According to Keynes, recessions and financial crises can be avoided if central banks maintain general equilibrium in the money markets (via monetary policy). It can reduce money supply by selling bonds. It can increase money supply by buying bonds. This increase-decrease in money supply is a general mechanism utilized by central banks to ensure the robustness of the financial market. In short, the aim of the policy is to make the prices of financial assets stable (prevents panic). Keynes, however, argued that monetary policy does not raise the national income.
Monetary policy only creates an ‘illusion’ of economic prosperity. Keynes favored the use of fiscal policy in increasing the level of national income because of two major reasons. First, fiscal policies are easier to implement than monetary policies. A government can increase or decrease its expenditure level depending on the status of the economy. If an economy is in recession, then the government can increase its level of expenditure. If actual GDP exceeds potential GDP, then a slight decrease in government spending is necessary.
Note that the mechanism by which fiscal policies are implemented are much less sophisticated than that of implementing monetary policies. Second, the effects of fiscal policy are more ‘pronounced’ than that of monetary policy. An increase in government spending automatically increases the level of national income. B) Explain what Friedman thought were the pros and cons of the active use of fiscal policy and of monetary policy. (3 points) Friedman argued that fiscal policy is not an effective tool for preventing recessions and financial crises.
For instance, deflationary fiscal policy would be ineffective if the marginal propensity to consume tend to increase with respect to the interest rate. Inflation would therefore be a very difficult problem to solve. This instance led Friedman to conclude that fiscal policy is actually an economic barrier to foster economic activity. Friedman, however, viewed monetary policy as a mechanism for stabilizing an economy. For example, too much money in an economy would cause prices of goods and services to increase. Too little money in an economy causes a contraction in the GDP.
Monetary policies are designed to effectively combat both inflation and deflation, and increase efficiency in the money markets. According to Friedman, the cause of the Great Depression was not overproduction, but rather the Crash of 1929. The inefficiency of the money market created instability in stock prices, which ultimately led to the Crash of 1929. For Friedman, efficiency of money markets is an important determinant of economic stability. C) Where do these two economists agree? Where do they disagree? (2 points)
Both economists recognized the importance of interest rate adjustments in boosting an economy. For Keynes, interest rate is an important factor in inreasing investment and consumption level in an economy. For Friedman, interest rate serves as a stabilizing agent in adjusting the prices of financial and non-financial instruments. The two economists however differed on the extent to which interest rates can be used to boost an economy. Keynes preferred a more rigorious reduction in interest rates while Friedman a more conservative approach in interest rate adjustments.
There is another significant disagreement between the two theorists. Friedman rejected the concept of permanent income hypothesis which states that as income increases, the fraction allocated to savings also increases. Keynes supported this hypothesis. D) What is your own view on this debate? Explain. (2 points) The use of either fiscal or monetary policy is dependent on economic circumstances. For example, a demand-induced recession can be effectively resolved by fiscal policy while a supply-induced recession can be resolved by monetary policy.
No single macroeconomic theory can fully explain or resolve all macroeconomic problems. A) Neoclassical economic theories are based on the assumption that people are rational. Did Thorstein Veblen have a favorable view of neoclassical economics? Discuss his views on this issue. (3 points) Thorstein Veblen rejected many of the assumptions of neoclassical economics. He argued that the term ‘rational’ is generally vague even from the standpoint of modern economics. Rationality is an idea that excludes behavior which is not based on a measured calculation of costs and benefits.
Veblen argued that rationality itself is a relative idea; an idea which is based on economic, political, socio-cultural, and economic factors. Veblen established the idea of ‘conspicuous consumption. ‘ According to him, demand is often fueled not only by economic factors alone but also by sociological factors. Those individuals belonging to the upper strata of society often engaged in conspicuous consumption because it enhances status. By conspicuous consumption, Veblen meant a general precedent of artificially increasing demand out of conscious desire to enhance status.
Conspicuous consumption is a state where actual consumption greatly exceeds actual needs. B) Consider the articles on behavioral economics at http://myweb. liu. edu/~uroy/eco54/histlist/behav-econ/index. html. Read and summarize the main thrust of some of these articles. (3 points) In the article, “How Obama is Using the Science of Change,” Grunwald argued that Obama hired some of the best professors in behavioral science to help him in his campaign. This so-called ‘behavioral team’ assisted Obama in evaluating the behavioral instance of the voters, in order to find the correct political stance.
According to the author: “Obama won the election because he looked like change, sounded like change and never stopped campaigning for change. But he didn’t call for just change in Washington – or even just change in America. From his declarations that ‘change comes from the bottom up’ to his admonitions about ‘an era of profound irresponsibility,’ Obama called for change in Americans” (Grunwald, 2009). According to the author, Obama relied his presidency on the ability of every American to change behavior.
Although his top priorities – health care, energy, international peace – depended on this change. For Obama, economic prosperity could only be achieved through constant moralistic evaluation of individual conduct. Saving energy, protecting the environment, and promoting a responsible system of governance are highly related to individual decisions. C) Based on these articles, what is your opinion of the value of the contributions of behavioral economics to economic analysis? Explain. In the past, economic phenomena were solely explained by economic factors.
For example, fluctuations in GDP were generally explained by varying levels in consumption, investment, trade accounts, and government expenditure. Efficiency in money and capital markets were solely explained by confidence levels, risk based assets and liabilities, and in general, federal funds rate. Today, there is a growing interest in associating economic phenomena with non-economic factors. This interest is not without basis. Some economists, notably Hayek and Kuznets, were able to show that some non-economic factors influenced, sometimes, determined economic phenomena.
For example, the failure of capitalist reforms in Latin America during the 1970s was attributed solely to political instability. Becker, for instance, proved that individual reaction to income and tax changes affect the overall labor supply in an economy. In his time allocation model, Becker posited the hypothesis that individual behavior directly influence aggregate income. D) Do you think behavioral economics represents a return of Veblen’s ideas? (2 points) Behavioral economics may be thought as a return to Veblen’s ideas.
Behavioral economics has the following assumptions which reflected Veblen’s ideas: 1) Individual decision-making patterns influence economic decision making in the public sphere; 2) Individual behavior is influenced by the behavior of other individuals; 3) Economic phenomena are sometimes directly influenced by actions of institutions; 4) And, consumption and investment are not solely determined by interest rate and confidence levels respectively. It should, however, be noted that most of Veblen’s ideas tackled non-economic issues, so it is impossible to assume that behavioral economics is a determined return to Veblen’s ideas.
A) To what extent has economics benefited from the application of mathematical methods in the analysis of economic issues? (2 points) The application of mathematical methods benefited economics in the analysis of economic issues in three respects. First, mathematical methods allowed the construction of elaborate and sophisticated models in explaining economic phenomena. Second, these models greatly enhanced the means by which prediction is utilized. Many of the models used were helpful in assessing economic trends, and in general, in determining future consumption, investment, and public budget levels.
Third, these methods provided economists formal, logical reference points. It is very difficult for an economist to analyze an economic phenomenon without the proper guidance from theory (it is very probable for an economist unguided by theory to draw misleading and sometimes, false conclusions). B) What is game theory? Discuss some of its contributions to economic analysis. What is your opinion of the value of the contributions of game theory to economic analysis? (3 points) Generally, game theory is a mathematical system for analyzing and predicting how humans behave in strategic situations (Camerer, 2001).
Standard equilibrium analyses assume all players: 1) all forms of belief based on analysis of what other may do (this is called strategic thinking); 2) choose a best response given those beliefs (optimization); 3) adjust best responses and beliefs until they are mutually consistent (equilibrium). Game theory, unlike the ‘nomothetic’ macroeconomic theories, assumes that not all players behave rationally in complex situations. Assumtions (1) and (2) are violated, or more accurately relaxed. Players’ fate are intertwined. The presence of players who do not think strategically or optimize can change what rational player will do.
As a result, the standard way of predicting individual behavior often becomes invalid. At best, game theory offers a new approach in analyzing individual behavior. It relaxes the concept of rationality. This is desirable because individual often act irrationally in many circumstances. Game theory may provide supplementary insight in economic analysis of actor units. Game theory may provide vivid differentiation between collective and individual action. Note that sometimes, there is discrepancy between collective and individual action (which is not shown in standard microeconomic analysis).
C) What is econometrics? Discuss some of its contributions to economic analysis. What is your opinion of the value of the contributions of econometrics to economic analysis? (3 points) Econometrics is the use of statistical tools in formal economic analysis (Garcia, 2004). Paul Samuelson was one of the first economists who developed the field of econometrics. He used complex regression systems to predict specific economic phenomena like business cycles and GDP fluctuations, and to determine optimal tax and desired levels of public goods.
In general, the contributions of econometrics to economic analysis are as follows: 1) accurate prediction systems, 2) precise determination of specific contribution of economic factors (in regression anaysis), and 3) determination of direction of economic trends. At best, econometrics is used to confirm or dispove economic theories. It is a means by which theories can be empirically verified. D) Comment on Paul Krugman’s article “Two Cheers for Formalism” which is available at his web page http://web. mit. edu/krugman/www/.
It is much safer to assume that formalist economics is still useful in analyzing economic events. The reason is evident. Much of economic theorizing are essentially based on logical analysis of economic precedents which altogether comprised what is called ‘models’ – the physical representation of reality. Many of Krugman’s assumptions are essentially based on whimsical distortion of economic facts. This distortion is evident. Krugman treated theory as if it was based on pure logical thinking. For the most, theories are partially constructed from actual observations.
In any case, there is no sense in arguing that a new economics is needed to explain current trends in the world economy, for economic theories, at the present, can explain those trends.
Camerer, Colin. 2001. Behavioral Game Theory: Thinking, Learning, and Teaching. California: California Institute of Technology. Garcia. Yolanda. 2004. Lectures in Econometrics. Universit of the Philippines. Grunwald, Michael. 2009. How Obama is Using the Science of Change. Retrieved on April 25, 2009 from http://myweb. liu. edu/~uroy/eco54/histlist/behav-econ/index. html The New Palgrave Dictionary of Economics.
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