Classical Theory Week 8 Friedman - PowerPoint Presentation

1. Classical TheoryWeek 8 Friedman, M. `The quantity theory of money', in Newman, P., M. Milgate and J.Eatwell (eds) The New Palgrave Dictionary of Money and Finance. (London: Macmillan, 1994).Harris, L. Monetary Theory. (New York; London: McGraw-Hill, 1985) Chapters 4 and 5.Lewis, M.K. and P.D. Mizen Monetary Economics. (Oxford; New York: Oxford University Press, 2000) Chapters 3 and 4.Patinkin, D., `Neutrality of money', in Newman, P., M. Milgate and J. Eatwell (eds) The New Palgrave Dictionary of Money and Finance. (London: Macmillan, 1994).1

2. ContentThe Walrasian systemRules that enable tradeA barter economyA monetary economy General equilibrium systemThe quantity theoryThe classical dichotomy and money as a veilThe transmission mechanismDirect effectIndirect mechanismLoanable fundsPatikin’s critiqueSolution: Real balance effect2

3. Classical model- beginning of monetary economics (1790-1936)The Walrasian systemSystem of general equilibriumincludes supply and demand for all goods market clear simultaneously Formal market structure, rules enable tradeMarket days – trade & settlement of accountsSupply: endowment + goods produced since previous market day Market is coordinated by auctioneer Relative prices, for markets to clear Exchange between suppliers &demanders, supply= demandEquilibrium without use of money- through activity of auctioneer3

4. A barter economyTraders supply real tangible goods: x1, x2…xn-1Total supply of good xi = Si (supply in the i-th market)Total supply is fixed, cannot vary as response to ∆relative p or incomeDemand for goods = DiFunction of relative ps & income (∑endowments received): Prices- not in monetary terms, but one chosen good (gold)Di is a function of n-2 relative pricesAbsolute price level:Auctioneer is critical to the operation of the marketHe equilibrates Si (fixed quantities) & Di (relative Ps)Takes care- participants play by the rulesPrice-makingEDi = Di-SiExcess Di →relative pi must ↑ to clear the market → equilibriumExcess Si → relative pi must ↓ 4

5. ED is function of relative ps and incomeCalculated for any marketGives info to auctioneer – is market in equilibrium Walras’s Law: possible to find a set of relative ps that equilibrates all markets simultaneouslyMarket will not clear otherwise Application of Say’s Law of markets to Walras’s market structure “production (supply) creates fund from which flows the demand for its productsDemand in aggregate can’t be higher than supply in aggregate → budget constrain Excess EDi must be matched by excess supply in at least one other market If all markets but one are in equilibrium, then that last market must also be in equilibrium→ no general oversupply or over demandAll markets must always clear  supply creates its own demand5

6. A monetary economyMoney as n-th goodHow conditions & functioning of the market alter?Relative ps in monetary units Goods can be exchanged for money Purchasing power from one market day- used another Individuals can delay purchase or make purchases in advance (if there is a loans market)Walras’s Law: pn- relative price of moneyExcess demand for money pn(Dn-Sn) = to the value of excess supply of goods on the real side of economyES =0 when EDn=0 → only when monetary side of the economy is in equilibrium, real side will also be6

7. Say’s law may not holdHoarding of money → oversupply in some goods marketsSome traders might wish to hold money as the store of value until the next market day → insufficient demand for some productsHigher demand than supply for some goods It is temporaryMoney is held not for own intrinsic qualities, but for purchases of goodsIt enables separation of earning and spendingPurchase of goods will be in another periodIn equilibrium:Value of money demanded is sufficient to cover the purchase of goodsSupply of money is enough to cover the value of demand for goods Mill’s principle:All goods in the market compose the demand for moneyThe whole of the money constitutes the demand for goodsThey are seeking each other to be exchanged7When supply ≠ demand for money Confirms the role of money as a medium of exchange

8. Walras’s general equilibrium system: Excess demand function is homogenous of degree zeroIf pn doubles (because MS doubled), p1, p2,…pn will also double → relative prices: p1/pn, …, pn-1/pn will not ∆ → no ∆ in EDi → ∆MS will have no effects in the real economy → money is neutral8Absolute price level, average of all other prices

9. The quantity theoryClassical theory dealt with absolute level of ps through quantity theoryIt is established through equation of exchange: MV = PT Y2 ways to measure all monetary transactions in the economyMill: “the money laid out is equal in value to the goods it purchases” Determines price level on the basis of assumptions on variables V: exogenous, institutional features (payment frequency)T: the number of transactions, real variables- preferences, fees, technologyM: determined by the governmentP: proportional to M lnMt + lnVt = lnPt + lnTtDifferentiate it with respect to time:If V & T are exogenous → not ∆ through time = 0Inflation can’t occur without corresponding ↑MS9The growth rate of MSThe growth rate of prices Flow equation  relates T made per period to flow of money handed per period over to facilitate transactions =

10. The Cambridge view of the quantity theoryTransformed QT to a demand function: M = kPY V is constant: k = 1/VFisher’s (US) version of quantity theory P= f(M, V, T)V, T are not constantT (trade): -conditions affecting producers -conditions affecting consumers -conditions connecting producers & consumers (transportation, freedom of trade, monetary conditions, business confidence) V: -individual habits and spending patterns -the payment system and its efficiency -other general causes (social conditions, proximity) - interest rates (high i→ lower money balances, money is spent faster) The velocity of money How many times a unit of money is used to purchase goods and services per periodMeasure of stability of money demandInfluence of ↑V on equation of exchange? 10stock concept of QT based on particular value of money at a point of timeFlow approach, defined amount of money over an interval

11. Example: Maya has monthly salary ₤800Spends a quarter at beginning of each weekShe is paid twice per month 11600-400-200-800-Week 1Week 2Week 3Week 4Average money holdings over the month: ₤600∙¼+₤400∙¼+₤200∙¼+₤0∙¼ = ₤300600-400-200-Week 1Week 2Week 3Week 4Payment period∆ frequency of payment →V doubled→ average money holdings halvedAverage money holdings over the month:(₤300∙⅛+₤200∙⅛+₤100∙⅛+₤0∙⅛)·2 = ₤150

12. The classical dichotomy and money as a veil Real sector can work with any level of pricesMoney is a veil: real sector operates based on relative prices, money is a cover to the processMoney is intermediary but not necessary for exchangeFrom Walrasian model:MS determines nominal value of absolute price level pnRelative prices (at which goods exchange) will not be affected (homogeneity)Classical dichotomy:Only real variables (preferences, endowments, technology) → real outcomes (quantities & relative ps)Quantity of money → absolute price level from equation of exchange Money is neutral → its quantity has no effect on any real variable in the economy 12

13. The transmission mechanismDirect mechanism If MS↑ & T (Y) not ∆ → “more money is chasing the same quantity of goods” →ps↑ proportionally to rise in MS D: real value of money in terms of goodsThe indirect effectImpact of MS through ∆i Thornton: banking system, takes deposits & makes loans↑MS →↑D → more funds to lend→↑supply of loans →↓p of loans (Wicksell “market rate”)→ market rate < “natural rate” (≡ rate of return on newly created capital, r of return required to clear the loans market)→ opportunity for entrepreneurs to borrow at market rate and invest in newly formed capital, and earn natural r → ↑demand for loans until rates are equal ↑MS →↑demand for goods and ↑ps13E’’E’S’S’’D’D’’2M3MXXESDMMoney↑MS has no final effect on the real sector Money is neutral Real balance at any point is the same

14. Wicksell: when market rate < natural rate → inflationMoney is still neutral: ∆Sm → equivalent ↑Pr: determined in the real sector by rn on newly formed capitalDetermined by savings & investments (productivity)Money doesn’t ∆ long run rCompatible with any Sm Loan market clears at rn 14S’lD’lE”lE’lrmLoans marketrSlDlElrnLoans Money marketS’mD’mE”mEmE’mMoneyrSmDmMM’

15. Loanable fundsr depends on supply & demand for funds Supply of funds: savingsDemand: for I in physical capital A flow modelSupply of new bonds: new issuance & individuals sell bonds to rearrange portfolio (hold money)15Factors that govern S&I behavior (thrift, desire to save & productivity, return on capital) p of loanable fundsrBd=Ls=SBs=Ld=IB,LrB͠S = Ĩ + ∆MDB͠S : flow supply of bonds Ĩ: new investment∆MD : change in demand for moneyB͠D = S͠ + ∆MS B͠D: demand for new bondsŜ: new saving∆MS: change in money supplyB͠S = B͠ D Ĩ + ∆MD = S͠ + ∆MS MDMSMS’MoneyĨS͠rnr’Loanable fundsBondsB͠DB͠D’B͠S LS͠’B͠S’ Ĩ’

16. Patikin’s critique A flow in classical modelReal side & quantity theory → incompatible explanations of how the whole economy worksRelative prices are determined in real sector independently of the aggregate price level (monetary sector)Decisions to sell & by goods → money-holding decisionsMonetary & real decisions brought simultaneouslyED for goods → ED for money monetary & real sectors can’t be kept apartDetermination of ED and pricesMonetary side of the model MS = M = constant MD = kpnYExcess demand function for money: MD-MS = kpnY-MIt depends on absolute p level, not relative psReal side ED for money is the sum of ED for goods:It depends on relative prices16

17. How will ∆absolute pn influence ED for money?Monetary side: ∆ kpnY Real side: no effectED for money & excess supply of goods must be comparable Real balance effectPatikin: included the value of real money balances as determinant of demand for each good:17+?Effect of real money supply on the ED function for goods

18. Adding Sn/pn ≈ additional wealth effectIt ∆ED function like a wealth changeThrough ∆ in Sn (equivalent to positive wealth effect) →↑ ED for all commoditiesOr ∆pn, ↓pn → same resultED functions do not depend only on relative psED function for money is consistent with one derived from quantity theory:Says law no longer holds as an identity↑ real balances →↑ED for all goods(SL: ΣED for all goods = 0)Excess supply in money market → ED in the goods marketIn the system as a whole Walras’s law holds ( )Stability & neutrality in the modelExcess MS → ED for goods →↑ps → ↑prices in following periodsStability: ps ∆→system goes back to equilibriumNeutrality: new equilibrium, EDs =0 when ps ↑ proportionally with the ↑ MS ↑ps restores real balance to original level18

19. Analysis of real balance effect in model with indifference curves and budget constraint: Money yields utility (potential consumption, future purchasing power)  provides satisfaction like current consumption (just delayed) U = U(x1, x2, .., xn-1, M/pn)Budget constraint: Derived from Walras’s lawRelationship between demand & supply of commodities and demand & supply of money 19I2I1E1E2G2G0GM/Pn(M/Pn)1(M/Pn)2(M/Pn)0Real balance effects- like wealth effect

20. Homework-QuestionsThe classical dichotomy refers to a case where money demand and money supply should be analysed separately. Explain the meaning of the term “the neutrality of money”. According to the quantity theory of the demand for money, the demand for money is proportional to income and does not depend on the rate of interest.The quantity theory of money states that the total value of all monetary transactions must be equal to the real value of goods and services it buys. A halving of the velocity of money will lead to a halving of output.Say’s Law is inconsistent with the predictions of the Quantity Theory of Money. 20

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