GRIPS Macroeconomics II

Fall II Semester, 2016

Lecture 2a: Determination of National Income  Classical Theory
Junichi Fujimoto
December 5, 2016

Classical AD and AS Curves (overview)

Let us review the gure from the last lecture.

Demand Side

Supply Side

quantity equation of money:

M=kPY

Firms
optimization problem
Labor demand LD

Households
optimization problem
Labor supply

equilibrium labor input

AD Curve

LS

L*

Y * = F ( L* )
vertical AS curve Y = Y *

equilibrium output

kP

Downward sloping AD curve

Determination of national income (classical)

Figure 1: Derivation of AD and AS Curves (Classical Theory)

Classical AS Curve

In the last lecture, we analyzed production and the labor market. Let Y denote equilibrium output obtained in
the analysis. Then the classical AS curve is given by
Y = Y .

(1)

Classical AD Curve

The classical AD curve is derived from the following `quantity equation of money':
M = kP Y.

(2)

Here, M is the quantity of money, and k is a constant called Marshall's k (or propensity to hold money), which
indicates how much money people wish to hold for a unit of nominal income. This equation implies that money
demand (which equals money supply in equilibrium) is proportional to nominal GDP (or that demand for real
balances M/P is proportional to real GDP). From (2), we obtain the AD curve
Y =

M
.
kP

(3)

AS

P**

AD

P*

AD
Y*

Figure 2: The Eect of Increasing the Money Supply (Classical Theory)

Sometimes, the quantity equation is written as
M V = P T,

(4)

where V is the transactions velocity of money, which measures the rate at which money circulates in the economy.
T denotes the number of transactions in a given period of time, and P T denotes the total value of transaction. But
since the measurement of transactions is dicult, this equation is more often used in the following form:
M V = P Y,

(5)

where V is the income velocity of money, which indicates the number of times a unit of money enters someone's
income in a given period of time. Combining (2) and (5) yields
k = 1/V.

(6)

It is important to note that (2) and (5) always hold as identities. What is key to the classical theory of money
(= quantity theory of money) is the assumption that k (or V ) is constant, and when combined with the analysis of
the supply side of the economy, this assumption yields strong implications as discussed below.

Equilibrium of the Economy and its Implication

The equilibrium of the economy is given by the intersection of the AD and AS curves, (P , Y ). What is important
is that Y is determined from the supply side, independent of the aggregate demand; the AD curve only matters
for the determination of P .
Now, suppose that the government doubles the money supply from M to 2M . This expansionary monetary
policy will shift the aggregate demand curve from AD to AD0 (conrm this from eq (3)). From Figure 2, we observe
that P rises and Y remains unchanged. Furthermore, the analysis from the previous lecture tells us that real
variables Y , L , and ( Pw ) are all determined solely from the supply side, so are unaected by this monetary policy.
On the other hand, nominal variables P and w will double when M doubles.
That the quantity of money does not aect real variables is called `the neutrality of money'. Also, that real
variables are determined independently of nominal variables is called `the classical dichotomy'. Many economists
think these are approximately correct in the long run, but not necessarily so in the short run (see textbook p112).
(Problem) In the classical model, suppose M rose by 2%, and Y fell by 4%. What is the ination rate ?

Problem of the Classical Model

In the classical model, changes in Y can only be explained from the shift of the AS curve. For example, a fall in Y
must be explained as due to a leftward shift of the AS curve, in which case P should rise. Therefore, a simultaneous
fall in Y and P , as observed in the U.S. during the Great Depression, cannot be easily explained by the classical
model. We will next look at the Keynesian model, which can explain this.
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