Macroeconomics

CHAPTER 7: Here, our focus is on macroeconomic analysis as it was before the Great depression (which greatly revolutionized macroeconomic analysis as we know it today: bringing forth fiscal policy measures and the advantages therein, e.g. economic recovery) i.e. Classical Macroeconomics.

Money supply did not respond to changes in interest rates during the early 1900s because of: 1) the gold standard i.e. the standard economic unit of account is a fixed mass of gold (held by the treasury), and 2) the concept of finance companies (as a sector) lending money, was still relatively new.

Due to the fact that classical macroeconomists had not factored in variables (such as: corporate lenders, investment of idle cash from sales by giant private firms and investment of temporarily idle taxes by government) which, contemporarily cause the money demand (M) and Velocity of money (V) to respond to interest rate changes, the Aggregate Supply of Funding (ASF) line was vertical when plotted. Further, the classical economists had not come up with a hypothesis pertaining to how the Aggregate Planned Expenditure (APE) responds to changes in Gross Domestic Income (GDY) therefore, their diagrams lacked an IS line (which is present in modern day diagrams).

The APE line, where the economy is in equilibrium (from a classical macroeconomist’s point of view) is similar to a present day diagram. As illustrated in the diagram, where GDP=APE=ASF (Io and GDP0), ASF line however being atop the GDP line. The repercussion of the ASF line being horizontal is seen given a scenario where the APE line shifts to the right (at the existing interest rate levels); implying an increase in expenditure with no funding to compliment it. Meaning, due to the unresponsiveness of M and V to changes in the interest rates, the rates just continue to rise but the funding doesn’t increase. Firms end up not bothering to increases prices or output because the demand that would have been there has been crowded out...