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Classical economics is traditional old school economics. Starting with
the great grandfather of economics Adam Smith, classical economists
claim the free markets regulate themselves when free of any intervention.
So, Adam Smith referred to a so called invisible hand which will move
markets towards the natural equilibrium without requiring any outside
intervention. So, one of the things that believe in this is that prices
are flexible. Now, this belief has great implications on the interpretation
of money. When money supplies increase, they believe the price levels
will increase. In other words, there will be inflation. This happens
because there is more money in the economy but the real goods, the amount
of cookies that money can buy in the economy is still the same. So,
say originally there are 10 cookies in the economy and it’s 100 dollars
floating around the economy. So, naturally each one cookie costs 10
dollars. But now if the government increases the money supply and there
are 200 dollars floating in the economy, then each cookie naturally costs
20 dollars. So, there will be an increase in price level, in other words,
inflation if the government increases the money supply. At the same
time, now remember our graph of money demand and supply, so whenever
the supply increases, there will be decrease in interest rate temporarily.
So, yes, the money supply does shift to the right but because of higher
price levels, people demand more money. Because of inflation people
demand more money. Now, if cookies now cost 20 dollars each, people
will require more cash at hand to buy them. So, money demand increases
as well, not just the money supply and interest rate eventually stays the
same. So, eventually the short run interest rate never changes due to
money supply movements and money demand movements. So, this is all because
classical economists believe that prices are flexible, that when money
supply increases, price level necessarily increases as well. So, short
run interest rates cannot be subject to manipulation by the central bank
through the money supply and hence it always follows the long term
interest rate. In other words, those two are one and the same to classical
economists.