Question

 

1) Compare and contrast the way Classical and Keynesian theory determine the Demand for Money and how it is related to the Money Supply. As a part of your comparison, indicate which of these theories developed the concept of a Liquidity Trap and what this does to the Demand for Money as part of that theory.

2) Explain the ways in which Fiscal Policy and Monetary Policy interact by using Keynesian IS and LM curves. Discuss the impact of an expansionary Fiscal Policy and Monetary Policy on the overall level of economic activity. Include the conditions in which Monetary Policy would have a greater influence on GDP growth and the conditions in which Fiscal Policy would have a greater influence on GDP growth.

3) Name and discuss the major types of financial intermediaries in the U.S. and illustrate the differences in the way assets and liabilities are recorded on their balance sheets. Describe the major differences between depository and nondepository intermediaries, which institutions have recently handled the majority of financial transactions and the major factors that have caused this shift over the past several decades.

4) Discuss the role of the FOMC and the three major policies it implements to help regulate banks. Briefly describe the equation used to measure bank reserves and the definition of the federal funds rate and their role as operating targets of the Federal Reserve as part of the FOMC directive.

Answer 1

Answer 1-The demand for money arises from two important functions of money-money acts as a medium of exchange and the it is a store of value. Thus individuals and businesses wish to hold money partly in cash and partly in the form of assets.

The views of both classical and keynesians regarding money supply are discussed below along with their similarities and comparisons-

The Classical Approach:

They emphasized the transactions demand for money in terms of the velocity of circulation of money. This is because money acts as a medium of exchange and facilitates the exchange of goods and services. In Fisher’s “Equation of Exchange”.

MV=PT

Where M is the total quantity of money, V is its velocity of circulation, P is the price level, and T is the total amount of goods and services exchanged for money.

The classicists believed in Say’s Law whereby supply created its own demand, assuming the full employment level of income. Thus the demand for money in Classical/Fisher’s approach is a constant proportion of the level of transactions, which in turn, bears a constant relationship to the level of national income.

The Keynesian Approach:

Keynes suggested three motives which led to the demand for money in an economy: (1) the transactions demand, (2) the precautionary demand, and (3) the speculative demand.

The Transactions Demand for Money:The transactions demand for money arises from the medium of exchange function of money in making regular payments for goods and services. According to Keynes, it relates to “the need of cash for the current transactions of personal and business exchange.

The Precautionary Demand for Money:The Precautionary motive relates to “the desire to provide for contingencies requiring sudden expenditures and for unforeseen opportunities of advantageous purchases.” Both individuals and businessmen keep cash in reserve to meet unexpected needs. Individuals hold some cash to provide for illness, accidents, unemployment and other unforeseen contingencies.

The Speculative Demand for Money:The speculative (or asset or liquidity preference) demand for money is for securing profit from knowing better than the market what the future will bring forth”. Individuals and businessmen having funds, after keeping enough for transactions and precautionary purposes, like to make a speculative gain by investing in bonds. Money held for speculative purposes is a liquid store of value which can be invested at an opportune moment in interest-bearing bonds or securities.

Similarities between Classical and keynesian-

While classical gave much consideration to borrowing reasons like stockpiling, the Keynesian concept depicts the aim of funds provision and bank credit, which one cannot overlook as a factor of the proportion of interest.

Keynes considers money as a determinant concluding the percentage of interest. This symbolic alliance brings both concepts together notwithstanding them having a contrasting viewpoint of the administration of the economy by the nation.

Differences between Classical and keynesian-

1.One significant difference between Keynesian and Classical economics is the government’s role in each. Classical economics is free-market economics; it induces a policy that limits the involvement of the government in managing the economy.

Keynesian economics supports the active involvement of the government in managing the economy, especially during recession or depression.

2.Classicists are focused on achieving long-term results by allowing the free market to adjust to short-term problems. They see issues short-term as just bumps on the road that will eventually dissolve on its own.

Keynesians tend to focus more on solving short-term problems. They believe that getting the government to address these issues immediately will enhance the long-term growth of the economy.

3.Keynesians describe money as an active force that influences total output. They worry less about the cost of goods or the purchasing power of the currency. Classicists completely ignored the precautionary and speculative motives for holding money. They do not subscribe to the view that money could also influence the rate of employment, output, and income.

Liquidity Preference by Keynes-

Keynes in his General Theory used a new term “liquidity preference” for the demand for money.

Liquidity means shift ability without loss. It refers to easy convertibility. Money is the most liquid assets. Money commands universal acceptability. Everybody likes to hold assets in form of cash money. If at all they surrender this liquidity they must be paid interest. As water is liquid and it can be used for anything at will, so also money can be converted to anything immediately.

Other costly assets like gold and landed property may be valuable but they cannot be shifted at will. Thus they lack liquidity. As money are highly liquid people to hold money with than in form of Cash. This preference according to Keynes is popularly called liquidity preference. Thus according to Keynes interest is the price paid for surrendering their liquid assets. Greater the liquidity preference higher shall be the rate of interest. The liquidity preference constitutes the demand for money.

A liquidity trap is marked by the failure of injections of cash by the central bank into the private banking system to decrease interest rates. Such a failure indicates a failure in monetary policy, rendering it ineffective in stimulating the economy. Simply put, when expected returns from investments in securities or real plant and equipment are low, investment falls, a recession begins, and cash holdings in banks rise. People and businesses then continue to hold cash because they expect spending and investment to be low creating is a self-fulfilling trap. It is the result of these behaviors (individuals hoarding cash in anticipation of some negative economic event) that render monetary policy ineffective and create the so-called liquidity trap.

According Keynes rate of interest is demand by the supply of and demand for money. The rate of interest on the demand side is governed by the liquidity preference of the community arises due to the necessity of keeping cash for meeting certain requirements. The demand for liquidity arises due to three motives.