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 says 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 says 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 says 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 shortterm 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. 1
st
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