The Interest Rating to Develop a Theory of Liquidity Preference - Essay Example

Question One: Hyman Minsky is a little known economist who has gained much popularity after the recent financial crises. It has so happened because Misnsky has developed a hypothesis identifying the fundamental causes of the universal financial crises. Minsky has struggled to discover answer to a frequently asked question that inquires about the reasons of the failure of markets and his response seems to reflect the realities. The crux of his theory lies in the statement that stability is destabilizing. Minsky's core model is known as "Financial Instability Hypothesis" (FIH), which simply declares that stability is inherently destabilizing (Thomas Tan, 2008). When the economy is doing well, the corporate cash flows rise above what is required to pay the debt off. This leads to speculative euphoria where this act of borrowing and lending goes on and reaches a point where the borrowers are no longer able to pay off the debt. As borrowers are no longer able to pay back, it leads to financial crises where banks do not have liquidity. As a result of the borrowers’ default, banks further tighten their lending, which means that even deserving borrowers that could pay back do not get access to capital in such circumstances. According to Minsky, these swings are a part of free market economy and cannot be avoided unless there is the provision of a government enforced regulation. Mishkin, on the other hand focused on the role of asymmetric information in the financial system. This essentially means that one party in the transaction has less information than the other party. For example a lender is not aware of the potential ways in which the borrower is going to use the money, but in case the money is lost, it is always the lender who is at the loosing end. This asymmetric information creates two problems, namely the adverse selection and the moral hazard. Adverse selection is a trend in which lenders choose borrowers who can pay a higher interest, knowing that they can pay higher interest because their business is riskier and hence there is a grater chance of losing the money on the part of the lender. The interest rate on such investments is quite exaggerated to reflect the risk premium. Moral hazard occurs when the borrowers may choose to invest the money in activities that are undesirable from the lenders’ point of view or else they simply do not work. As this loss is to be borne by the lenders, they will refrain from lending thus causing a financial crisis. Question Two: Mishkin concentrates on interest rates to develop a theory of liquidity preference. According to this theory, liquidity preference can be gauged from the interest rate cycles we see in the industry. When there is a depression, there is no demand for money as it cannot be used in an effective manner, which causes the interest rates to decrease. On the other hand the opposite effect can be seen when the economy is performing at its best. The liquidity preference framework thus generates the conclusion that when income is rising during a business cycle expansion (holding other economic variables constant) interest rates will rise. (Mishkin Frederic, 2009). Keynes theories have preached in favor of a mixed economy where the government intervenes for macroeconomic stability. The money multiplier developed by Keynes shows how a small government spending could lead to a multiplier effect in the economy. When government gives the financial stimulus, it goes either to the individuals or else to the corporate. The money which goes to individuals could be used for consumption or when the corporate organizations get this money, they hire new people who in turn spend their salary on consumption. Thus, this process continues with the effect decreasing incrementally at each step. According to Keynes theory, it was not the funds available that favored the investment, it was rather the funds that the corporate organizations invested when they had long run profit expectations. What this means is that rather than focusing on interest rates, government could regulate the economy through its own monetary policy, that is, by varying the money supply. Question Three: Mishkin’s orthodox interpretation of aggregate demand and aggregate supply highlights the link between the evils of inflation and unemployment. The theory also suggests that markets are very quick to adjust to the new factors caused by the changes made in the government policy. This basically means that the anticipated policy and actions will have no effect on the aggregate demand or the employment levels. The reduction in unemployment without a change in inflation can happen only when the changes in the policy are unexpected. Thus, Mishkin’s orthodox interpretation places importance on the market expectations. Thus according to Mishkin, anticipated policy actions or any changes to the fiscal policy will not influence the aggregate demand and the unemployment. On the other hand, Keynes has a quite different view on this topic. According to this theory, several wrong decisions by firms at the microeconomic level will cause a bad effect at the macroeconomic level. This view believes that the government can and should get involved to control the productivity and employment in the economy. It states that government policies can essentially be used for increasing the aggregate demand which in turn will reduce the level of unemployment. There is not a significant emphasis on expectations, as the interpretation believes that the positive outcome is possible even when the policy changes are expected. Question Four: Recently, nearly the whole world has experienced financial crises. In this period of economic recession, businesses have declined and the circulation of money has come to a hault. The modern money view identifies two main reasons for the global financial crises. These are the repression in the real wage rates in the developed world and also the conservative fiscal policies adopted by the national governments. The resulting policy of fiscal withdrawal has sucked the real wealth out of national economies (James Juniper). As productivity has continued to increase in the developed world, the wage rate has not seen a similar increase. This has meant that a lot of consumption was being done on credit. Similarly, there has been very little government spending or efforts aimed at lowering the unemployment rate. Government investment was avoided as it was seen as increasing the national debt. In accordance with the modern money perspective, governments do not need to ‘finance’ their deficit spending (James Juniper). The different outcome to the global financial crisis in the US and Australia has been due to the difference in policies adopted. The Australian government chose to quickly increase government spending and increase the government sector jobs, till the economy was back on its feet. This has led to better outcomes for the country. On the other hand there was not significant government public spending in the US. The orthodox model of financial crises underestimated the difference that government policy can have on the economy. Some of the orthodox models argue that the core of the problem lies in the banking system but is silent about major structural reform. The main factors of the crisis are exogenous, such as, trade deficit, industrial problems etc. But money and uncertainty are not given due importance. Despite the fact that the governments are sincere in pursuing their fiscal program, there efforts are hindered by a lack of the required resources. However, public can play a big role in defeating the current economic recession by imparting donations. Public spending has enough capability to deal with the financial crisis. (Juniper and Mitchell, 2008). Question Five: In a study conducted by (Mitchell and Muysken, 2008), the researchers have overtly expressed their concern on the relationship between the employment and inflation saying that it is not essential for inflation to rise as a result of increased job opportunities to individuals in the society. Inflation and unemployment have always been two opposing targets. A higher inflation level is undesirable in an economy and mainstream economists target a steady low rate of inflation. Inflation levels are controlled through monetary measures and changes in interest rates. The changes in employment level will be as a result of the multiplier effect of government policies. The mainstream view belies that there has to be a trade off between unemployment and price stability. The modern money view tries to achieved a target inflation rate and maintain full employment at the same time through job guarantee scheme. In this scheme, the pool of people who would be temporarily unemployed during low inflation will be provided work by the government. It provides the protection against inflation without the ill effects of unemployment. The people employed in this scheme get a minimum wage and will be gradually absorbed by the private sector when the conditions are favorable. Therefore it does not follow the Phillips curve trade off between price stability and unemployment. Moreover, it provides a fixed in built mechanism to control inflation level without the need for continuous policy changes by the government. References: James J, “A Modern Money View of the Global Financial Crisis”. viewed 12 Aug. 2010. . Juniper, J. and Mitchell, W., 2008. "There is no financial crisis so deep that cannot be dealt with by public spending". Working Paper No. 08-10. viewed 12 Aug. 2010. . Mishkin F 2009, “The Economics of Money, Banking and Financial Markets Prentice Hall”. London: Prentice Hall. Print. Mitchell, W. and Muysken, J., 2008. “Labour underutilisation and the Phillips Curve”. Working Paper No. 08-09. viewed 12 Aug. 2010. . Thomas T 2008, “Introduction To Minsky Theory” viewed 12 Aug. 2010. . Wray, R 1998. “Understanding Modern Money: The Key to Full Employment and Price Stability”, Cheltenham, UK: Edward Elgar. Print. Read More