Ngân hàng, tín dụng - Chapter 22: The classical foundations

1Copyright © 2009 Pearson Addison-Wesley. All rights reserved. Chapter 22 The Classical Foundations Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 22-2 Learning Objectives • Define Say’s law and the classical understanding of aggregate supply • Understand the supply of saving and demand for investment that leads to the equilibrium interest rate • Explain the quantity theory of money and its implication for the aggregate demand curve • Differentiate between nominal and real rate of interest Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 22-3 Introduction • Origins of monetary theory lie in Classical Economics, starting with the works of Adam Smith (1723–1790) • Two cornerstones of classical economics – Say’s Law—deals with interest rates, employment and production – Quantity Theory of Money—examines the role of money in the economy • Focused on long-term view of the economy 2Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 22-4 Introduction (Cont.) • Classical economics was attacked by John Maynard Keynes during the Great Depression • Theory was resurrected and refined by modern monetarists and new classical macroeconomics beginning in the 1970s • The starting point of classical theory is what determines gross domestic product (GDP)—total value of goods and services produced domestically Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 22-5 Classical Economics • “Supply creates its own demand” • The economy could never suffer from underemployment • Total spending (demand) would always be sufficient to justify production at full employment (supply) Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 22-6 Classical Economics (Cont.) • Potential output of an economy – Determined by the size of the labor force to work with existing capital stock and level of technology (real factors in the economy) – Production function defines the total supply of goods and services that can be produced – Because of interplay of market forces (an invisible hand), production will always be at the full employment level 3Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 22-7 Classical Economics (Cont.) • Potential output of an economy (Cont.) – Flexible wages and prices would assure that all markets would clear—all goods sold and all people employed – If the economy deviated from full employment, this flexibility would bring all markets back into equilibrium at the full employment level – Laissez-faire—government intervention was not required Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 22-8 Classical Economics (Cont.) • The economist Reverend Thomas Malthus (1766–1834) attacked the classical assumption of full employment: – While production of output generates income in the amount of total production, there is nothing to force spending to equal total production – If spending in the economy is less than income (due to increased savings), part of the goods produced will not be sold resulting in reduced production and unemployment Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 22-9 Classical Economics (Cont.) • However, classical economists countered Malthus’s criticism: – Individuals save, but such funds do not disappear – Savings are diverted from the spending stream, but flow to entrepreneurs to use for capital investment projects – Savers receive interest on funds and borrowers are willing to pay as long as expected return on their investment exceeds the rate of interest 4Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 22-10 Classical Economics (Cont.) • However, classical economists countered Malthus’s criticism: (Cont.) – Flexibility in the rate of interest causes savings to be equal to investment spending, thereby flow back into the economy – Therefore, interest rates fluctuate to make entrepreneurs want to invest what households want to save Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 22-11 Classical Interest Theory • Overall level of interest rates is determined by supply and demand for loanable funds (Figure 22.1) • However, classical economics focused on savings and investment, the two factors that underlie the long-run supply and demand for loanable funds Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 22-12 FIGURE 22.1 Classical interest theory. 5Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 22-13 Classical Interest Theory (Cont.) • Savings (Figure 22.1) – Function of interest rates—the higher the rate of interest, the more will be saved (positive or direct relation) – Interest earned on savings is a reward for delaying consumption in favor of future consumption – At higher interest rates people will be more willing to forgo present consumption Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 22-14 Classical Interest Theory (Cont.) • Investment (Figure 22.1) – Also a function of interest rates—the lower the rate of interest, the more entrepreneurs will borrow and invest (negative or indirect relation) – Investment in physical capital is undertaken because capital goods produce output in the future – The firm will undertake the investment if the rate of return exceeds the cost of borrowing Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 22-15 Classical Interest Theory (Cont.) • Investment (Figure 22.1) – The return on investments is subject to diminishing returns, each successive project earns a lower return on investment – Therefore, a lower rate of interest induces entrepreneurs to undertake more and more investments 6Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 22-16 Classical Interest Theory (Cont.) • Equilibrium rate of interest (Figure 22.1) – Represented by the intersection of the supply/demand curve for loanable funds – Total savings is equal to total investment – That portion of income that was diverted from spending to savings flows back into the spending stream in the form of investment – As long as the supply or demand for loanable funds do not shift, this equilibrium rate of interest will not change Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 22-17 Classical Interest Theory (Cont.) • Shifts in supply or demand (Figure 22.2) – Any shift in the supply or demand for loanable funds will cause market forces to drive the rate of interest back into equilibrium at a different level – This flexibility in the rate of interest will ensure that the amount of savings is always equal to investment and total income will always equal total spending Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 22-18 FIGURE 22.2 Increased saving calls forth increased investment. 7Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 22-19 Classical Interest Theory (Cont.) • Role of money in determining interest rate – Rate of interest is influenced in the long run by the savings of the public (personal preferences) and investment of entrepreneurs (productivity of capital) – Money plays no role in determining real factors in the classical system – Real factors are determined by the supply of capital, the labor force, and existing technology – Interest rates are determined by the thriftiness of the public and the productivity of capital Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 22-20 Quantity Theory of Money • In classical economics, money is strictly a veil— it affects the price level, but not the real factors in the economy • Increase in money will lead only to increase in prices, but not output or employment Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 22-21 Quantity Theory of Money (Cont.) • Equation of Exchange – M × V = P × Y • Where: M = money supply • V = Income velocity (rate of turnover) • P = price level • Y = real income (GDP) 8Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 22-22 Quantity Theory of Money (Cont.) • Equation of Exchange (Cont.) – This expression is a truism—true by definition – Generally, “Y” is referred to as real gross domestic product (GDP) – The price level “P” is an index of the current prices of all goods (CPI) – The product of “Y × P” represents the nominal level of GDP – This equation equates total spending (left hand) with total purchases (right hand) Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 22-23 Quantity Theory of Money (Cont.) • Equation of Exchange (Cont.) – Originally this equation was expressed in terms of “T”, the total level of transactions – Includes both real and financial assets – In this expression, “V” is called the transactions velocity – The remainder of this discussion will be in terms of the income velocity Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 22-24 Quantity Theory of Money (Cont.) • The Cambridge Approach – Restates equation of exchange to focus on fraction of total expenditure people hold as money – Manipulation of the equation of exchange results in the Cambridge cash-balance approach or the demand-for- money equation • M = kPY – Where: k = fraction of spending that people have command over in the form of money balances – Since “k” = 1/V, both the equation of exchange and the cash-balance approach are identical 9Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 22-25 Quantity Theory of Money (Cont.) • Quantity Theory of Money – Re-interprets equation of exchange as a behavioral relationship—an increase in quantity of money (M) causes what changes in other variables – According to the quantity theory of money, a change in the money supply leads to a proportionate change in the price level (cause- and-effect conclusion) Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 22-26 Quantity Theory of Money (Cont.) • Quantity Theory of Money (Cont.) – The above is based on two propositions: • “Y” is assumed fixed at full employment levels • “V” is assumed fixed by payment habits of the population – The transmission mechanism of an increase in the money supply is as follows: • Money supply increases • Individuals now hold larger cash balances • Reduce cash balances by spending on goods/services • Since output (Y) [real GDP] is fixed, the increased demand drives up prices with no increase in real output Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 22-27 Quantity Theory of Money (Cont.) • Quantity Theory of Money (Cont.) – Therefore, a change in the money supply leaves the real amount of goods and services produced (real GDP) unchanged, but increases the dollar value of GDP (nominal GDP) – Money is a veil in the economy and has no effect on real output or employment levels 10 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 22-28 Money Demand and the Quantity Theory • When explaining transmission mechanism, cash- balance version (M = kPY) is superior • The fraction of nominal GDP (PY) people want to hold in the form of money, k, is determined by many forces – It is essentially a transactions demand for money – Since money is a medium of exchange, the value of k is influenced by the frequency of receipts and expenditures Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 22-29 Money Demand and the Quantity Theory (Cont.) • Fraction of nominal GDP held as cash (Cont.) – The ease you can buy on credit also influences k by permitting people to reduce the average balances in their checking accounts – Money is used as a temporary abode of purchasing power— waiting until an individual wants to spend on real goods or services – Although the value of k may vary by individuals, for the population as a whole it appears to be rather stable Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 22-30 Money Demand and the Quantity Theory (Cont.) • If the money supply increases: – Individuals hold larger cash balances and spend it on real goods and services – Spending will stop when nominal balances have increased proportionately through price increases – Therefore, the real value of money (M/P) held is the same in both the initial and final position – The increase in money must result in an equal percentage in prices for the real value of money to be in equilibrium 11 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 22-31 Aggregate Demand and Supply: A Summary • Figure 22.3 – Price (index of all prices) is measured on the vertical and quantity (real aggregate output) is on the horizontal – Since output and income are identical in the classical theory, the terms income and output are interchangeable – Aggregate supply curve • Perfectly vertical at the full employment level of output • Does not vary with the price level Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 22-32 FIGURE 22.3 The equilibrium price level. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 22-33 Aggregate Demand and Supply: A Summary (Cont.) • Figure 22.3 (Cont.) – Aggregate demand curve • Downward sloping • Drawn for a given level of the money supply (M) • Hence, a lower price level means that the amount of goods and services demanded is greater – Intersection of the supply and demand curve • Indicates the equilibrium price level • Flexibility of prices means that a change in aggregate demand will result in only a change of price at a constant level of output 12 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 22-34 Aggregate Demand and Supply: A Summary (Cont.) • Figure 22.4 – This shows the effect of shifting the demand curve to the right by an increase in the money supply – Before the increase of M, individuals held the right amount of real cash balances at price P – However, when the money supply increases, people now hold too large real cash balances – They spend until the price increases to P’ and equilibrium of real cash balances has been restored Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 22-35 Figure 22.4 An increase in aggregate demand raises prices Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 22-36 Aggregate Demand and Supply: A Summary (Cont.) • Figure 22.4 (Cont.) – Continued expansion of the money supply results in increasing prices (inflation), but not in increased real output – Therefore, in classic economic theory, inflation is a monetary phenomenon and only supported by ever increasing money supply 13 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 22-37 Real Versus Nominal Rates of Interest • With the possibility of inflation, it is necessary to make a distinction between the real rate of interest and the nominal rate • Inflation erodes the real purchasing power of income earned at a given nominal rate of interest • Real interest = nominal interest – anticipated inflation Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 22-38 Real Versus Nominal Rates of Interest (Cont.) • Savers and investors will factor inflation when considering whether to save/invest at a given level of nominal interest • Increasing expectations of inflation will drive the nominal interest rate up until the real interest rate is at the level determined by savings and investment • Therefore, inflation will not cause the real rate of interest to change Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 22-39 Modern Modifications: Monetarists and New Classicists • Modifications to the classical economic theory were developed at the University of Chicago starting in the late 1940s • Monetarists – Adhere to virtually all tenets of classical economics – However, they have made some modifications – They focus on the relationship between M and PY rather than just M and P 14 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 22-40 Modern Modifications: Monetarists and New Classicists (Cont.) • Monetarists (Cont.) – Recognizes the fact that real output may deviate temporarily from full employment, however, eventually the economy will tend toward the full employment level of output – In the 1950s, Milton Friedman replaced the idea of the stability of velocity with a less restrictive notion that it varies in a predictable manner – Money demand may not be a fixed fraction of total spending, but is related to PY in a close and predictable way Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 22-41 Modern Modifications: Monetarists and New Classicists (Cont.) • Monetarists (Cont.) – Therefore, in the short run an increase in M might lead to temporary higher real output, but eventually is reflected just in higher prices – Since the monetarists upheld the classical tradition of inherent stability of the economy at full employment, they rejected governmental attempts to fine-tune the economy – Governmental intervention is unnecessary to regulate the economy and may be potentially damaging Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 22-42 Modern Modifications: Monetarists and New Classicists (Cont.) • New Classical Macroeconomists – Added another reason for futility of government efforts at fine-tuning the economy – Rational Expectations • People formulate expectations based on all available information and recognize that the economy will always tend toward full employment • Therefore, attempts to reduce unemployment by increasing the money supply will not be successful since people will immediately drive up prices • No real effect on economy, just higher prices 15 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 22-43 EQUATION 1 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 22-44 EQUATION 2 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 22-45 EQUATION 3 16 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. Appendix GDP DEFINITIONS AND RELATIONSHIPS Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 22-47 APPENDIX—GDP DEFINITIONS AND RELATIONSHIPS • Divide the economy into two groups—firms and households • Gross domestic product (GDP)—total value of goods and services produced within the United States • GDP can be measured in two ways – The total output sold by firms – The total income received by households • Figure 22A.1 summarizes these relationships – Inner circle records the flows of real things – Outer circle records the associated money flows – Assumes all income (Y) is spent on consumption (C): Y = C – Does not allow for savings Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 22-48 APPENDIX—GDP DEFINITIONS AND RELATIONSHIPS (Cont.) • Saving (S) – Typically households don’t spend all their income, save some fraction – This represents a leakage in the circular flow – Therefore: S = Y - C • Investment (I) – Firms want to add to their stock or production facilities – If firms want to invest exactly what households want to save, equilibrium has been reached: S = I – Therefore, the injections into the circular flow by business investment equals the leakage from saving 17 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 22-49 APPENDIX—GDP DEFINITIONS AND RELATIONSHIPS (Cont.) • Figure 22A.2 shows the connecting link between saving and investment in the financial markets – In the classical model, changes in interest rates would bring desired saving and investment together • Role of the government – Taxes (T) represents a leakage from the circular flow – Government expenditures (G) represent an injection into the circular flow • Equilibrium occurs when the total leakages from the spending stream (S + T) equals total spending injections (I + G): S + T = I + G Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 22-50 FIGURE 22A.1 The circular flow of spending, income, and output. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 22-51 FIGURE 22A.2 The circular flow including saving and investment.