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Chapter 22 - The classical foundations. In this chapter you will learn to define Say's law and the classical understanding of aggregate supply, understand the supply of saving and demand for investment that leads to the equilibrium interest rate, explain the quantity theory of money and its implication for the aggregate demand curve, differentiate between the nominal and real rate of interest. | Chapter 22 The Classical Foundations Copyright © 2009 Pearson Addison-Wesley. All rights reserved. Learning Objectives • Define Say’s law and the classical understanding of aggregate supply • Understand the supply of saving and demand for investment that leads to the equilibrium interest rate • Explain the quantity theory of money and its implication for the aggregate demand curve • Differentiate between nominal and real rate of interest Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 22-2 Introduction • Origins of monetary theory lie in Classical Economics, starting with the works of Adam Smith (1723–1790) • Two cornerstones of classical economics – Say’s Law—deals with interest rates, employment and production – Quantity Theory of Money—examines the role of money in the economy • Focused on long-term view of the economy Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 22-3 1 Introduction (Cont.) • Classical economics was attacked by John Maynard Keynes during the Great Depression • Theory was resurrected and refined by modern monetarists and new classical macroeconomics beginning in the 1970s • The starting point of classical theory is what determines gross domestic product (GDP)—total value of goods and services produced domestically Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 22-4 Classical Economics • “Supply creates its own demand” • The economy could never suffer from underemployment • Total spending (demand) would always be sufficient to justify production at full employment (supply) Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 22-5 Classical Economics (Cont.) • Potential output of an economy – Determined by the size of the labor force to work with existing capital stock and level of technology (real factors in the economy) – Production function defines the total supply of goods and services that can be produced – Because of interplay of market forces (an invisible hand), .
