rate of interest (∆S/∆r > 0), household consumption must be negatively

related to the rate of interest (∆C/∆r < 0). Investment expenditure on capital

goods is negatively related to the rate of interest in the classical model (∆I/∆r

< 0) and represents a demand for loanable funds in the capital market.

Investment spending by ¬rms can only be justi¬ed if the expected rate of

return from the expenditure is greater than, or at least equal to, the cost of

acquiring the funds used to purchase the capital goods. The higher the rate of

48 Modern macroeconomics

interest, the higher the explicit (and implicit) cost of the funds used to

purchase the capital goods. We can therefore represent business expenditure

(I) as a declining function of the interest rate. The relationship between

investment, saving and the interest rate in the classical model is shown in

panel (a) of Figure 2.3. The twin forces of productivity and thrift determine

the real rate of interest, and variations in the interest rate act as an equilibrat-

ing force which maintains equality between the demand for and supply of

loanable funds, ensuring that aggregate demand is never de¬cient. By refer-

ring to Figure 2.3 we can see how important ¬‚exibility in the interest rate was

to the classical equilibration process. In panel (a) we represent the classical

theory of interest rate determination, with the interest rate on the vertical axis

Figure 2.3 The classical interest rate mechanism and Say™s Law

Keynes v. the ˜old™ classical model 49

and the ¬‚ows of saving and investment measured on the horizontal axis. In

panel (b) real output is measured on the vertical axis with the overall demand

for commodities (C + I) measured on the horizontal axis. From Figure 2.2 we

know that competition in the labour market will yield an equilibrium real

wage and level of employment which, when combined with the production

function, give a level of full employment output of Ye. Panel (b) of Figure 2.3

indicates that aggregate expenditures of an amount equal to E0 are necessary

to purchase the output of Ye. Since output and demand are identical at all

points along the 45° line, any point such as B and C is consistent with the

weak version of Say™s Law. Point A in panel (b) corresponds to the strong

version of Say™s Law. Not only are aggregate expenditure and output in

equality, Ye corresponds to the level of output associated with full employ-

ment labour market equilibrium.

We can best see the importance of interest rate ¬‚exibility in this model by

asking what would happen if households suddenly decided to save more

(consume less). This is represented in panel (a) of Figure 2.3 by a rightward

shift of the saving function from S0 to S1. The initial excess supply of loanable

funds would lead to a fall in the rate of interest from r0 to r1. This would

encourage an increase in investment expenditure from I0 to I1. Since E0 “ I0

equals consumption expenditure, it is clear that the rise in investment ex-

penditure, I1 “ I0, exactly offsets the fall in consumption expenditure equal to

“∆C in the diagram. Aggregate expenditure would remain at E0, although its

composition would change.

Even though in the classical model the decisions to save and invest can be

carried out by different sets of people, the rate of interest will change so as to

reconcile the desires to save and invest. In Keynesian theory divergences

between S and I cause a quantity response. In the case of an increase in

saving, the Keynesian model predicts a decline in aggregate spending, output

and employment; that is, Keynes™s paradox of thrift. The classical model,

armed with Say™s Law, ¬‚exible wages, prices and the interest rate, can experi-

ence changes in the structure of ¬nal demand but no prolonged demand

de¬ciency and involuntary unemployment. A remarkable result.

Not all the classical economists accepted Say™s Law and its implications.

Robert Thomas Malthus argued that a general glut of commodities was

possible. Whereas Ricardo, Mill and the followers of Say believed that the

conditions of supply determine aggregate output, Malthus, anticipating Keynes,

gave emphasis to demand as the determining factor (see Dorfman, 1989). But

˜Ricardo conquered England as completely as the Holy Inquisition con-

quered Spain™ (Keynes, 1936, p. 32). For Keynes the completeness of the

Ricardian victory was something of a curiosity and a mystery. For this reason

he gave high praise to Malthus for anticipating his own ideas with respect to a

general de¬ciency of aggregate demand (see Keynes, 1936, pp. 362“71).

50 Modern macroeconomics

Although Ricardo appeared to be stone deaf to what Malthus was saying, part

of the disagreement had its origin in the time horizon adopted by each writer.

Ricardo had his eyes ¬xed ¬rmly on the long run, whereas Malthus, like

Keynes, was more concerned with the short run.

In our discussion of the classical model so far we have concentrated on the

real sector. The operation of the labour and capital markets, buttressed by

Say™s Law, provided the classical economists with a theoretical system capa-

ble of explaining the determination of the real variables in the system. But

what determines the price level in the classical model? The ¬nal component

that explains the determination of the price level and the other nominal values

in the classical economists™ system is the quantity theory of money.

2.5 The Quantity Theory of Money

The hallmark of classical macroeconomic theory is the separation of real and

nominal variables. This classical dichotomy enables us to examine the behav-

iour of the real variables in the economic system while ignoring the nominal

variables. In the stylized classical model we have developed, the quantity of

money is irrelevant for the determination of the real variables. Long-run

money neutrality is a crucial property of the classical model.

To explain the determination of the nominal variables in the system, the

classical economists subscribed to the quantity theory of money. A long line

of famous economists have either contributed to the development of this

theory or have been associated with its policy prescriptions. The list includes

Cantillon, Hume, Ricardo, Mill, Marshall, Fisher, Pigou, Hayek and even

Keynes. More recently the quantity theory of money has been associated with

the development of monetarism and the work of Milton Friedman, perhaps

the most in¬‚uential economist in the past quarter-century. Although the term

˜monetarism™ did not emerge until 1968 (see Brunner, 1968), its main core

proposition, the quantity theory of money, was well established in classical

macroeconomics following the publication of David Hume™s in¬‚uential es-

say, Of Money, in 1752. Indeed, Mayer (1980) has argued that the salient date

for the birth of monetarist ideas was 1752, since most of the fundamental

propositions which characterize monetarism date back to Hume™s essay. Here

we will present only a short exposition of the quantity theory in order to

complete the classical scheme. For a more detailed discussion, see Laidler

(1991).

The dominant macroeconomic theory prior to the 1930s was the quantity

theory of money. Two highly in¬‚uential versions of the quantity theory can

be identi¬ed in the literature. The ¬rst version, associated with Marshall and

Pigou, is known as the Cambridge cash-balance approach. The second ver-

sion is associated with Irving Fisher.

Keynes v. the ˜old™ classical model 51

The Cambridge economists drew a clear distinction in their version of the

quantity theory between the demand for money (Md) and the supply of

money (M). The demand for money was primarily determined by the need to

conduct transactions which will have a positive relationship to the money

value of aggregate expenditure. Since the latter is equal to money national

income we can represent the Cambridge money demand function as equation

(2.13):

Md = kPY (2.13)

where Md is the demand to hold nominal money balances, and k is the

fraction of the annual value of money national income (PY) that agents (¬rms

and households) wish to hold. The reader should be aware that the Cam-

bridge monetary approach did recognize that k could vary in the short run

(see Laidler, 1993) but, in the stylized presentation we consider in equation

(2.13), the coef¬cient k is assumed to be constant. As it stands, the Cam-

bridge equation is a theory of the demand for money. In order to explain the

price level we must introduce the supply of money. If we assume that the

supply of money is determined by the monetary authorities (that is, M is

exogenous), then we can write the condition for monetary equilibrium as

equation (2.14):

M = Md (2.14)

Substituting (2.14) into (2.13) we obtain (2.15):

M = kPY (2.15)

To obtain the quantity theory result that changes in the quantity of money

have no real effects in the long run but will determine the price level, we

simply need to remember from our earlier discussion that Y is predetermined

at its full employment value by the production function and the operation of a

competitive labour market. With k and Y constant, M determines P. If the

money market is initially in equilibrium, then an increase in the money