Classical Theory of Money

Supply & Interest Rate

Lecture 6
Learning Objectives.
• What are the basic assumptions of Say`s Law(Classical Economist)?
• How do the Credit market & Interest rate function in Classical Model?
• How do the Money market function in Classical Model?
• What is Quantity theory of Money?
• What are the criticisms against classical theory of full employment?
1st Goal: Say`s Law
• Say`s law states “ Supply creates its own demand”.

• Say`s law is explained indifferent ways i.e.

1. Barter Economy
2. Money Economy
3. Labor Market
 1. Say`s law in Barter (Goods) Economy
• In Barter economy people produce goods either for their own use or to exchange
them for goods.
• It states that “ Whatever is produced in the barter economy is sold out
completely”. AS = AD or ΣS = ΣD
• AS = Aggregate Supply of goods
• AD = Aggregate Demand of goods
• If the price of one good is higher then another good, the resources will shift from
the production of low value good to high value good.
• The value of good will fall where the resources are moving out and rise the value
of good where the resources are coming in.
Equilibrium in Goods Market
2. Say`s law in Money Economy
• What so ever is earned is spent on the goods & services produced in
the market. In other words, income received is always spent on
consumption and investment i.e. no money hoarding.
• Money only acts as medium of exchange.
• Earnings are represented by AD and output by AS. i.e. AD=AS
• When nothing remains unsold, no producer will face losses, hence
the possibility of unemployment is ruled out.
3. Say`s law in Labor Market
• There is no possibility of general unemployment in economy.
• If labor is welling to accept the wages equal to the value of its marginal
product, there cannot be unemployment.
VMP = MP * P = W
VMP = Value of Marginal Product
MP = Marginal Product
P = Price of Product
W = MP. P → W/P = MP
In the presence of perfect competition, wages are determined by the forces
of demand and supply. i.e. if wages are flexible there cannot be
unemployment.
 2nd Goal: Credit Market in Classical Model
• According to classical
economics, at full
employment level, saving
and investment are equal.
i.e.
S=I
Whereas S = f(i)
it has a +ve relation
I = f(i)
it has a -ve relation
3rd Goal: Money Market In Classical Model
• According to classical economists, money is just a
medium of exchange, it is used to carry out day today
transactions and has neutral impact on an economy.
• It cannot influence the real variables as output and
employment.
• However, it influences the monetary variables as wage
rate and price level.
 Quantity Theory of Money
• Quantity theory of money states that: the price level is proportional to the
quantity of money.
MV = PY
M= Quantity of Money
V = Velocity of money ( rate at which money turns over in GDP
transaction during a given period, i.e. the
average number of times each Rs is used in
GDP transactions)
P = Price level
Q/Y = Output Level.
 Quantity Theory of Money
1. Velocity is stable.
2. The amount of goods/services that can be produced is fixed in the short run.
3. If the Fed increases the MS by 15%, we will see a proportional 15% increase in
prices.
4. V and Q aren’t in the equation & a change in MS will result in a change in P.
According to quantity of money
MV =PY
And we know that Y = GDP = C + I +G
• If we assumes that Y and V are constant in a short run then
M=P
• Quantity of money is directly proportional to the price level i.e. double the
quantity of money double will be the price level.
Quantity Theory of Money: Graphic Presentation
5th Goal: Criticism Against Classical Economist
1. Possibility of Over Production: During great depression market was
flooded with goods but there was no demand as people don`t have
the power to purchase. There was high inflation and high
unemployment in economy.
2. Saving is not always equal to investment, according to classical
economist. Keynes objected that savers and investors are two
different classes, their motives & incentives are different. In the
presence of complicated economic system it is not guaranteed that
saving must be equal to investment.
3. Fall in money wage decrease aggregate demand. Wages are
flexible upward and rigid downward (ratchet Effect).
The Ratchet Effect
A ratchet (socket wrench)
permits one to crank a
tool forward but not backward.

Like a ratchet, prices can easily move

up but not down!
14
 Does deflation (falling prices) often occur?
Not as often as inflation. Why?
• If prices were to fall, the cost of resources must fall or
firms would go out of business.
• The cost of resources (especially labor) rarely fall
because:
• Labor Contracts (Unions)
• Wage decrease results in poor worker morale.
• Firms must pay to change prices (ex: re-pricing
items in inventory, advertising new prices to
consumers, etc.) 15
Criticism Against Classical Economist
4. Non-Existence of Perfect competition: Classical model is of the view that
full employment is based on flexibility of wages, prices, rate of interest &
operation of forces of demand and supply. But practically, goods market are
characterized by monopolies, cartels and oligopolies etc.
5. Trade unions and unemployment allowances; leads to imperfect
competition and rise in unemployment level.
6. Full employment is not possible. The capitalism operates under “price
mechanism & self interest motives”. This statement is optimistic in nature.
Economy is faced with lack of resources i.e. shortage of goods, lack of
investment opportunities, unevenly distributed wealth, price rise etc.
Moreover, the difference b/w social benefit, private benefit and the
possibilities of externalities.
Review
We have learned about:
1. Say`s Law
2. The classical view of money and credit market.
3. The quantity theory of money.
4. The criticism raised against the classical/monetarist.
THANK YOU