Page | 1 ASSIGNMENT ON INTERMEDIATE MACROECONOMIC (ECN 304 ) BERNARD OKPE REG. N O.

/GROUP/LEVEL:University of Abuja, Nigeria DEPARTMENT & FACULTY:ECONOMICS & SOC IAL SCIENCESQUESTION: Question 1: Compare and contrast Classical theory of inter est rate and Keynesian theory of interest Question2: Highlight all the controver sies between Keynesian, Monetarist, and the ClassicalQUESTION 1:COMPARE AND CONT RAST CLASSICAL THEORY OF INTERESTRATE AND KEYNESIAN THEORY OF INTEREST Page | 21.2. KEYNES LIQUIDITY PREFERENCE THEORY OF INTEREST Precautionary motive :Precautionary motive for holding money refers to the desire to hold cash balanc esfor unforeseen contingencies. Individuals hold some cash to provide for illnes s, accidents, unemploymentand other unforeseen contingencies. Similarly, busines smen keep cash in reserve to tide over unfavorableconditions or to gain from une xpected deals. Keynes holds that the transaction and precautionary motivesare re latively interest inelastic, but are highly income elastic. The amount of money held under these twomotives (M1) is a function (L1) of the level of income (Y) a nd is expressed as M1= L1(Y) Page | 3Algebraically, Keynes expressed the speculative demand for money as M 2= L2(r)Where, L2is the speculative demand for money, and r is the rate of interes t.Geometrically, it is a smooth curve which slopes downward from left to right.N ow, if the total liquid money is denoted by M, the transactions plus precautiona ry motives by M1and the speculative motive by M2, then M = M 1+ M 2. Since M 1= L1(Y) and M 2= L2(r), th e total liquidity preference function is expressed as M = L (Y, r).1.2.2. Supply of Money: The supply of money refers to the total quantity of money in the country. Though the supply of money isa function of the rate of interest to a certain degree, y et it is considered to be fixed by the monetaryauthorities. Hence the supply cur ve of money is taken as perfectly inelastic represented by a verticalstraight li ne.The totaldemand for moneyis obtained by summating the transactions, precautio nary and speculativedemands. Represented graphically, it is sometimes called the liquidity preference curveand is inverselyrelated to the rate of interest.Money Demand and Increases in Real GDP Consider a period of sustained economic growth in the economy. Rising real incomes and increasingnumbers of people employed wil l increase the demand for money at each rate of interest. Thereforehigher real n ational income causes an outward shift in the demand for money. This is shown in thediagram below.Financial Innovation and the Demand for Money The pace of chan ge in financial markets is rapid and this affects our demand for money balances in orderto finance our purchases. In recent years the demand for cash balances ( M0) has declined relative to the demand for interest-bearing deposit accounts. Most people can finance their purc hases using debit cardsand credit cards rather than carrying around large amount s of cash. Financial innovation has reduced thedemand for cash balances at each rate of interest - represented by an inward shift in the money demandcurve. Page | 41 .2.3. Determination of the Rate of Interest: Like the price of any product, the rate of interest is determined at the level where the demand for mo neyequals the supply of money. In the following figure, the vertical line QM rep resents the supply of moneyand L the total demand for money curve. Boththe curve s intersect at E2where the equilibriumrate of interest OR is established.If ther e is any deviation from this equilibriumposition an adjustment will take place t hroughthe rate of interest, and equilibrium E2will bere-established.At the point E1the supply of money OM isgreater than the demand for money OM1.Consequently, the rate of interest will startdeclining from OR1till the equilibrium rate of in terest OR is reached. Similarly at OR2levelof interest rate, the demand for mone y OM2isgreater than the supply of money OM. As aresult, the rate of interest OR2 will start rising till it reaches the equilibrium rate OR.It may be noted that, if the supply of money is increased by the monetary authorities, but the liquidi typreference curve L remains the same, the rate of interest will fall. If the de mand for money increases andthe liquidity preference curve sifts upward, given t he supply of money, the rate of interest will rise.1.1.1. Criticisms of the Key nesian Theory Of Interest Rate: Keynes theory of interest has been criticized o

n the following grounds:1. It has been pointed out that the rate of interest is not purely a monetary phenomenon. Real forces likeproductivity of capital and th riftiness or saving by the people also play an important role in thedeterminatio n of the rate of interest.2. Liquidity preference is not the only factor governi ng the rate of interest. There are several otherfactors which influence the rate of interest by affecting the demand for and supply of investible funds.3. The l iquidity preference theory does not explain the existence of different rates of interest prevailingin the market at the same time.4. Keynes ignores saving or wa iting as a means or source of investible fund. To part with liquiditywithout the re being any saving is meaningless.5. The Keynesian theory only explains interes t in the short-run. It gives no clue to the rates of interest inthe long run. Page | 56. Keynes theory of interest, like the classical and loanable funds th eories, is indeterminate. We cannotknow how much money will be available for the speculative demand for money unless we know howmuch the transaction demand for money is.1.3. Comparison between Classical and Keynesian Theories of InterestThe Keynesian theory of interest is an improvement over the classical theory in tha t the former considersinterest as a monetary phenomenon as a link between the pr esent and the future while the classical theoryignores this dynamic role of mone y as a store of value and wealth and conceives of interest as a non-monetary phe nomenon.Thus, the classicists made the serious error of ignoring the monetary el ement in formulating the theory of interest a monetary theory.Thus, the classica l theory of interest in comparison with Keynes liquidity preference theory has severalweaknesses. They are as under:1. The classical theory treated interest as the price for not spending, for saving, while, in fact, as theliquidity theory points out, it is price paid for not hoarding i.e. parting with liquidity.2. The classical theory views the demand for money exclusively in terms of investment. It fails toconsider the fact that the demand for money might also arise from th e demand for hoarding, i.e.,holding idle cash balances on account of the liquidi ty preferences. It is the Keynesian theory of interest that recognizes the impor tant role of liquidity preference in the determination of the interestrate.3. Th e classical theory is narrow in scope as it ignores the borrowing motives like h oarding or thepurpose of consumption and concentrates only on savings demanded f or productive purposes, i.e.,real investment demand.4. Classical economists did not pay any attention to the money supply and bank credit which can neverbe igno red as a determinant of the rate of interest. Keynes does pay attention to the q uantity of moneyas a factor determining the rate of interest.5. The classical th eory is rather ambiguous and indefinite. It ignores the fact that saving is a fu nction of income but regards it as a function of the interest rate. This is wron g; Keynes argued that when therate of interest goes up level of income will be l ess since investment will decline so savings will beless. Keynes thus stressed t he fact that saving is a function of income rather than that of the interestrate .6. The main weakness of the classical theory is, therefore, that it assumes the level of income to bealways given. This is because it assumes full-employment e quilibrium. The theory is, therefore,rejected by Keynes because it is applicable only to a case when income is fixed at a pointcorresponding to the level of ful l employment. Keynesian theory, on the other hand, is more realisticas it consid ers the economies of less than full employment also.7. In fine, an important dis tinction between the Keynesian and classical theories of interest is that thefor mer theory is completely stock theory whereas the latter is a completely flow th eory.8. In some respects, the Keynesian theory is narrower in scope, compared wi th the classical theory.Keynes liquidity preference theory applies to the suppl y and demand for money savings or moneycapital only whereas the classical theory applies to non-monetary capital also.9. Moreover, the liquidity preference theo ry assumes that a person should lend capital to somebody toget interest; for the n alone can one say that he has parted with liquidity and that interest is assum ed tobe a reward for parting with liquidity as such. According to the classical theory, on the other hand,even if a person does not necessarily part with his sa vings but uses them in his own productiveactivity (real investment), interest wi ll arise.

Page | 61.4. Conclusion:Nevertheless, we may conclude that Keynesian theory is superior to the classical theory of interest sincethe former is concerned with equilibrium in the real sector. Thus, in the money economy of the presentworld, the Keynesian theory is more realistic than the classical theory of interest.QUE STION 2: HIGHLIGHT ALL THE CONTROVERSIES BETWEEN KEYNESIAN, MONETARIST AND THE C LASSICAL ECONOMIC 2.0. Introduction:Over the years, macroeconomists from diffe rent schools of thought have had a divergent view on whatreally drives economic growth for an economy in achieving the macroeconomic. In this case, I will limit my idea to the controversies and the divergent view between Keynesian, Monetaris t and the Classicaleconomic theory. 2.1. The Controversies: The primary phenomen a and controversies among these three (3) schools of thought investigated are:1. The proposed Structure and Stabilization Policies of the Economy2. 3. 4. The p roposed Structure and Stabilization Policies of the Economy:The fundamental mess age of theKeynesian is that the private enterprise needs to be stabilized, and t herefore should be stabilized byappropriate monetary and fiscal policies. Moneta rists by contrast take the view that there is no seriousneed to stabilize the ec onomy; that even if there were a need it should not be done since stabilizationp olicies would be more likely to increase than to decrease instability. To the Cl assical, which uses thePassive Strategy approach that assumes that the self -corre cting mechanisms will work well, if not stifledby unnecessary meddling by policy makers. They Classical believe that erratic, improperly timed activistpolicies a re actually a source of economic instability, and that economy would be better o ff if it maintainstable, predictable fiscal and monetary policy during all phase s of the business cycle. Therefore, tomonetarists there is no active role for st abilization policy, and to Keynesians there is. Classical, assumesself-correctin g mechanisms. Macroeconomics Thought on Demand for Money(Quantity Theory of Mone y):The Classicaleconomists assumed that the velocity of the money was constant. They believed the institutional,structural and customary conditions determined t he velocity. P is the general price level. It is an averageof prices of all thos e final goods and services provided and exchanged in the economy over the timepe riod chosen for observation. The classical macroeconomists assumed that, because of full employmentand flexibility of price, wage and interest, physical output would be constant. As a result, a change in theamount of money supply will cause a proportional change in the general price level-1. Modern QuantityTheory expre ssed in its most basic form, the simple quantity theory of money makes the deman d fornominal money balances depend only on the nominal income level: M = P f{Y). The Keynesian theoryadds the interest rate as a determinant to give us a differ ent function: M = P f(Y,r).During the post-Keynesian period, another theory was developed. Its creator, Milton Friedman who championed theMonetarist sees the mo dern quantity theory as a restatement of the old one, whereas others see it as a n Page | 7elaborate statement of Keynesian theory. One way of expressing the dem and for money in the simplequantity theory is M = k(PY), where k is a constant. Macroeconomics Thought on Inflation:In order to explain inflation, the Keynesian s tend to argue thatthe long-run Phillips curve is not vertical and that the gov ernment needs to, pursue an unemploymenttarget via discretionary demand manageme nt policies. Such policies will involve inflation owing to thetrade-off between unemployment and inflation and believe that the long-run Phillips curve can be s hifteddownward by the adoption of a prices and incomes policy. Fig-3: Keynesian Inflationary Gap. Using the Keynesian model is the relation between equilibrium and fullemployment. The relation between the inflationary gap and recessionary g ap indicates which of the gaps,if either, might exist. In this particular exampl e, full employment results with $9 trillion of aggregate production, which is le ss than the $12 trillion equilibrium level of aggregate production. The relation between equilibrium and full-employment aggregate production means the economy h as an inflationarygap. The resulting inflationary gap is $3 trillion of aggregat e production. In other words, aggregate production needs to decrease by $3 trill ion to eliminate this gap.The Monetarists argue that inflation is essentially a monetary phenomenon propagated by excessivemonetary growth. They accept that in the short run there may be a trade-off between inflation andunemployment but arg

ue that once people have fully adjusted their inflationary expectations the trad e-off disappears, resulting in a vertical long-run Phillips curve at the natural rate of unemployment. In short,monetarists advocate that discretionary demand m anagement policies should be replaced by a monetaryrule in order to avoid econom ic instability. New classical macroeconomics incorporates the monetaristview tha t inflation: is essentially a monetary phenomenon propagated by excessive moneta ry growth andcan only be reduced by slowing down the rate of monetary expansion. Macroeconomics Thought on Growth: One growth theory relates the growth rate of the economy saggregate output to that of its capital stock. In this approach, ca pital is the only factor of productionexplicitly considered and it is assumed th at labor is combined with capital in fixed proportions. Withregard to the rate a t which capital accumulates, this theory is Keynesian in nature. Keynesian-based growth theory is commonly known as the Harrod-Domar theory. The Classical is bas ed their idea on"subsistence level" to model their Growth Theory. They believed that if real GDP rose above thissubsistence level of income that it would cause the population to increase and bring real GDP back downto the subsistence level. It was sort of like an equilibrium level that real GDP would always revert to i nthis theory. Alternatively, if the real GDP fell below this subsistence level, parts of the population woulddie off and real income would rise back to the subs istence level. Keynesian growth theory appearsessentially a theory of the medium period, Classical a theory of the long period. The main differencesbetween the two theories concern the formation of expectations with respect to factor prices and thebehavior of capacity utilization. Basically monetarism views government roles in policy to ensure a stableequilibrium in the Money Market (supply and de mand for money). This is known as Price Stability. Toomuch growth equals higher than normal levels of inflation. Too little growth and the economy may slow.Mone y is the only way to manage the "health" of the economy, as defined by stability fo economicvariables (unemployment, inflation, output growth, etc.) Macroeconom ics Thought on Unemployment:The Keynesian approach is usually associated withKey nesian AD-AS model. In terms of the IS-LM model the Keynesian position has been characterized bya relatively flat LM curve and a relatively steep IS curve. Fisc al policy is preferred as the main policyinstrument to maintain the economy at a high and stable level of employment. In contrast to Keynesianbeliefs, monetaris ts argue that capitalist economies are inherently stable and that when subjected to somedisturbance the economy will return to equilibrium at the natural rate o f unemployment. As such, theyquestion the need for discretionary aggregate-deman d management policies and tend to argue that such Page | 8policies cannot stabilize the economy. Regarding fiscal policy, moneta rists argue that while pure fiscalexpansion can influence output and employment in the short run, and in the long run it will have noeffect. Monetarists argue t hat if governments wish to reduce the natural rate of unemployment in order toac hieve higher employment levels they should pursue microeconomic or what are refe rred to as supplyside policies rather than macroeconomic policies. According to Classical, anticipated aggregate demandpolicies will be ineffective in influenci ng level of output and employment even in the short run, and thatonly random and unanticipated shocks to aggregate demand can temporarily affect output andemplo yment. Any attempt to affect output and employment by random or non-systematic a ggregatedemand policies would, only increase the variation of output and employm ent. Macroeconomics Thought on Wage Price Stickiness: Sticky prices lie at the v ery heart of Keynesianmacroeconomics, and it explains quantity fluctuations in g oods and labor markets as equilibratingmovements arising because prices do not i mmediately change when aggregate demand shifts. Thepostulate of price flexibilit y lies at the center of new-classical economics. It has it that prices always mo veto equilibrate markets when demand shifts, but that individual agents, who are not fully informed aboutthe behavior of all money prices in the economy, mistak e money price changes in the markets for thegoods they sell for relative price c hanges. Hence they respond by changing the quantities of goods theysupply. In th e aggregate, an unperceived demand increase which raises the general price level thereforecauses an expansion of output along aggregate supply curve, and a fall of demand causes a contraction. Macroeconomics Thought on Consumption:The consu

mption function is the centerpiece of KeynesGeneral Theory. Keynesians approach t o consumption was Absolute income Hypothesis .One of theearliest attempt to deriv e a theory of consumption function in accord with the empirical discoveries wasJ ames Duesenberry s Relative Income Hypothesis (1949).A household s consumption d epends not on itsabsolute income but on its relative income; relative that is to (1) the income of other households and (2)its own Previous income. Later Milton Friedman proposed the PIH to explain consumer behavior 2.3. Conclusion The main stream schools of thoughts highlighted above carries different views on a specif ic giveneconomic variable in discussing economic policy stabilization .The impor tance of such is that it gives thereader to appreciate different tools and techn iques theories adopted to achieve economic policystabilization.The drastic chang e that has occurred in economic theory has not been the result of ideological wa rfare. It has not resulted from divergent political beliefs or aims. It has resp onded almost entirely to the force of events: brute experience proved far more p otent than the strongest of political or ideological preferences.(Friedman, 1977 , p. 470)References Leslie .D, Advanced Macro Economics(1993) L.Rosalind, R.Alexan der, Macro Economics An Introduction to Keynesian ClassicalControversies. (1982) L ipsey .R.G , Chrystal.K.A, An Introduction to Positive Economics(1989) Shapiro. Ed ward , Macro Economic Analysis.(2004) Samelson .P, Nordhaus .W, Economics(2002) The N ew Classical contribution to Macro Economics Cross, Rod, ed. Unemployment, Hyster esis, and the Natural Rate Hypothesis. Oxford: Blackwell,1988. Page | 9 Friedman, Milton. The Role of Monetary Policy. American Economic Review 58, no. 1 (1968): 1 17. Lucas, Robert E. Jr. Econometric Testing of the Natural Ra te Hypothesis. In Otto Eckstein, ed., The Econometrics of Price Determination. Was hington, D.C.: Federal Reserve System, 1972. Phelps, Edmund S. Phillips Curves, Ex pectations of Inflation and Optimal Employment over Time.Economica, n.s., 34, no. 3 (1967): 254 281. Phillips, A. W. H. The Relation Between Unemployment and the R ate of Change of Money WageRates in the United Kingdom, 1861 1957.Economica, n.s., 25, no. 2 (1958): 283 299. Samuelson, Paul A., and Robert M. Solow. Analytical Asp ects of Anti-inflation Policy. AmericanEconomic Review 50, no. 2 (1960): 177 194. Sheffrin, Steven M. Rational Expectations. 2d ed. Cambridge: Cambridge Universit y Press, 1996. Symposium: The Natural Rate of Unemployment. Journal of Economic Per spectives 11, no. 1(1997): 3 108.