Questions
1. Explain why Friedman recommended the rule of a fixed rate of monetary growth, in light of his understanding of EAPC as the way the economy works, in terms of unemployment and inflation. Explain how the Volker experiment proves that Friedman's theory was wrong.
A: Keynesians thought that there is an inflation and unemployment tradeoff (the Phillips curve) and policy makers can choose outcome. But according to Monetarist inflation choices would get build into the system (hysteresis) and cause harm to the efficiency of the system and accelerating inflation would result from Keynesian policies. Therefore, Monetarist argued that you should have a tight monitory policy. Don’t inject money into the economy and you should have a fix rule of money growth according to Friedman. The monetarist argued that if government attempted to reduce unemployment below the natural rate (sometimes called non-accelerating inflationary rate of unemployment or NAIRU), then as the inflation rate rose, workers would demand even higher money wages to achieve their desired real wage levels. Ultimately, this would result in a rising rate of inflation. Expectations adjusted Phillips curve showed that there is no trade-off between inflation and unemployment in the long run. According to him the best monitory policy is to fix rate of increase at 6% this will allow real growth of 3% and 3% inflation. As without inflation real wage adjustment cannot be done easily. By allowing inflation wage rigidity can be fixed as real wages will adjust. In 1980s Volcker tried to implement the Friedman’s rule. He fixed the growth rate of money supply at 6% and he repeatedly failed to hit the target. The reason was that central bank cannot control the money supply and money supply growth is not a good indicator of growth in prices and income.
2. Keynes argued that decline in wages below equibrium would lead to further declines, moving further away from equilibrium, instead of coming back to full employment. To this, Minsky added that increases in wage toward full employment would lead to further increases, creating inflation and destabilizing the economy. Explain the Keynes-Minsky mechanisms which show that the economy is fundamentally unstable, and tends to move out of equilibrium, rather than towards equilibrium
A: According to Keynes money matters and underemployment do exist. Keynes said that money is never neutral because if there is underemployment than there is under investment and when there is under investment that has a permanent long-term effect on the economy. So, if you intervene properly and inject money into the system than you can build up the long run growth of the system. Money matters in the short run by eliminating unemployment and it matters in the long run by increasing the capacity of the economy. Keynes argued that one of the condition for stability of the economy is stickiness in wages. This prevents debt deflation cycle which happens in a crisis.
Minsky extends the Keynesian theory, he added the financing aspects that were not the part of the Keynesian theory. According to Minsky even if we get to full employment this will generate destabilizing forces restoring unemployment. Main instability in modern capitalist economy is tendency towards explosive euphoria. According to Minsky high aggregate demand and high profits will raise expectations and will encourage increasingly risky ventures that are based on commitments of future revenues that are too optimistic. When the expected revenues are not realized, a snowball of defaults then leads to debt deflation (debtors default on their debts, which are assets of creditors) and high unemployment unless there are “circuit breakers” that intervene to stop the market forces, including most importantly intervention by Big Government and the Big Bank.
3. Explain the three types of financing: Hedge, Speculative, and Ponzi, and explain why growth and stability naturally lead from less risky to more risky forms of financing, which is why the economy is fragile.
A: Three types of financing:
Hedge finance is the one in which we expect that we can pay interest and the principal amount. Streams of payments are not known if we are doing repeated short-term financing rather than one long term loan. Expected revenue streams cover your expected payments for interest and principal.
Speculative finance is when the revenue stream covers the interest but not the principal. Here we are speculating that asset prices would rise so we will be able to pay. In the future revenue stream will increase in some way like balloon mortgages. If asset price increases than it’s a good deal for everybody.
Ponzi finance is in which you can’t even make interest payments for your loan. So, you have to borrow to make the interest payments. This is not sustainable as you must keep borrowing to repay your interest.
If we have a system which has the growth and stability the financing shifts from hedge to speculative and Ponzi financing. As the risk of financing will become low and margin of getting more returns will be high. That’s why the risk to the system increases. If there is a growth and stability in the economy than financial lobby will take advantage of this prosperity to create more money because in growing and healthy economy, there is a room for more money. People will start investing more so financial lobbies will find a way to give them money which will be riskier, that is why economy is known to be fragile.
Minsky Ch 3 Financial Instability Hypothesis - YouTube Video Lecture