Econ Test 2...2

Question 1

Referring to Davidson’s capital market diagram, Harvey says that ps is an important 
benchmark even when?

Answer 1

This price is a key benchmark even if there is not a single, solitary unit of existing capital actually for sale.

Question 2

According to Harvey, which of Davidson’s prices is that which entrepreneurs would be 
willing to pay for a unit of existing capital? Which is the price they must pay to have new 
capital built?

Answer 2

a) The Demand Price b) The Supply Price

Question 3

Echoing Davidson, Harvey says that investment will inevitably decline because of the continuous additions to the capital stock. Why will this not lead to a stationary state and what happens instead?

Answer 3

This will not be the case because falling investment will have shifted D down to D’, disappointing the expectations represented by Φ. Agents had undertaken the investment decisions represented by the intercept of D on the assumption that the economy would at least remain at N1; but, it has fallen to N2. Entrepreneurs are rudely reminded that never had a firm basis for their expectations in the first place and their error of optimism “is replaced by a contrary ‘error of pessimism’

Question 4

What is the hope of those who favor functional finance?

Answer 4

The hope of those who favor functional finance is that the government will decide on its level of spending and taxation, running deficits of surpluses to keep the total level of spending in the country on goods and services, neither greater nor less than the rate which would buy all the goods it is possible to produce.

Question 5

Explain in your own words how automatic stabilizers operate in a recession (two factors).

Answer 5

If the economy faces a down-turn, tax receipts go down while the government pays more money to the private sector in the form of unemployment transfers. As a result, purchasing power is impacted less that it would be in an unregulated economy.

Question 6

What are the two fears that the public associates with rising government debt?

Answer 6

1) today’s debt will burden our children and grandchildren who will have to pay off the debt.
2) The government will finance the debt by printing money which will result in runaway inflation.

Question 7

What is the moral of the history of the national debt from the Depression through WWII?

Answer 7

The moral is that there is nothing to fear about running big government deficits when, during a recession with significant unemployment, the federal government is the only spender that can take the responsibility to sufficiently increase the market demand for the products of our industries, and thereby maintain a profitable entrepreneurial system.

Question 8

Our desire to hold money as a store of wealth is a barometer of what?

Answer 8

It is a barometer of the degree of our distrust of our own calculations and conventions concerning the future.

Question 9

Uncertainty and unwillingness to commit all one’s earned income to current purchases of producibles will do what and when?

Answer 9

It will cause unemployment, if, and only if, the object of the savers’ desire is a resting place for their savings that is nonproducible and not readily substitutable for producibles, even if prices are flexible.

Question 10

Without what would real world entrepreneurial activities quickly wither away

Answer 10

Animal spirits

Question 11

In the General Theory, Keynes distinguishes what three motives for holding money? Please explain each briefly. Also note which one Keynes’ later admitted was misspecified.

Answer 11

1) The Transaction Motive- the need for cast for the current transaction of personal and business exchanges
2) The Precautionary Motive- the desire for security as to the future cash equivalent of a certain proportion of total resources
3) The Speculative Motive- the object of securing profit from knowing better than the market what the future will bring forth.
Keynes admitted that the transactions demand for money was messpecified, and he rectified his error by adding a fourth category for demanding money, the finance motive.

Question 12

Draw the speculation demand curve for money as shown in Figure 7.3 (you may exclude the exogenous money supply curves). In your own words, why does it have that slope?

Answer 12

If interest rates are relatively high, then market participants will be bullish. If however, they are low then participants will expect them to rise and so will behave bearishly. The first situation will give us poin A and second point B. Connecting those two points, gives us the downwards sloping demand curve shown on the graph.

Question 13

Keynes later realized that omitting the finance motive from the General Theory was a 
mistake. In discussing it, he said that if contractual commitments to buy new capital per period were unchanged, then the money held to “finance” the production of new capital goods was more or less constant and could be lumped under the transactions motive. But, and here was the novel and important part of the transactions motive, he also said that if decisions to invest are increasing, then he says that the demand for money to pay for production of these additional investments at any given interest rate will increase when?

Answer 13

Even before any additional employment and income are generated.

Question 14

According to Keynes, who holds the key position in the transition from a lower to a higher scale of economic activity and what happens if they refuse to relax? The investment market can become congested through what and not through what?

Answer 14

The banks hold the key position in the transition from lower to a higher scale of economic activity and if they refuse to relax, the investment market can become congested through a shortage of cash and not through a shortage of savings.

Question 15

Davidson argues that the money supply is endogenous, or created automatically in response to private market activities (central banks generally play only a passive role). In your own words, how has this, combined with the fact that production takes time (and the finance motive), led some empiricists to incorrectly infer that an increase in the money supply “causes” an increase in output?

Answer 15

Because production takes time, changes in measured output flows will tend to lag behind changes in the volume of outstanding bank loans. This calendar sequence of events has led some empiricists to infer incorrectly that an increase in the money supply causes an increase in output.

Question 16

Very briefly, in what sense is the existence of liquidity-creating financial markets a double-edged sword (good times versus bad times)?

Answer 16

The existence of liquidity-creating financial markets is a double-edge sword that in good times facilitates investments in real capital goods but in bad times adds greatly to the instability of the system.

Question 17

The fast exit strategy that calms all financial asset holders’ fears of the uncertain future is available to all only as long as what (note that a market maker is, according to the Securities and Exchange Commission, “a firm that stands ready to buy and sell a particular stock on a regular and continuous basis at a publicly quoted price”)?

Answer 17

The fast exit strategy is available only as long as the vast majority of people do not simultaneously try to execute this exit or, if many try, they do not overwhelm the resources of the market maker attempting to maintain an orderly market.

Question 18

With the repeal of the Glass Steagall Act in 1999, there was a tremendous growth in innovative financial derivative markets. What happened when events occurred to make most holders of these derivatives into bears and why?

Answer 18

Because there was no market maker, orderliness disappeared and the financial derivative securities became virtually illiquid

Question 19

What is the result of the fact that minority shareholders have little knowledge or interest in the long-run prospective yield of capital assets that they legally own?

Answer 19

The result is that financial asset market valuations are a result of a convention established on the mass psychology of a large number of ignorant individuals

Question 20

Davidson argues that security prices are not really reflective of the underlying fundamentals involved. Worse yet, those irrational prices from the financial sector have an impact on the real economy. What, for example, do depressed security prices retard and why? And what problem results when the spot price of titles to capital goods is high relative to the flow-supply (or production) price for real capital?

Answer 20

If security prices are depressed, it becomes possible to purchase the title to capital goods at a much smaller cost that producing new capital goods. This retards the formation of new capital goods as resources are shifted towards mergers and acquisitions. Meanwhile, if the spot price of title is high, then entrepreneurs are likely to take on extravagant projects because they are likely to turn an immediate profit. This practice quickly turns into an economic bubble.

Question 21

What did Keynes say about the wealth effect of a change in the price of financial assets?

Answer 21

a country is no richer when it swaps titles to capital at a higher price than a lower one, but the citizens, beyond question, feel richer.

Question 22

Shadow banking evolved as non-bank financial intermediaries created securitized assets that they claimed were nearly as good as money because they were so liquid and stable in value. Such claims were made with respect to the derivatives created from subprime mortgages (note that there is an omitted “not” in the last full sentence on page 158 in Davidson–I think you’ll know where!). In reality, it was next to impossible to determine the true value of the assets and in 2007-8, mortgagees began to default. Why did the mortgage originators have an incentive to approve people for those loans and why did they not care too terribly much whether or not they defaulted?

Answer 22

Mortgage originators were incentivized to make loans by the fees they received as well as to servicing mortgage payment receipts. They had little to fear in terms of default because they loans were quickly taken off of their balance sheets and put on the balance sheets investors, pension funds and mutual funds through a process called securitization.

Question 23

In the 1990s, banks started selling their loans to non-bank intermediaries. While this allowed them to shed much of their default uncertainty, there was a downside. What was it?

Answer 23

Loan officers bank loan officers do not worry as much about the credit worthiness of borrowers as long as there is a strong market demand to hold these loans for their returns

Question 24

What assumptions are made regarding M, V, P, and y in the “money growth ==>inflation” 
view?

Answer 24

M: That which is money is easily defined and identified and only the central bank can affect it’s supply, which it can do with autonomy and precision.
V: The velocity of money is related to people’s habits and the structure of the financial system. It is, therefore, relatively constant.
P: The economy is so competitive that neither firms nor workers are free to change what they charge for their goods and services without there having been a change in the underlying forces driving supply and demand in their market.
y: The economy automatically tends towards full employment and thus y (the existing volume of goods and services) is as large as it can be at any given moment (although it grows over time).

Question 25

Given the assumptions of the “money growth ==>inflation” view, why is it that M ==> P 
is the only logical outcome?

Answer 25

P1. MV=Py
P2. V is constant because people’s demand for money is constant
P3. y is constant at the level associated with Say’s Law
∴ if the government raises M, the only possible result is a rise in P as people get rid of their excess money balances

Question 26

The Post Keynesian view argues that since V and y can and do vary in the real world, there is no reason to believe that changes in P can necessarily be linked directly to changes in m. 
However, the real nail in the coffin of the “money growth==>inflation” is what? Explain it briefly (be sure to mention the three means by which the Fed can affect the money supply).

Answer 26

But perhaps the real nail in the coffin of the “money growth==>inflation” view is this: the phenomenon that Milton Friedman identifies as key to the whole process, i.e., the excess of the money supply over money demand, cannot happen in real life. The actual mechanisms available are Fed purchases of government debt from the public, Fed loans to banks through the discount window, or Fed adjustment of reserve requirements so that the banks can make more loans from the same volume of deposits. All of these can raise M, but, not a single solitary one of them can occur without the conscious and voluntary cooperation of a private sector agent

Question 27

What are the four factors Post Keynesians say actually do cause inflation? Explain each very briefly

Answer 27

Market Power: Competitive agent exercises market power to avoid competitive pressures
Demand Pull: A rise in demand relative to supply
Asset Market Boom: inflation injected from the asset market
Supply Shock: Storm or natural disaster shocks the supply

Question 28

Explain the process by which the inflation of the 1970s occurred and show how it is that a rise in the money supply may accompany a rise in prices, even though the former does not, indeed cannot, cause the latter.

Answer 28

The OPEC oil cartel in the 1970s and 1980s is a classic example of marker power. Had there been other viable sources of what they sold, they could not have restricted supply and driven up prices as they did because the competition would not have allowed them to do so. We would have just bought oil (or a close substitute) from someone else. Up to late 1973, they lacked the political will to set strict quotas among the various exporters. But, once the motivation was provided by US involvement in the Yom Kippur War, they made a conscious decision to raise prices by cutting supply. And because they were able to avoid competition, it worked! Even though households do not buy barrels of oil, it caused terrible inflation. It drove up the prices of anything that used petroleum or petroleum-based products, it raised the price of gas and, therefore, anything that needed to be transported, and it caused inflation in other energy sources as users shifted to those products. Market power–not money growth–caused this inflation. The money supply only rose as a result of the fact that firms and consumers took out larger loans and sold assets for cash.

Question 29

Economists stood idly by (and even praised) as what four transformations took place in the US economy over the past thirty years?

Answer 29

• Jobs went overseas
• Demand was sapped by increasingly uneven distributions of income
• Competition was destroyed by lax attitudes towards antitrust laws
• Safeguards were discarded in the financial sector.

Question 30

How is the incentive structure skewed in mainstream (Neoclassical) evidence and what did graduate students list last when asked what was most important to success as an economist?

Answer 30

Economics is skewed towards rewarding people for building complex mathematical models, not for explaining how the actual economy works. The last item listed was having a thorough knowledge of the economy.

Question 31

Steve Keen published the paper upon which his award-winning forecast of the financial crisis was based during what period, which was being characterized how by some mainstream economists?

Answer 31

It was written in the midst of the longest peacetime expansion in US economic history, a period when some mainstream economists were declaring it a “New Economy” where recession had been banished forever.

Question 32

Minsky’s financial instability hypothesis is best understood by considering the early stages 
of an expansion, where the economy is growing but everyone (firms, consumers, and banks) is still cautious. This means that most projects succeed. As a consequence, what two things gradually become evident to managers and bankers and as a result, what do they do?

Answer 32

It becomes evident that existing debts are easily validated and units that were heavily in debt prospered: it pays to lever. As a result the both bankers and managers come to see the previously accepted risk premium as excessive.

Question 33

The general decline in risk aversion that accompanies early expansion sets off what in terms of investment and the price level of assets (he means financial, incidentally)? Also, why is the external finance needed to fund these forthcoming?

Answer 33

It sets off both growth in investment and exponential growth in price level of assets, which is the foundation of both the boom and its eventual collapse. The external finance needed to fund this is forthcoming because the banking sector shares the increased optimism of investors.

Question 34

During the euphoric economy, what important actor in Minsky’s drama is created? Although their servicing costs exceed their cash flows, how do they expect to profit?

Answer 34

The Ponzi financier, they expect to profit because the capital appreciation they anticipate far exceeds the interest bill.

Question 35

How does the decrease in firm viability check the asset price boom and what then happens to the euphoria and boom?

Answer 35

These businesses have to sell their assets to finance their debt and this entry of new sellers into the market for assets pricks the exponential growth of asset prices. The Market becomes flooded and the euphoria becomes panic and the boom becomes a slump.

Question 36

In what two ways does the picture of a bust change when there is a big government involved?

Answer 36

With a developed social security system, the collapse in cash flows that occurs when a boom becomes a panic will be at least partly ameliorated by a rise in government spending- the classic “ automatic stabilizers” thought this time seen in a more monetary light. The collapse in credit can also be tempered or even reversed by rapid action by the Federal Reserve Bank to increase liquidity

Question 37

In the section Modeling Minsky, how does Keen describe the essence of Minsky’s analysis?

Answer 37

In a capitalist economy with finance, an endemic tendency toward euphoric expectations will generate both cycles and a secular trend of rising debt, leading ultimately to a debt-induced crash.

Question 38

Keen says that his model suggests that any policies aimed at lowering interest rates once the collapse has occurred will be futile since the economy has “passed into its catastrophic region.” In fact, he says, “the weight of the accumulated debt upon a depressed economy (is) so great that any government action at that time may be too little, too late.” What does Keen say is the essential policy message of the financial instability hypothesis and what institutional arrangements are necessary?

Answer 38

We should avoid crises in the first place by developing and maintaining institutions and policies that enforce a good financial society in which the tendency by businesses and bankers to engage in speculative finance is constrained. These institutional arrangements include close and discretionary supervision of financial institutions and financial arrangements, and a bias towards income equity rather that inequality.

Question 39

In closing, Keen says that the chaotic dynamics in his paper should warn us against what?

Answer 39

He says that it should warn us against accepting a period of relative tranquility in a capitalist economy as anything other than a lull before the storm.