ASSIGNMENT ON INTERMEDIATE MACROECONOMIC MACROECONOMIC (ECN 304 )
BERNARD OKPE REG. NO./GROUP/LEVEL: University of Abuja, Nigeria DEPARTMENT & FACULTY: ECONOMICS & SOCIAL SCIENCES QUESTION:
Question 1: Compare and contrast Classical theory of interest rate and Keynesian theory of interest Question2: Highlight all the controversies between Keynesian, Monetarist, and the Classical
QUESTION 1:
COMPARE AND CONTRAST CLASSICAL THEORY OF INTEREST RATE AND KEYNESIAN THEORY OF INTEREST
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1.2.
KEYNES’ LIQUIDITY
PREFERENCE THEORY OF INTEREST
Precautionary motive: Precautionary motive for holding money refers to the desire to hold cash balances for unforeseen contingencies. Individuals hold some ca sh to provide for illness, accidents, unemployment and other unforeseen contingencies. Similarly, businessmen keep cash in reserve to tide over unfavorable conditions or to gain from unexpected unexpected deals. Keynes holds that the transaction transaction and precautionary motives motives are relatively interest inelastic, but are highly income elastic. The amount of money held under these two motives (M 1) is a function (L1) of the level of income (Y) and is expressed as M 1 = L1 (Y)
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Algebraically, Keynes expressed the speculative demand for money as M 2 = L2 (r) Where, L2 is the speculative demand for money, and r is the rate of interest. Geometrically, it is a smooth curve which slopes downward from left to right. Now, if the total liquid money is denoted by M, the transactions plus precautionary motives motives by M 1 and the speculative motive by M 2, then
M = M 1 + M 2. Since M 1 = L1 (Y) and M 2 = L2 (r), the total liquidity preference function is expressed as M = L (Y, r). 1.2.2. Supply of Money: The supply of money refers to the total quantity of money in the country. Though the supply of money is a function of the rate of interest to a certain degree, yet it is considered to be fixed by the monetary authorities. Hence the supply curve of money is taken as perfectly inelastic represented by a vertical straight line. The total demand for money is obtained by summating the transactions, precautionary and speculative demands. Represented graphically, it is sometimes called the liquidity preference curve and is inversely related to the rate of interest.
Money Demand and Increases in Real GDP Consider a period of sustained economic growth in the economy. Rising real incomes and increasing numbers of people employed will increase the demand for money at each rate of interest. Therefore higher real national income causes an outward shift in the demand for money. This is shown in the diagram below.
Financial Innovation and the Demand for Money The pace of change in financial markets is rapid and this affects our demand for money balances in order to finance our purchases. In recent years the demand for cash balances (M0) has declined relative to the demand for interest-bearing deposit accounts. Most people can finance their purchases using debit cards and credit cards rather than carrying around large amounts of cash. Financial innovation has reduced the demand for cash balances at each rate of interest - represented by an inward shift in the money demand curve.
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1 .2.3. Determination of the Rate of Interest: Interest: Like the price of any product, the rate of interest is determined at the level where the demand for money equals the supply of money. In the following figure, the vertical line QM represents the supply of money money and L the total demand for money curve. Both the curves intersect at E2 where the equilibrium rate of interest OR is established. If there is any deviation from this equilibrium position an adjustment will take place through the rate of interest, and equilibrium E 2will be re-established. At the point E 1 the supply of money OM is greater than the demand for money OM 1. Consequently, the rate of interest will start declining from OR1 till the equilibrium rate of interest OR is reached. Similarly at OR2 level of interest rate, the demand for money OM 2 is greater than the supply of money OM. As a result, the rate of interest OR2 will start rising till it reaches the equilibrium rate OR. It may be noted that, if the supply of money is increased by the monetary authorities, but the liquidity preference curve L remains the same, the rate of interest will fall. If the demand for money increases and the liquidity preference curve sifts upward, given the supply of money, the rate of interest will rise. 1.1.1.
Criticisms of Criticisms of the Keynesian Theory Of Interest Interest Rate:
Keynes theory of interest has been criticized on the following grounds: 1. It has been pointed out that the rate of interest is not purely a monetary phenomenon. Real forces like productivity of capital and thriftiness or saving by the people also play an important role in the determination of the rate of interest. 2. Liquidity preference is not the only factor governing the rate of interest. There are several other factors which influence the rate of interest by affecting the demand for and supply of investible funds. 3. The liquidity preference theory does not explain the existence of different rates of interest prevailing in the market at the same time. 4. Keynes ignores saving or waiting as a means or source of investible fund. To part with liquidity without there being any saving is meaningless. 5. The Keynesian theory only explains interest in the short-run. It gives no clue to the rates of interest in the long run. Page | 4
6. Keynes theory of interest, like the classical and loanable funds theories, is indeterminate. We cannot know how much money will be available for the speculative demand for money unless we know how much the transaction demand for money is. 1.3.
Comparison between Classical and Keynesian Theories of Interest
The Keynesian theory of interest is an improvement over the classical theory in that the former considers interest as a monetary phenomenon as a link between the present and the future while the classical theory ignores this dynamic role of money as a store of value and wealth and conceives of interest as a nonmonetary phenomenon. Thus, the classicists made the serious error of ignoring the monetary element in formulating the theory of interest a monetary theory. Thus, the classical theory of interest in comparison with Keynes' liquidity preference theory has several weaknesses. They are as under: 1. The classical theory treated interest as the price for not spending, for saving, while, in fact, as the liquidity theory points out, it is price paid for not hoarding i.e. parting with liquidity. 2. The classical theory views the demand for money exclusively in terms of investment. It fails to consider the fact that the demand for money might also arise from the demand for hoarding, i.e., holding idle cash balances on account of the liquidity preferences. It is the Keynesian theory of interest that recognizes the important role of liquidity preference in the determination of the interest rate. 3. The classical theory is narrow in scope as it ignores the borrowing motives like hoarding or the purpose of consumption and concentrates only on savings demanded for productive purposes, i.e., real investment demand. 4. Classical economists did not pay any attention to the money supply and bank credit which can never be ignored as a determinant of the r ate of interest. Keynes does pay attention to the quantity of money as a factor determining the rate of interest. 5. The classical theory is rather ambiguous and indefinite. It ignores the fact that saving is a function of income but regards it as a function of the interest rate. This is wrong; Keynes argued that when the rate of interest goes up level of income will be less since investment will decline so savings will be less. Keynes thus stressed the fact that saving is a function of income rather than that of the interest rate. 6. The main weakness of the classical theory is, therefore, that it assumes the level of income to be always given. This is because it assumes full-employment equilibrium. The theory is, therefore, rejected by Keynes because it is applicable only to a case when income is fixed at a point corresponding to the level of full employment. Keynesian theory, on the other hand, is more realistic as it considers the economies of less than full employment also. 7. In fine, an important distinction between the Keynesian and classical theories of interest is that the former theory is completely stock theory whereas the latter is a completely flow theory. 8. In some respects, the Keynesian theory is narrower in scope, compared with the classical theory. Keynes' liquidity preference theory applies to the supply and demand for money savings or money capital only whereas the classical theory applies to non-monetary capital also. 9. Moreover, the liquidity preference theory assumes that a person should lend capital to somebody to get interest; for then alone can one say that he has parted with liquidity and that interest is assumed to be a reward for parting with liquidity as such. According to the classical theory, on the other hand, even if a person does not necessarily part with his savings but uses them in his own productive activity (real investment), interest will arise.
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1.4. Conclusion: Nevertheless, we may conclude that Keynesian theory is superior to the classical theory of interest since the former is concerned with equilibrium in the real sector. Thus, in the money economy of the present world, the Keynesian theory is more realistic than the classical theory of interest.
QUESTION 2:
HIGHLIGHT ALL THE CONTROVERSIES BETWEEN KEYNESIAN, MONETARIST AND THE CLASSICAL ECONOMIC ECONOMIC
2.0. Introduction: Over the years, macroeconomists from different schools of thought have had a divergent view on what really drives economic growth for an economy in achieving the macroeconomic. In this case, I will limit my idea to the controversies and the divergent view between Keynesian, Monetarist and the Classical economic theory. 2.1.
The Controversies:
The primary phenomena and controversies among these three (3) schools of thought investigated are: 1. The proposed Structure and Stabilization Policies of the Economy 2. 3. 4. The proposed Structure and Stabilization Policies of the Economy: The fundamental message of the Keynesian is that the private enterprise needs to be stabilized, and therefore should be stabilized by appropriate monetary and fiscal policies. Monetarists by contrast take the view that there is no serious need to stabilize stabilize the economy; that even if if there were were a need it should not be done since stabilization policies would be more likely to increase than to decrease instability. To the Classical, which uses the -correcting mechanisms will work well, if not stifled ‘Passive Strategy’ approach that assumes that the self -correcting by unnecessary meddling by policymakers. They Classical believe that erratic, improperly timed activist policies are actually a source of economic instability, and that economy would be better off if it maintain stable, predictable fiscal and monetary policy during all phases of the business cycle. Therefore, to monetarists there is no active role for stabilization policy, and to Keynesians there is. Classical, assumes self-correcting mechanisms. Macroeconomics Thought on Demand for Money (Quantity Theory of Money): The Classical economists assumed that the velocity of the money was constant. They believed the institutional, structural and customary conditions determined the velocity. P is the general price level. It is an average of prices of all those final goods and services provided and exchanged in the economy over the time period chosen for observation. The classical macroeconomists assumed that, because of full employment and flexibility of price, wage and interest, physical output would be constant. As a result, a change in the amount of money supply will cause a proportional change in the general price level-1. Modern Quantity Theory expressed in its most basic form, the simple quantity theory of money makes the demand for nominal money balances depend only on the nominal income level: M = P • f{Y). The Keynesian theory adds the interest rate as a determinant to give us a different fu nction: M = P • f(Y,r).During the post Keynesian period, another theory was developed. Its creator, Milton Friedman who championed the Monetarist sees the modern quantity theory as a restatement of the old one, whereas others see it as an
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elaborate statement of Keynesian theory. One way of expressing the demand for money in the simple quantity theory is M = k(PY), where k is a constant. Macroeconomics Thought on Inflation: In order to explain inflation, the Keynesians tend to argue that the long-run Phillips curve is not vertical and that the government needs to, pursue an unemployment target via discretionary demand management policies. Such policies will involve inflation owing to the trade-off between unemployment and inflation and believe that the long-run Phillips curve can be shifted downward by the adoption of a prices and incomes policy. Fig-3: Keynesian Inflationary Gap. Using the Keynesian model is the relation between equilibrium and full
employment. The relation between the inflationary gap and recessionary gap indicates which of the gaps, if either, might exist. In this particular example, full employment results with $9 trillion of aggregate production, which is less than the $12 trillion equilibrium level of aggregate production. The relation between equilibrium and full-employment aggregate production means the economy has an inflationary gap. The resulting inflationary gap is $3 trillion of aggregate production. In other words, aggregate production needs to decrease decrease by $3 trillion to eliminate eliminate this gap. The Monetarists argue that inflation is essentially a monetary phenomenon propagated by excessive monetary growth. They accept that in the short run there may be a trade-off between inflation and unemployment but argue that once people have fully adjusted their inflationary expectations the trade-off disappears, resulting in a vertical long-run Phillips curve at the natural rate of unemployment. In short, monetarists advocate that discretionary demand management policies should be replaced by a monetary rule in order to avoid economic instability. New classical macroeconomics incorporates the monetarist view that inflation: is essentially a monetary phenomenon propagated by excessive monetary growth and can only be reduced by slowing down the rate of monetary expansion. Macroeconomics Thought on Growth: Growth: One growth theory relates the growth rate of the economy's aggregate output to that of its capital stock. In this approach, capital is the only factor of production explicitly considered and it is assumed that labor is combined with capital in fixed proportions. With regard to the rate at which capital accumulates, this theory is Keynesian in nature. Keynesian-based growth theory is commonly known as the Harrod-Domar theory. The Classical is based their idea on "subsistence level" to model their Growth Theory. They believed that if real GDP rose above this subsistence level of income that it would cause the population to increase and bring real GDP back down to the subsistence level. It was sort of like an equilibrium level that real GDP would always revert to in this theory. Alternatively, if the real GDP fell below this subsistence level, parts of the population would die off and real income would rise back to the subsistence level. Keynesian growth theory appears essentially a theory of the medium period, Classical a theory of the long period. The main differences between the two theories concern the formation of expectations with respect to factor prices and the behavior of capacity utilization. Basically monetarism views government roles in policy to ensure a stable equilibrium in the Money Market (supply and demand for money). This is known as Price Stability. Too much growth equals higher than normal levels of inflation. Too little growth and the economy may slow. Money is the only way to manage the "health" of the economy, as defined by stability fo economic variables (unemployment, inflation, output growth, etc.) Macroeconomics Thought on Unemployment: The Keynesian approach is usually associated with Keynesian AD-AS model. In terms of the IS-LM model the Keynesian position has been characterized by a relatively flat LM curve and a relatively steep IS curve. Fiscal policy is preferred as the main policy instrument to maintain the economy at a high and stable level of employment. In contrast to Keynesian beliefs, monetarists argue that capitalist economies are inherently stable and that when subjected to some disturbance the economy will return to equilibrium at the natural rate of unemployment. As such, they question the need for discretionary aggregate-demand management policies and tend to argue that such Page | 7
policies cannot stabilize the economy. Regarding fiscal policy, monetarists argue that while pure fiscal expansion can influence output and employment in the short run, and in the long run it will have no effect. Monetarists argue that if governments wish to reduce the natural rate of unemployment in order to achieve higher employment levels they should pursue microeconomic or what are referred to as supply side policies rather than macroeconomic policies. According to Classical, anticipated aggregate demand policies will be ineffective in influencing level of output and employment even in the short run, and that only random and unanticipated shocks to aggregate demand can temporarily affect output and employment. Any attempt to affect output and employment by random or non-systematic aggregate demand policies would, only increase the variation of output and employment. Macroeconomics Thought on Wage Price Stickiness: Sticky prices lie at the very heart of Keynesian macroeconomics, and it explains quantity fluctuations in goods and labor markets as equilibrating movements arising because prices do not immediately change when aggregate demand shifts. The postulate of price flexibility lies at the center of new-classical economics. It has it that prices always move to equilibrate markets when demand shifts, but that individual agents, who are not fully informed about the behavior of all money prices in the economy, mistake money price changes in the markets for the goods they sell for relative price changes. Hence they respond by changing the quantities of goods they supply. In the aggregate, an unperceived demand increase which raises the general price level therefore causes an expansion of output along aggregate supply curve, and a fall of demand causes a contraction. Macroeconomics Thought on Consumption: The consumption function is the centerpiece of Keynes’ General Theory. Keynesians approach to consumption was “Absolute income Hypothesis .One of the earliest attempt to derive a theory of consumption function in accord with the empirical discoveries was James Duesenberry's Relative Income Hypothesis (1949).A household's consumption depends not on its absolute income but on its relative income; relative that is to (1) the income of other households and (2) its own Previous income. Later Milton Friedman proposed the PIH to explain consumer behavior 2.3. Conclusion The mainstream schools of thoughts highlighted above carries different views on a specific given economic variable in discussing economic policy stabilization .The importance of such is that it gives the reader to appreciate different different tools and and techniques theories adopted to achieve economic policy policy stabilization. The drastic change that has occurred in economic theory has not been the result of ideological warfare. It has not resulted from divergent political beliefs or aims. It has responded almost entirely to the force of events: brute experience proved far more potent than the strongest of political or ideological preferences. (Friedman, 1977, p. 470)
References
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Friedman, Milton. “The Role of Monetary Policy.” America n Economic Review 58, no. 1 (1968): 1 – 17. Lucas, Robert E. Jr. “Econometric Testing of the Natural Rate Hypothesis.” In Otto Eckstein, ed., The Econometrics of Price Determination. Washington, D.C.: Federal Reserve System, 1972. Phelps, Edmund S. “Phillips Curves, Expectations of Inflation and Optimal Employment over Time.” Economica, n.s., 34, no. 3 (1967): 254 – 281. 281. Phillips, A. W. H. “The Relation Between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861 –1957.”Economica, 299. –1957.”Economica, n.s., n.s., 25, no. 2 (1958): 283– 283– 299. Samuelson, Paul A., and Robert M. Solow. “Analytical Aspects of Anti -inflation Policy.” American Economic Review 50, no. 2 (1960): 177 – 194. 194. Sheffrin, Steven M. Rational Expectations. 2d ed. Cambridge: Cambridge University Press, 1996. Symposium: “The Natural Rate of Unemployment.” Journal of Economic Perspectives 11, no. 1 (1997): 3 – 108. 108.
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