Question

Explain the workings of the classical model.

What would the model imply for the economy if there was

a) rise in personal savings

b)rise in money supply

c)rise in government spending financed by borrowing

Answer 1

a) In classical model, raise in personal savings is equivalent to raise in demand for bonds. Savings are positively related to interest rates, so higher saving corresponds to higher interest rates. This increases the cost of borrowing and investment in the economy, causing a fall in income.

b) A raise in money supply does not cause any real change in the long run equilibrium output. The increase in money supply increases price levels which may increase supply of the goods in the short run but in the long run the demand also declines, bringing back the output to the original equilibrium while further increase in prices.

c) Rise in government spending by borrowing increases the interest rate in the market, lowering investment and output in the economy. There is no positive effect of government spending in the classical model on the output in the economy.