Page 58 - DECO201_MACRO_ECONOMICS_ENGLISH

Unit 3: Theories of Income, Output and Employment: Classical Theory

Figure 3.22 Notes
Y
Price Sm Sm
level o 1 Dm

P E
1 1
E o
P o A

X
O M o M 1 Money Supply

Figure 3.23
Y
Price Sm
level Dm o

Dm 1
E A
P o o

P E 1
1

X
O M o Money Supply

The easiest way to reduce M is to spend it. The increased spending starts raising prices. As prices
rise, people now need to hold more money to carry out transactions. This raises demand for
money. The Dm-Sm equality is restored when the price level has risen enough to make rise in
Dm equal to the increased Sm. The Dm-Sm is restored at OP .
1
Now suppose demand for money changes: People hold OM (=P E ) of money at OP . Suppose
o o o o
now they want to hold P A. This rotates the demand for money curve to the right. People are
o
now holding less money at OP than they want to hold. Dm exceeds Sm by E A. To hold more
o o
money people cut back on spending. As a result, the price level falls. As P falls people now need
to hold less money to carry out transactions. This reduces demand for money. The Dm-Sm
equality is restored when the price level has fallen enough to make fall in Dm equal to the initial
increase in Dm. The Dm-Sm equality is restored at OP .
1
Neutrality of Money (Classical Dichotomy)

When price level rises, nominal GDP rises but the real GDP remains unchanged. In the labour
market, nominal wage rises but the real wage remains unchanged. In the capital market only
nominal saving, nominal investment and nominal ROI increase but real saving, investment and

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