Friday, 12 July 2013

Interest rate determination: Classical, Neo-classical and Keynesian theories.

The Classical Theory of the Rate of Interest
Macroeconomics considers the performance of the economy as a whole, which involves two major approaches to study the pattern and influence on the economy. Economists who believe in either of the types of thoughts are at loggerheads about various aspects about the way the economy influences people and vice-versa. Here, we have tried to draw a brief comparison that highlights the major differences. 
Difference between Classical and Keynesian Economics
Keynes refuted Classical economics' claim that the Say's law holds. The strong form of the Say's law stated that the "costs of output are always covered in the aggregate by the sale-proceeds resulting from demand". Keynes argues that this can only hold true if the individual savings exactly equal the aggregate investment.
While Classical economics believes in the theory of the invisible hand, where any imperfections in the economy get corrected automatically, Keynesian economics rubbishes the idea. Keynesian economics does not believe that price adjustments are possible easily and so the self-correcting market mechanism based on flexible prices also obviously doesn't. The Keynesian economists actually explain the determinants of saving, consumption, investment and production differently than the classical economists.
Classical economists believe that the best monetary policy during a crisis is no monetary policy. The Keynesian theorists on the other hand, believe that Government intervention in the form of monetary and fiscal policies is an absolute must to keep the economy running smoothly.
Classical economists believed in the long run and aimed to provide long run solutions at short run losses. Keynes was completely opposed to this, and believed that it is the short run that should be targeted first.
Keynes thought of savings beyond planned investments as a problem, but Classicists didn't think so because they believed that interest rate changes would sort this surplus of loanable funds and bring the economy back to an equilibrium. Keynes argued that interest rates do not usually fall or rise perfectly in proportion to the demand and supply of loanable funds. They are known to overshoot or undershoot at times as well.
Both Keynes and the Classical theorists however, believed as fact, that the future economic expectations affect the economy. But while, Keynes argued for corrective Government intervention, Classical theorists relied on people's selfish motives to sort the system out.
For a much better understanding of the difference it is essential that we delve a little deeper and try to understand the basics of these two approaches.
Classical Economics Explained
This is considered to be the first school of economic thought. Let us start with a general overview of what this school of thought propagates. By the way, I am an out-and-out Classical economist, so forgive any biases that might creep in. Also understand, that even if it may seem so in this particular article at times, one cannot conclude that Keynesian economics is flawed or classical economics is flawed (there's no absolute right and wrong in economics, different theories are applicable under different economic assumptions).

Definition and Groundwork for the Classical Economics Model
"By pursuing his own interest, he (man) frequently promotes that (good) of the society more effectually than when he really intends to promote it. I (Adam Smith) have never known much good done by those who affected to trade for the public good." - Adam Smith (1776), An excerpt from 'An Inquiry into The Nature and Causes of The Wealth of Nations'.
Adam Smith is the great economist, who is known as the founder of the classical economics school of thought. Though many others (David Ricardo, Thomas Malthus, John Stuart Mill, William Petty, Johann Heinrich Von Thunen, etc.) have come and gone, and added a few things here and there, to the classical theories, we will only be stressing on Adam Smith's version in this article.
The Classical economics theory is based on the premise that free markets can regulate themselves if left alone, free of any human intervention. Adam Smith's book, 'The Wealth of Nations', that started a worldwide Classical wave, stresses on there being an invisible hand (an automatic mechanism) that moves markets towards a natural equilibrium, without the requirement of any intervention at all. In better economic words, the division of labor and the free market will automatically tend toward an equilibrium that advances public interests. Sounds fascinating? Let us see how.
Classical Economics Assumptions
Before working our way towards the working of this model, let us first know and understand the assumptions. The idea, is that like any theory, if the founding assumptions do not hold, the theory based on them is bound to fail. There are three basic assumptions. They are:
Flexible Prices: The prices of everything, the commodities, labor (wages), land (rent), etc. must be both upwardly and downwardly mobile. Unfortunately, in reality, it has been observed that these prices are not as readily flexible downwards as they are upwards, due a variety of market imperfections, like laws, unions, etc.
Say's Law: 'Supply creates its own demand'. The Say's law suggests that the aggregate production in an economy must generate an income enough to purchase all the economy's output. In other words, if a good is produced, it has to be bought. Unfortunately, this assumption also does not hold good today, as most economies today are demand driven (production is based on demand. Demand is not based on production or supply).

Savings - Investment Equality: This assumption requires the household savings to equal the capital investment expenditures. Now it takes no genius to know, that this is rarely the case. Yet, should the savings not equal the investment, the 'flexible' interest rates should be able to restore the equilibrium.
Classical Economics - The Workings of An Economy
"Civil government, so far it is instituted for the security of property, is in reality instituted for the defense of the rich against the poor, or of those who have some property against those who have none at all." - Adam Smith from 'The Wealth of Nations', 1776.
All the normal principles of economics apply to classical economics as well. If all the assumptions hold, classical economics works as follows.
Wage Markets
Classical economics negates the fact that there can be some unemployment (especially involuntary) in an economy, because classical economists believe in the self-correcting mechanism of an economy. Their contention is based on the following:
Whenever there is unemployment in an economy, it is usually a temporary disequilibrium because it is an equilibrium caused by excess labor available at the current wage rate.
Whenever wages are high, there are always more people willing to work at that ongoing rate and this is termed as unemployment.
In an unregulated, classical economy, where wages are perfectly flexible, the wage rates fall, eliminating the excess labor available and reducing the unemployment back to equilibrium levels.
How exactly does this happen? This happens because all hirers favor their self-interest motives. When laborers are still available when he pays them a lower wage, why should he pay more. He thus adjusts his wage rates downwards, acting in the overall welfare of society, without knowing it.
Commodity Markets
The Say's law that equates the demand and supply in an economy actually applies to aggregates and not single goods and commodities. Classical economists believe that the commodities markets will also always be in equilibrium, due to flexible prices. If the supply is high and there is inadequate demand for it, it is a temporary situation. The prices for the commodity in question, decrease, to equate the demand and supply and bring the situation back to equilibrium. How does this work? Well, what would you do if you had a commodity that you needed to sell but weren't able to secure a buyer. You'd obviously reduce the prices step by step, in a trial and error manner and finally reach a price that might tempt a buyer to buy. It is a similar case with the aggregate demand and supply, say the classical theorists.

Capital Markets
In the beautiful free world of classical economics, no human intervention is required to lead the capital markets to equilibrium as well. If the economy does not follow the last assumption and shows a mismatch in savings and investments, the classical economists provide the evergreen solution - do nothing, it is temporary and will correct itself. If savings exceed investment, the interest rates fall and the market achieves equilibrium again. On the other hand, if savings fall short of investments, the interest rates rise and once again, the economy reaches its own equilibrium. Let us now see how all the markets come together in the classical economics model.
One potential problem with the classical theories is that Say's law may not be true. This may happen because not all the income earned goes towards consumption expenditures. The total savings thus saved, translate into the missing potential demand, which is the cause of the disequilibrium. When supply falls short of effective demand like this, several things spiral downwards: producers reduce their production, workers are laid off, wages fall resulting in lower disposable incomes, consumption declines reducing demand by further more and starting a self-sustaining vicious cycle. However, classical economists argue that what happens to the savings that started to the whole chain is the key solution here. If all of these savings go in as investments, the interest rates adjust to bring the economy back to equilibrium once again, with absolutely no problems at all. The only glitch, are all savings actually invested in reality? By investment, classical economists mean capital generation, so I doubt it! But as one can see, according to classical theories, there is really no need for any government intervention. No wonder then, that they are against it, for they can provide good backing to all the arguments that state, that government intervention cannot help, but can actually harm the economy in the long run.
We will contemplate this later, in the comparison of Classical economics and Keynesian economics section. For now, we will move on to the next economic theory, Keynesian economics.
Keynesian Economics Theory Explained
Keynesian economics is the brain child of the great economist, John Maynard Keynes. The Keynesian school of economics considers his book, 'The General Theory of Employment, Interest and Money' (1936) as its holy Bible. Let us have an overview of this theory, which contradicts and confronts the classical theory on almost all counts.
Definition and Groundwork for the Keynesian Economics Model
"Long run is a misleading guide to current affairs. In the long run we are all dead." - John Keynes's most famous quote, to stop the Classical economists from rapping about the 'long run'.
Keynesian economics is wholly based on a simple logic, that there is no divine entity, nor some invisible hand, that can tide us over economic difficulties, and we must all do so ourselves. Keynesian economic models stress on the fact that Government intervention is absolutely necessary to ensure growth and economic stability. While classical economists believe that the best monetary policy is no monetary policy, Keynesian economists (Alvin Hansen, R. Frisch, Tinbergen, Paul Samuelson etc.) believe otherwise. In the Keynesian economic model, the government has the very important job of smoothing out the business cycle bumps. They stress on the importance of measures like government spending, tax breaks and hikes, etc. for the best functioning of the economy.
Keynesian Economics Assumptions
Like all economic theories, the Keynesian Economics school of thought is based on a few key assumptions. Let us have a look at them first, before we progress on to the application of Keynesian economics in the actual economy.
Rigid or Inflexible Prices: Mostly we see that while a wage hike is easier to take, wage falls hit some resistance. Likewise, while for a producer, commodity prices are easily upwardly mobile, he is extremely reluctant for any reductions. For all such prices, it is easily notable that they are not actually as flexible as we'd like, due to several reasons, like long-term wage agreements, long-term supplier contracts, etc.
Effective Demand: Contrary to Say's law, which is based on supply, Keynesian economics stresses the importance of effective demand. Effective demand is derived from the actual household disposable incomes and not from the disposable income that could be gained at full employment, as the classical theories state. Keynesian economics also recognizes that only a fraction of the household income will be used for consumption expenditure purposes.
Savings and Investment Determinants: Keynesian economics directly contradicts the savings-investment proponent of Classical economics, because of what it believes to be the savings and investment determinants. While classical economists believe that savings and investment is triggered by the prevailing interest rates, Keynesian economists believe otherwise. They believe that household savings and investments are based on disposable incomes and the desire to save for the future and commercial capital investments are solely based on the expected profitability of the endeavor.
Keynesian Economics - The Workings of an Economy
"The biggest problem is not to let people accept new ideas, but to let them forget the old ones." - John Maynard Keynes.
As classical economics and the Great Depression did not go so well together, with the latter exposing several flaws in the former, but Keynesian economics came up with a solution. Keynesian economics and the Great depression worked well together, with the former giving ways to avoid and escape the latter. Keynesian economics is equipped to teach everyone about surviving an economic depression. Let us have a look at how the Keynesian theory works.
Keynesian economists believe that the macroeconomic economy is more than just an aggregate of markets. Also, these individual commodity and resource markets are not capable of achieving an automatic equilibrium and it is quite possible that such disequilibrium last for very long. As full employment is not guaranteed automatically, Keynesian economics advocates the use of beneficial government policies in order to give the economy a helping hand.
Commodity Markets
The Keynesians start with a graph showing a 45 degree line starting at the intersection of both the axis. This line depicts all the points where the aggregate expenditure equals the aggregate production. In other words, the economy is at a full employment equilibrium. They then chart a real aggregate expenditures line, an aggregated amount of all the macroeconomic sector expenditures (Household Consumption, Investment, Government Spending, etc.) and capture the effective demand. When the economy is below or above the intersection between these two lines, there is an obvious disequilibrium or imbalance.
If aggregate production is more than the aggregate expenditures, there is excess supply. Inventories increase and businesses reduce their production to stop these. On the other hand, when the demand is more than the supply (aggregate expenditure supersedes aggregate production) the accumulated inventories of businesses decrease and there is an incentive to increase production. Through this mechanism of inventories, the commodity markets find their equilibrium.
Employment Markets
When there is a recessionary gap, that is when the actual aggregate production in an economy is less than the aggregate production that should have come off full employment and there is rampant unemployment in the economy. On the other hand, under an inflationary gap, the actual aggregate production exceeds the aggregate production that should have come off full employment. Both the situations cannot be solved automatically, contrary to the classical economics fundamentals.
The solution to all the economic problems lies in the manipulation of some key indicators, say the Keynesian economists. These indicators include interest rates (increase in interest rates, decrease in aggregate expenditures), confidence or expectations (pessimistic economic outlook, fall in aggregate expenditures) and Government Policies and Federal Deficit (Increase in taxes or fall in Government spending, fall in aggregate expenditures). The government can manipulate these variables (and even many others) through the two market intervention tools that it has at its disposal, namely the fiscal policy and the monetary policy.
What is the Classical Theory of the Rate of interest? It is something upon which we have all been brought up and which we have accepted without much reserve until recently. Yet I find it difficult to state it precisely or to discover an explicit account of it in the leading treatises of the modern classical school. [p. 175]
Nevertheless, for Keynes it means the doctrine that the rate of interest is what brings savings and investment in line. As we have seen, for Keynes savings and investment are equal by definitionand causally, the motivation to invest comes first. The classical view implies that investment requires a prior pool of savings; for Keynes investment creates the savings by raising incomes. For the classicals, a high interest rate induces savings but restrains investment. For Keynes a high interest rate may reducesavings because it restrains investment.
There is also a large strand in (neo)classical economics linking the interest rate to the marginal disutility of abstaining from immediate consumption. The implication (again, Keynes writes that he has “not found actual words to quote” [p. 176]) is that the interest rate brings the marginal disutility of ‘waiting’ in equilibrium with the marginal productivity of capital. This suggests that capitalism has a tidy mechanism for allocating exactly the right proportion of resources to increasing production for the future - no more and no less than is necessary to meet everyone’s preferences for consuming what they want to consume, when they want to consume. Keynes quotes several passages which seem to me to say this pretty much outright – I don’t know why Keynes is so reticent about accusing the classicals of making this argument.
I think this is still true today:
Certainly the ordinary man – banker, civil servant or politician – brought up on the traditional theory, and the trained economist also, has carried away with him the idea that whenever an individual performs an act of saving he has done something which automatically stimulates the output of capital, and that the fall in the rate of interest is just so much as is necessary to stimulate the output of capital to an extent which is equal to the increment of saving; and, further, that this is a self-regulatory process of adjustment which takes place without the necessity for any special intervention or grandmotherly care on the part of the monetary authority. Similarly – and this is an even more general belief, even to-day – each additional act of investment will necessarily raise the rate of interest, if it is not offset by a change in the readiness to save. [p. 177]
We have already seen where Keynes disagrees with this, inChapter 9. Keynes accepts that the interest rate may have some impact on the marginal propensity to save. But income will have a much bigger effect, and if a higher interest rate lowers income (because it lowers investment), people will be saving a slightly larger proportion of substantially smaller incomes. Keynes accuses the classicals of ignoring this effect on the level of aggregate income. They consider the effect of changes in the interest rate on saving ‘assuming all else is equal’, but forget that it is impossible that everything else remain equal if the interest rate changes. Ceteris cannot be paribus.
Interestingly, in proving this point we get a graph, the only one in the whole book. It is the IS (investment-savings) section of what would later become known as Hicks’ IS-LM system (LM standing for liquidity preference-money). IS-LM is a bit of a bugbear for post-Keynesians as a bastardisation of Keynes, though Keynes gave some support to the interpretation himself. Here the only point is to show that the classical theory gives the IS section by itself. That is, out of any given income, a savings curve can be given linking the rate of interest to the amount of saving. This curve would be upward-sloping in saving/investment – interest space; i.e., the higher the rate of interest, the more saved. In the same space, the investment curve would slope down: the higher the rate of interest, the lower the investment. Thus the point where the curves cross gives the equilibrium interest rate and the amount saved and invested.
But Keynes points out that the two curves are interrelated, because if investment rises, income also rises. So a move along the investment curve could shift the whole savings curve. Therefore, there are a number of different equilibrium positions – the interest rate cannot be determined with reference to the propensity to save and the marginal productivity of capital alone. There is thus a need to bring in a whole other set of curves relating the state of liquidity preference and the quantity of money. Then, with the interest rate given, the classical system relating savings and investment can determine the level of income. Or, if the rate of income is given, the classical system can tell us what the rate of interest has to be. It cannot tell us both.
The alternative (neo)classical theory of the rate of interest – that it equals the marginal productivity of capital – also fails, for reasons addressed in Chapter 11: it is a circular argument. “For the ‘marginal efficiency of capital’ partly depends on the scale of current investment, and we must already know the rate of interest before we can calculate what this scale will be.” [p. 184]
Appendix on the Rate of Interest in Marshall’s ‘Principles of Economics’, Ricardo’s ‘Principles of Political Economy, and elsewhere
The title says it all really – this is just a closer look at what exactly the ‘classical theory of the rate of interest’ is. It is an extension of the argument in the chapter about what the (neo)classicals imply rather than say outright in scattered observations, and about thelack ofa coherent theory. Keynes thinks their problem boils down to the fact that money is mostly ignored in their vision of economics:
The perplexity which I find in Marshall’s account of the matter is fundamentally due, I think, to the incursion of the concept ‘interest’, which belongs to a monetary economy, into a treatise which takes no account of money… Nevertheless these writers are not dealing with a non-monetary economy (if there is such a thing). They quite clearly presume that money is used and that there is a banking system. [pp. 189-90] 


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