Classical Macroeconomics: Money, Prices and interest

Dear Students,

Hope you have read my earlier topics shared with you online! In
this lecture series I am discussing the determination of equilibrium
rate of interest in the classical model, policy implications and
effects of changes in Government spending and taxes on output
and employment. Finally we also discuss the role of money in
classical model.

In the classical theory the equilibrium rate of interest is

the one which equals the supply of loanable funds to
the demand for loanable funds .
Borrowing consists of selling a standard bond which
promises to pay certain amount in the future or a
perpetuity that pays a fixed interest forever which does
not have any maturity date.
Lending consists of buying such bonds. The rate of
interest is the return to holding bonds and also the cost
of borrowing.
Rate of Interest depends on two factors —
(a) bond supply (borrowing)
(b) bond demand (lending).

In the classical system bonds are supplied by both

firms and governments.

Firms sell bonds to finance all investment

expenditures. The government sell bonds to finance
their deficit i.e. spending in excess of tax resources.
In the classical model, business investment is a
function of the expected profitability of investment
projects and the rate of interest. Expected profitability
of project was assumed to vary with expectations of
project demand over their entire economic lives.
And these expectations are subject to exogenous shifts
in the expected profitability of investment projects.
Government deficit which will be financed by selling
bonds to the public is also an exogenous policy
variable.
If we assume expected profitability to remain
unchanged, then investment expenditures is inversely
related to the rate of interest. And business supply of
bonds equaled the level of investment expenditure.
So on the supply side of bond market the government
bond supply is exogenous and business supply of
bonds is equal to the investment expenditure.

On the demand side there are individual savers who

purchase the bonds. In the classical model, saving was
positively related to the rate of interest because at
higher rates of interest people saved more.

Equilibrium Rate of Interest:

Fig. 3.11 shows how the rate of interest is determined
in the classical model. The equilibrium rate of interest
is the rate that equates the supply of loanable funds,
which consists of saving , with the demand for loanable
funds, which consists of investment (I) plus the deficit
of the government (G – T), i.e., the portion of the
deficit the government must choose to finance by
selling bonds to the public.

Stabilising Role of the Interest Rate:

The rate of interest acts as a stabiliser in the classical
model. If, for example, due to an exogenous event (e.g.,
apprehension of a war in near future) business people
lower their expectations about future profits from
investment, they will reduce their investment levels
which would lead to a fall in the demand for loanable
funds.
If we think of a situation where the government budget
is balanced (G = T), private investment will be the only
source of demand for loanable funds. Now if due to a
fall in expected profitability of investment projects the
investment demand schedule shifts to the left from
I0 to I1, investment will fall by Δ I at the same rate of
interest.
So there will be an excess supply of loanable funds at
the original rate of interest which will cause the rate of
interest to fall from i0 to i1.
As a result two types of adjustment will occur:
(i) Firstly saving will fall and consumption will
increase, because full employment supply of output
remains fixed (as shown by the vertical line in Fig. 3.11
and Fig. 3.12).
(ii) Secondly, investment increases by Δ I’ due to a fall
in the rate of interest. New equilibrium occurs at the
interest rate-with saving (the supply of loanable funds)
again equal to investment (the demand for loanable
funds).
At new equilibrium point E” the increase in
consumption (fall in saving) plus the increase in
investment caused by the drop in the interest rate —
the distance Δ I’ + A C (= – Δ 5) in Fig. 3.12 — is just
equal to the original autonomous decline in investment
demand, Δ I. Since the interest rate falls, the sum of
private sector demands (C + I) remains unchanged
even if there is an autonomous decline in investment
demand.
Policy Implication of classical model

1 Fiscal Policy:
The government budget constraint is expressed as
G = T + Δ B + Δ M … (21)
where G is the government’s expenditure on goods
and services, T is tax revenue, ΔB is market borrowing
(funds raised by selling bonds to the public) and ΔM is
deficit spending (financed by creating/printing new
money through central bank).
If we assume that T remains fixed, and money supply
(M) also remains fixed , then it implies that the
increased government expenditures are financed by
deficit financing through sale of bonds.
Let us examine the effect of a change in government
spending on the interest rate. At the equilibrium rate of
interest (r0), shown by point E, the demand for
loanable funds is equal to its supply.
Due to deficit spending by the government by selling
bonds, the demand curve for loanable funds shifts to
the right to I + (G – T)j. The equilibrium rate of
interest rises from r0 to r1, as shown by point F.

As a result two things happen at the same time. The

volume of investment decreases from I0 to I1 and the
volume of saving increases (or consumption falls) from
S0 to S1. The fall in investment and consumption just
balances the increase in (G- T), the government deficit
spending .

This implies in the classical model a bond-financed

increase in government spending will have no effect on
the equilibrium values of output or the price level due
to nature of both aggregate demand and aggregate
supply curves. These two curves together determine
output and the price level, irrespective of the level of
government expenditure or its changes.

Policy Implication.
Neutral Demand-Side Effect of Tax Policy:
Like government expenditure, a policy of tax cut will
also have no effect on aggregate demand. A cut in tax
rates or lump some tax will increase disposable income
and lead to increase in household consumption. But if
the government sells bonds to recover the revenue loss
arising from tax cut, the crowding out effect will be
observed as is found in case of bond-financed increase
in government spending.
Investment will fall as usual if the rate of interest rises.
The increase in saving, caused by a rise in the rate of
interest, will lead to a fall in consumption. So
consumption will rise to its original level. Thus
aggregate demand will remain unchanged because the
increase in government expenditure will be offset by a
cut in I and C taken together.
If, however, revenue loss due to tax cut is recovered by
printing new money, then aggregate demand will
increase. In this case a policy of tax cut would lead to
proportional rise in the price level. However, tax cut
will have no direct effect (or independent) effect on
aggregate demand.
It will affect the price level independently — by
inducing the government to borrow money from the
central bank to cover the budget deficit.

Supply-Side Effects:
If the tax cut were simply a lump-sum one, then it
would have only demand-side effect. But if the tax cut
were in the form of reduced income tax rates in the
classical model, then it would have a favourable
incentive effect on the supply of labour. In this case
employment and aggregate output will increase.
If we include an income tax in the classical
model, the labour supply function becomes:

This means that for a given pre-tax real wage (W/P), a

cut in the income tax represents an increase in the
after-tax real wage and this, therefore, leads to an in-
crease in labour supply.
Fig. 3.14(a) illustrates the effect of a cut in the marginal
income tax rate from 40% to 20% in the context of the
classical model. In part (a), a cut in the marginal
income tax rate (from 0.40 to 0.20) increases the after-
tax real wage for a given value of the pre-tax real wage.
As a result the labour supply curve shifts to the right
and equilibrium employment rises from L0 to L1.
This, in its turn, leads to an increase in output, in the
classical model, through the production function in
Fig. 3.14(b).
The end result is a rightward shift of the vertical
aggregate supply curve, as shown in Fig. 3.15. Since
output is supply-determined, a rightward shift of the
aggregate supply curve from Ys (corresponding to a tax
rate of 40%) to Ys (corresponding to a tax rate of 20%)
leads to an increase in output from Y0 to Y1.
Since the aggregate demand curve is downward
sloping, the general price level falls from P0 to P1. Thus,
in the classical model, where the level of aggregate
demand remains unchanged because it is determined
by the money supply (there is only movement along the
aggregate demand curve, no shift of the curve), an
increase in aggregate supply due to tax cut and fall in
real wage leads to a fall in the price level.

Importance of Money in Classical Model:

In the classical system, the quantity of money

determines the general price level and, for a given real
income, the level of nominal income. So the stability of
money supply is important for ensuring price level
stability. If M rises, P will also rise proportionately.
But the quantity of money does not affect the
equilibrium values of any of the real variables, viz.,
output, employment, and the interest rate. In the
classical model employment and output are supply
determined. The theory of equilibrium interest rate is
also a real theory, not a monetary theory.
In the classical model the rate of interest is determined
by the real forces of ‘productivity and thrift’ such as
real investment demand, real saving and the real value
of the government deficit.

Classical Dichotomy:
Due to neutrality of money there is a dichotomy
between the factors determining real and nominal
variables. In the classical theory, real (supply-side)
factors determine real variables’. Employment and
output depend primarily on the size of the population,
capital formation and technology.
Interest rate is determined by productivity and thrift.
But monetary factors (such as the demand for and the
supply of money) do not play any role in determining
these real quantities.
In short, money determines only the normal values in
which quantities are measured. But it has no effect on
real quantities such as employment, output and the
interest rate.