fundamental analysis classical vs. keynesian. similarities both the classical approach and the...
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Fundamental AnalysisFundamental Analysis
Classical vs. KeynesianClassical vs. Keynesian
SimilaritiesSimilarities
Both the classical approach and Both the classical approach and the Keynesian approach are macro the Keynesian approach are macro models and, hence, examine the models and, hence, examine the interaction between asset, money, interaction between asset, money, and labor markets.and labor markets.
Both models depend on the Both models depend on the “fundamentals” (GDP, price levels, “fundamentals” (GDP, price levels, etc)etc)
DifferencesDifferences
Classical AnalysisClassical Analysis Keynesian AnalysisKeynesian Analysis
DifferencesDifferences
Classical AnalysisClassical Analysis• Prices are flexible,
markets clear• Money is “Neutral”• Emphasis on Relative
Prices• Asset markets play a
minor role• Emphasis on
Technology rather that policy (Supply side)
Keynesian AnalysisKeynesian Analysis
DifferencesDifferences
Classical AnalysisClassical Analysis• Prices are flexible,
markets clear• Money is “Neutral”• Emphasis on Relative
Prices• Asset markets play a
minor role• Emphasis on
Technology rather that policy (Supply side)
Keynesian AnalysisKeynesian Analysis• Prices are fixed in the
short run• Money can influence
output in the short run (Phillips curve)
• Asset markets play a pivotal role
• Emphasis on policy rather than technology (demand side)
Example: The Productivity Example: The Productivity SlowdownSlowdown
During the Mid 1970’s, productivity During the Mid 1970’s, productivity growth dropped from its long run growth dropped from its long run average of 1.5% to -.27%.average of 1.5% to -.27%.
Classical AnalysisClassical Analysis
How would this drop in productivity How would this drop in productivity influence capital markets?influence capital markets?
Classical AnalysisClassical Analysis
How would this drop in productivity How would this drop in productivity influence capital markets?influence capital markets? Investment demand would most likely Investment demand would most likely
drop as firm’s face lower profit drop as firm’s face lower profit expectations.expectations.
Classical AnalysisClassical Analysis
How would this drop in productivity How would this drop in productivity influence capital markets?influence capital markets? Investment demand would most likely Investment demand would most likely
drop as firm’s face lower profit drop as firm’s face lower profit expectations.expectations.
Lower productivity ,means shrinking Lower productivity ,means shrinking personal income. What happens to personal income. What happens to personal savings?personal savings?
Classical AnalysisClassical Analysis How would this drop in productivity influence How would this drop in productivity influence
capital markets?capital markets? Investment demand would most likely drop Investment demand would most likely drop
as firm’s face lower profit expectations.as firm’s face lower profit expectations. Lower productivity ,means shrinking Lower productivity ,means shrinking
personal income. What happens to personal income. What happens to personal savings?personal savings? Temporary drop in income tends to lower Temporary drop in income tends to lower
savingssavings Permanent declines in income tend to Permanent declines in income tend to
lower consumptionlower consumption
Classical Analysis Classical Analysis
Recall that at a Recall that at a (fixed) global (fixed) global interest rate, the interest rate, the current account current account balance is the balance is the difference difference between domestic between domestic savings and savings and domestic domestic borrowing (public borrowing (public and private)and private)
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Classical Analysis Classical Analysis
Suppose that, Suppose that, initially trade was initially trade was balances at the balances at the global interest rate global interest rate of 10%.of 10%.
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Classical Analysis Classical Analysis Suppose that, initially Suppose that, initially
trade was balances at trade was balances at the global interest the global interest rate of 10%.rate of 10%.
A drop in investment A drop in investment demand in a closed demand in a closed economy would lower economy would lower the domestic interest the domestic interest raterate
In an open economy, In an open economy, the economy runs a the economy runs a trade surplustrade surplus
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Classical Analysis Classical Analysis
How would this drop in productivity How would this drop in productivity influence money markets? influence money markets?
Classical Analysis Classical Analysis
How would this drop in productivity How would this drop in productivity influence money markets? influence money markets? Recall, the demand for money is Recall, the demand for money is
equal to equal to M = kPYM = kPY
A drop in income (Y) without a A drop in income (Y) without a corresponding drop in money supply corresponding drop in money supply creates rising pricescreates rising prices
Classical Analysis Classical Analysis
What happens to real/nominal What happens to real/nominal exchange rates?exchange rates?
Classical Analysis Classical Analysis
What happens to real/nominal What happens to real/nominal exchange rates?exchange rates? Recall, P=eP* (PPP)Recall, P=eP* (PPP) Assuming no change in the foreign price Assuming no change in the foreign price
level, a rise in the domestic price level level, a rise in the domestic price level causes an equal rise (depreciation) in causes an equal rise (depreciation) in the nominal exchange ratethe nominal exchange rate
PPP implies a constant real exchange PPP implies a constant real exchange raterate
SummarySummary
Current account improves Current account improves No change in domestic (real) No change in domestic (real)
interest rates interest rates A rise in the domestic price levelA rise in the domestic price level A depreciation in the nominal A depreciation in the nominal
exchange rateexchange rate A constant real exchange rateA constant real exchange rate
Keynesian Analysis Keynesian Analysis
As before, begin in capital As before, begin in capital markets. markets. Investment drops while savings Investment drops while savings
remains constantremains constant With excess demand for credit, With excess demand for credit,
interest rates fall and income falls interest rates fall and income falls (lower income lowers savings) – IS (lower income lowers savings) – IS shifts leftshifts left
Keynesian AnalysisKeynesian Analysis
The shift in IS The shift in IS reflects two reflects two opposing forces in opposing forces in the balance of the balance of payments:payments:
Keynesian AnalysisKeynesian Analysis
Lower income Lower income improves the improves the current account, current account, but lower interest but lower interest rates worsen the rates worsen the capital accountcapital account
Keynesian AnalysisKeynesian Analysis
With a high rate of With a high rate of capital mobility, capital mobility, the interest rate the interest rate effect dominates effect dominates and a BOP deficit and a BOP deficit resultsresults
A BOP deficit A BOP deficit forces a currency forces a currency depreciationdepreciation
Keynesian AnalysisKeynesian Analysis
We know that the long run impact We know that the long run impact is a currency depreciationis a currency depreciation
However, lower domestic interest However, lower domestic interest rates imply a future currency rates imply a future currency appreciationappreciation (Interest Parity) (Interest Parity)
Keynesian AnalysisKeynesian Analysis
We know that the long run impact We know that the long run impact is a currency depreciationis a currency depreciation
However, lower domestic interest However, lower domestic interest rates imply a future currency rates imply a future currency appreciationappreciation (Interest Parity) (Interest Parity)
Therefore, the initial currency Therefore, the initial currency depreciation must be larger than depreciation must be larger than the long run result (overshooting)the long run result (overshooting)
SummarySummary
Current account improves (by more Current account improves (by more in the short run due to the sharp in the short run due to the sharp depreciation)depreciation)
Domestic real interest rates fallDomestic real interest rates fall No change in domestic pricesNo change in domestic prices A sharp depreciation (both real and A sharp depreciation (both real and
nominal) followed by an nominal) followed by an appreciationappreciation
Savings: 1970-1980Savings: 1970-1980
Consumption: 1970-1980Consumption: 1970-1980
Investment: 1970-1980Investment: 1970-1980
Interest Rates: 1970-1980Interest Rates: 1970-1980
Current Account: 1970-Current Account: 1970-19801980
GDP: 1970-1980GDP: 1970-1980
Prices: 1970-1980Prices: 1970-1980
Exchange Rate: 1970-Exchange Rate: 1970-19801980
Example: Government Example: Government DeficitsDeficits
Currently, the US deficit is around Currently, the US deficit is around $500B dollars (projected to be $500B dollars (projected to be $550B in 2004)$550B in 2004)
Classical AnalysisClassical Analysis
Suppose that the Suppose that the government runs government runs a $500B deficita $500B deficit
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Classical Analysis Classical Analysis
Suppose that the Suppose that the government runs government runs a $500B deficit a $500B deficit A rise in demand A rise in demand
for loanable funds for loanable funds increases the increases the interest rateinterest rate
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Classical AnalysisClassical Analysis
Suppose that the Suppose that the government runs government runs a $500B deficita $500B deficit However, with However, with
higher anticipated higher anticipated future taxes, future taxes, households households increase their increase their savingssavings 0
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Classical AnalysisClassical Analysis
Suppose that the Suppose that the government runs government runs a $500B deficita $500B deficit These two effects These two effects
offset each other, offset each other, leaving savings, leaving savings, investment, and investment, and the interest rate the interest rate unchanged.unchanged. 0
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SummarySummary
The current account is unaffected The current account is unaffected as are domestic interest ratesas are domestic interest rates
Assuming that the deficit has no Assuming that the deficit has no effect on GDP, money markets are effect on GDP, money markets are unaffected leaving prices and unaffected leaving prices and exchange rates (real and nominal) exchange rates (real and nominal) unchanged.unchanged.
Keynesian AnalysisKeynesian Analysis
Suppose that the Suppose that the government deficit government deficit increases. increases.
The long run impact The long run impact should be zero.should be zero.
Keynesian AnalysisKeynesian Analysis However, in the short However, in the short
run, the IS curve shifts run, the IS curve shifts right – output increases right – output increases and interest rates rise.and interest rates rise.
In this example, the In this example, the worsening of the trade worsening of the trade deficit is more than deficit is more than offset by higher offset by higher interest rates attracting interest rates attracting foreign capital. A foreign capital. A balance of payments balance of payments surplus is created.surplus is created.
SummarySummary
In the short run, a BOP surplus is In the short run, a BOP surplus is created causing a currency created causing a currency appreciationappreciation
However, interest parity suggests However, interest parity suggests that higher domestic interest rates that higher domestic interest rates imply a currency depreciationimply a currency depreciation