for Topic 3: Classical Macroeconomics (II) Readings: Froyen Ch. 4 This section discusses the determination of prices in the classical model. The roles of money and the classical quantity theory of money are discussed. The classical aggregate demand curve is derived and equilibrium prices and output are determined by the intersection of aggregate demand and aggregate supply. The determination of interest rates and the role of interest rates in stabilisation are analysed, as well as the role of government policy. I. The Quantity Theory of Money There are two main versions of the classical quantity theory of money—Fisher’s quantity theory and the Cambridge quantity theory. Both models are similar and draw basically the same conclusions, but the techniques and analysis are a bit different. One of the oldest economic theories still in use today, the quantity theory of money traces its origins to theorists who were trying to determine the effects of an increase in the gold supply. 1 At that time, most of the world was on a gold standard, so the quantity of gold in the nation determined the quantity of money. When new gold supplies were discovered (i.e. in the New World) it increased the quantity of money in the economy. Under mercantilist theory, the increase in gold would make the country more affluent, but theorists such as David Hume and some of his contemporaries disagreed. They developed a theory which is familiar today—the idea that increases the money supply only cause inflation. The quantity theory shows a relationship between the quantity of money (the independent variable) and the price level (the dependent variable). Hume wrote that in the long run the absolute size of the money stock was insignificant because the price level would eventually adjust to match it. This idea became known as the neutrality of money, as mentioned in the last topic. If the money stock were to double, for example, prices would eventually double and employment would be at the normal level. The classical economists argued that 1 The first known mention of the quantity theory is actually in the writings of Copernicus in the 1520s, although the development of the theory happened much later as a response to New World gold entering Europe. 1
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ECON 1110 Lecture Notes 3 monetary policy would only cause inflation in the long run, although there was some room for short-run non-neutrality due to lags in the adjustment process. Therefore, early quantity theorists suggested that in the short run it may be possible to experience an increase in output as a result of an increase in the money supply, but this would be a transitory effect. Hume even suggested that output could be continually increased, but at the cost of ever-increasing inflation.
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