Question 1

Criticism leveled against the foundational ideas of the of

classical theory

Keynes attacked the classical theory o the following works:

1. Keynes rejected the fundamental classical assumption of full employment equilibrium in the

economy. He considered it as unrealistic and graded full employment as a special situation. Since

the general situation inn a capitalist economy is one of unemployment. This is because the

capitalist society does not function according to say’s law, and supply always exceeds it’ demand

we find thee are many workers who are prepared to work at the current wage rate and even

zbelow it., but they do not find work. Thus the existence of involuntary unemployment in

capitalist economies proves that under employment equilibrium is a normal situation and full

employment equilibrium is abnormal ad accidental.

2. The classicist believed that savings and investments where equal at the full employment level and

in case of any divergence the equality was brought about by the mechanism of rate of interest.

Keynes held that the level of savings depended upon the level of income and not on the interest

rate. Similarly, an investment is determined not only by rate of interest but by the marginal

efficiency of capital. A low rate of interest cannot increase investments if business expectations

are low. If savings exceeds investments, it means people are spending less on consumption. As a

result, demand declines. There is overproduction and fall in investment, income and employment

and output it will lead to reduction in savings and ultimately the equality between savings and

investments will be attained at a lower level of income. Hence it is variations in income rather

than in interest rate that brings equality between savings ad investments.

3. Keynes did not agree with classical view that the Laissez- Faire policy was essential for an

automatic and self- adjusting process of full employment equilibrium. He pointed out that the

capitalist of system was not automatic a self- adjusting because of the non- egalitarian structure of

its society consumption. The poor lack money to purchase consumption goods. Thus there is a

general deficiency of aggregate demand in relation to aggregate supply which leads to

overproduction and unemployment. If the economy would have an automatic and self- adjusting

system , this would not have occurred. Keynes, therefore, advocated state interventions.

4. Keynes refuted say’s law of Markets, that supply always created its own not be spent in buying

products which they helped to produce the produce. A part from savings and investments are

distinct functions when all earned incomes not spent on consumption goods and a portion is not

saved. There results a deficiency of aggregate demand, thus Keynes invalidated say’s law by

invoking the principle that marginal propensity to consume less than one.

5. The classicist believed that money was demanded for transactions and precautionary purpose but

Keynes did not agree with the view. He emphasized the importance of speculative demand for

money which the classical economists did not recognize. He pointed out that the earning of

interest from assets meant for transactions and precautionary purposes may be very small at a low

rate of interest. But the speculative demand for money would be infinitely large at a low interest

rate of interest, thus, the rate of interest rate will not fall below a certain minimum level, and the

speculative demand for money would become perfectly interest elastic. This is ( “liquidity trap”)

which the classicists failed to analyze.

6. The classical economists regarded money as neutral. They excluded the theory of output,

employment and interest rate from the monetary theory. Keynes criticized the classical view that

the monetary theory was separated with values theory. He integrated monetary theory with value

theory and brought the theory interest in the demand of monetary theory.

7. The classicists believed in the long run full employment equilibrium through a self adjusting

process. Keynes had no patience to wait for the long period for he believed that “in the long run,

we are all dead”. Assuming consumption demand to be constant. The short period he lays

emphasis on increasing investments to remove unemployment. But the equilibrium level so

reached is one of unemployment rather than of full employment. Thus, the classical theory of

employment is unrealistic and is incapable of solving the present day economic problems f the

capitalist world.

8. Keynes did not agree with Pigou that “Frictional maladjustments alone account for failure to

utilize fully our productive power”. The capitalist system is such that left to itself is incapable of

using productive power fully. Therefore activity on the supplement private investment. It may

also pass legislation. Recognizing trade unions, fixing minimum wages and providing relief to

workers through social security measures. So Keynes favored state action to utilize fully the

resources of the economy for attaining full employment.

9. Keynes refuted the Pigovian formulation that a lot of money wage could achieve full employment

in the economy. Reduction in wage rate can increase employment in a industry by reducing costs

and increasing demand by the adoption of such a policy for reducing costs and increasing demand

but the adoption of such a policy for the economy leads to the reduction in employment. When

there is a general wage cut, the income of the workers is reduced. As a result, aggregate demands

fall, leading to a decline in employment.

10. Keynes also differs with the classists that equality between savings and investments via the rate

of ineptest shifts only the investments curve and that the savings curve does not change. Keynes

view is that whenever the investments curve changes, there is a rise in income through multiplier

effect; as a result savings also increases.

Question 2

Discuss the rational expectations Theory in Macro-

Economics

The expectations theory regards future interests rate as the principal determinant of the present

structure of interest rate. The theory originated with irring fisher, was perfected by Hicks in his

value and capital, and is closely identified with lutz.

The expectation theory is based on the following assumption

1. All investors have definite expectations with respect to future short term interests rates,

and these expectations are held with complete confidence

2. The objective of investors is to maximize expected profits ad they are prepared to transfer

funds freely from one maturity to another in order to achieve this objective

3. There are no costs associated with investment and disinvestment in securities.

4. The short term and long term interest rate are adjusted for any difference due to risk and

liquidity

Given this assumptions, the theory states that long term interest rate at any point in time

represent an average of expected short term interest rates.

The expectation theory holds that differences in yields on securities of different maturities

are due to the fact that the market expects the interest rates on different securities to be the

same over an equal period of time if this is not the case the investor will buy security of one

maturity by selling security of another maturity that he expects to provide him the highest

yield

Investors generally have repressive interest rate expectations.

That is to say, at any particular time they have an opinion regarding the level of interest rates

they regard as normal, and as short- term rates rise above or fall below this level, they expect

them to regress back towards this normal level. Thus, as rates rise above normal, investors

expect them to fall and as rates fall below normal, invertors expect them to rise.

This relationship implies that:

1. When short- term rates are expected to fall, current sort term rates will be above long –

term rates and the yield curve will be negatively sloped.

2. When rates are expected to rise, current short- term rates will be below long-term rates

and the yield curve will be positively sloped when the short–term rate is at approximately

the level judged to normal and is expected neither to rise nor to fall, rate for all maturities

approximate a horizontal line.

However, the expectations theory has been criticized on several points.

1. 1st lenders may have expectations about long-term interest rates that may be independent

of their expectations about short-term interest rates.

2. 3nd the theory presupposes that investors can make long term expectations about short –

term interest rate but it is doubtful if such predictions can be made accurate.

3. Critics doubt the efficiency of changes in the central back discount rates to influence the

long-term interest rate for instance, a reduction in the discount rate can bring a fall short-

term interest rates only if the expectations is generated that short-term interest rates will

remain law. This will prevent the discount rate being changed very often by the central

bank.

4. If open marked operations which influence the slope of the yield curve are of successful,

the expectation theory fails