Question

Please provide short essays to answer the following questions:

1. Keynes describes how people set their expectations about the future in Chapter 12 of his General Theory. As he describes them, are human expectations "rational?"

2. True or false: "Banks cannot create money; each bank must acquire funds before they can lend them out."

3. Briefly describe Hyman Minsky's financial instability hypothesis.

Answer 1

1- keynes describes are human expectations rational.

Meaning of rational expectation- this concept is a modelling technique which is used in macro economics .this theory states thst an individual decisions are based on  three primary factors ie-

1- Human rationality

2- Information available

3- past experiences

It helps the people to expect the future state of the economy.for eg if past inflation rates are high then people expect to rise in future ratein inflation too.

Assumptions of the rationalexpectations

1- individuals use their ability while making decisions.

2-people hold expectations

3- rational expectations are best to guess future

4- on an average people's expectations are correct.

5- peoplelearn from past experiences.

6-importance of value of price,output and employment

7- people behave to maximising profits and enjoyment.

8- future inflation expectations influence current buying decisions

9-individuals expect on the basis of available information

10- the resultfrom predictions are very close to market equilibrium.

Rational expectation theory-

Human expectations are rational as the continuous feedback from past experiences to current expectations helps the people to adjust their forcast.

The theory does not deny that people oftenmake forcasting errors but it does not suggest that errors will not occur persistently. For eg federal reserve decided to use quantitative easing program to help the economy from financisl crisi in 2008.the program reduced the interest rates for about 7yrs..people expect low interest rate to prevail in future too.

2● the above statement is false

Banks create new money whenever they make losns.about 97% of the market in the economy is bank deposit only 3% is what can be touched..banks create money while making loans through accounting.every new loan that a bank makes create new money.a report was released in 2014 in which it states--- " money creation in the modern economy" which means banks creates money in the form of deposits by making new loans.

3● Hyman Minsky's Financial instability hypothesis

This hypothesis was developed by Hyman Minsky.it is a model of capitalist economy.it argued that financial crisis are endemic because periods of economic prosperity encouraged borrowers and lenders to be reckless.this created financial instability.it needs govt.regulation.

3 stages of minsky instability hypothesis-

1- hedge stage- in this stage the buyers cash flow coverinterest and payment for borrowers to buy assets,the debt is self liquidation and fully hedged,it is stabilizingfactor.

2-speculative stage-

It is a risk side as it moves further.cash flowsonly cover interest payment.ir is less stabilizing as tge borrowers are bettingon the ideathat interest rate is not giving up and value will decline.

3- ponzi stage - it is the last stage towards the end of bubble .cash flowscover neither interest rates nor principal and it depends on rising asset  prices to keepthe borrowers afloat.

In these 3 stages the market becomes risky as they appear to become stable.

Causes of financisl instability-

1- changes in house prices/ asset

A fall in price of asset caused a negative wealth effect.it leads to lower confidence and less spending.as a result banks loose money on failed mortgage payments.

2- fluctuations in stock markets- it also loose the confidence,a loss of consuner wealth and leads to recession leads to financial instability.

3- changes in interest rates- if interest rates are combined with other factors it may cause a big fall in spdnding.interest rates and tgeir effect are borne for long period of time.

4- global factors

The increase interdepence also leads to financial instability as the dependence may lead to recessionand slow growth.

5-govt.debt crisis-

If market is fear of govt.debt .or bondswill be sold ,it push up interest rate thus put pressure on govt.to cut spending and causes negative lower growth.