Mishkins Liquidity Preferences - Assignment Example

Answer 1: Mishkin believes that financial crises are caused by the imperfect information in the market. It is a result of this imperfect information that funds channeling to the right sectors is hindered and as a result these sectors suffer causing them fall and bring about trickle down changes to the economy as a whole. This imperfect information is caused by increased in interest rates which discourage investors to invest their money in the certain sector. They might think that interest rates are too high to cover the cost of investment. On the other hand, what they might not know is that return will cover the cost of investment and will earn them a decent return. This is because they do not have the right information or there is imperfect information that they may be discouraged to invest in a certain. Increases in uncertainty also create imperfect information at people might become too reserved and may not be able to distinguish bad investment from good investment. Problems in banking sector and Asset Market Effects on the Balance Sheets are yet other causes of imperfect information. The problems in banking sector signals investors that something is wrong and they fly away their investment to other countries causing liquidity problems and financial crises occur in a country. Minsky, on the other hand, believes that financial crisis occur due to capitalist approach in which the economies are run. He believed that fragility in the financial system is the result of privately owned businesses and resources in an economy. He also classified that firms use hedge, speculative and ponzi finance to run their operations. Minsky stated that in the first stage, banks were giving hedge finance to earn return on investment. However, even after this there was excess liquidity and banks started giving speculated finance in which they did not ask for collateral on loans and income certificate was enough to get a loan. However, the financial crisis started when the banks started using Ponzi finance. Here, they did not ask for either collateral or income certificate but gave loans on credit score. These loans are also known as subprime loans. The best example of this type of lending is subprime mortgages. He believed that banks were unable to recover these mortgages and due to declining house prices, they were not even able to recover their investment and as a result financial crisis started. In a nutshell, he believed that Ponzi finance was the result of these crises. Answer 2: Mishkin believed that Liquidity Preference is made up of people wanting to invest their money into profitable venture. This way they can increase their wealth and earn return on their investments. Any dollar that they invest in any venture should cover their initial cost of investment and should give decent amount of return on investment. On the other hand, Keynesian Liquidity preference is not just made up of money needed to invest, but also for two other motives. Theses motives are called precautionary motive and transaction motives. The transaction motive states that demand for money comes for people’s necessity make daily purchases for food, clothing etc. The precautionary motive states that demand for money comes from people wanting to hold money to meet unexpected events such as visit to a doctor etc. This shows that Keynesian liquidity preference is broader than Mishkin’s Liquidity preference. In other words, Mishkin’s liquidity preferences is dependent more on the market information than anything, whereas as Keynesian Liquidity preference also takes into account current and future needs. Answer 3: The major different between the Aggregate Demand and Aggregate Supply under the Keynesian and Mishkin’s liquidity preference are discussed in the next few paragraphs. As we know that Mishkin’s Liquidity preference is a part of Keynesian’s Liquidity Preference, any increase in Mishkin’s liquidity preference is going to increase the aggregate demand of Keynesian Liquidity Preference. It can also be concluded that fluctuations in aggregate demand and supply in the Mishkin’s Liquidity Preference will be greater than Keynesian Liquidity preference in case of financial panic and Mishkin’s Liquidity preference is more susceptible to financial crises. It can also drawn out that since Keynesian Liquidity preference holds that money is needed for purposes other than investment, aggregate demand for money will always be there even in recessionary periods, whereas the aggregate demand and supply for money under Mishkin’s liquidity preference may be zero or nil during the recessionary periods. All this said, due to high aggregate demand, the aggregate supply will always be higher in Keynesian Liquidity Preference as compared to Mishkin’s Liquidity Preference. Answer 4: The economic global down-turn which hit the world in the last quarter of 2007 was probably the most severe crisis that the economists witnessed since last decade. This crisis continued till 2008, matured and gnawed the world economy. Many arguments were given about how this financial crunch started. Many people argued that it was started by the booming oil prices, whereas other people stated that this crisis is a result of poor economic policies of IMF and World Bank which overheated the global economy and resulted in the financial crunch. Since this crisis has hit the World, many organizations in the banking sectors have filed bankruptcy. If we go deeper into the analysis, we will find out that most of these organizations were in some way or the other involved in the subprime lending business. The biggest subprime lending organization which filed for bankruptcy was New Century Financial Corporation. Another cause that is linked with the people’s inability to pay off their mortgage debts is declining house prices. When people are unable to pay their mortgage interest on the property they have leased, the lessor does not have any other option but to seize the property from lessee and offer it for sale in the market. Since, this crisis resulted in many such properties being offered for sale in the market, it increased the supply of houses in the Real-estate market. This shifted the supply curve to the right in the convention demand-supply model and reduced the prices of these houses. This also resulted in the overall decrease in the market prices, because in the competitive market, when price of one commodity goes down, the prices of its substitute follow. This was a common-phenomenon in the real-estate market since these crisis started out. Another reason of this decline in property prices in the market post global financial crisis could be the fact that people do not have much money right now and as a result they cannot spend hectic amounts on property. However, in Australia, the property prices and assets prices did not fell that much and banks and financial institutions were able to recover their lending and loans and recovered quickly then the USA. Answer 5: The mainstream economist believed that inflationary pressures are usually caused by too much money chasing too few goods. As a result, to decrease these pressures you need to reduce the supply of the money into the economy and this can be done by decreasing governmental development projects and other spending which pumps money into the economy faster. It can also be reduced by printing less money so that less money go into people’s hand and they have less to spend and hence the money supply in the economy decreased so as inflation. Inflationary pressures can also be reduced by letting the economy operate at NAIRU, so that inflation does not occur due to increase in labor wages. Imports should be stopped and firms should try to get their raw material from local sources to stop imported inflation for occur. However, modern economists had a completely different view as to inflation. They reflected their ideas about inflation and unemployment in Phillips curve. They believed that if people expect that in future prices are going to increase, inflation occurs. These people then start demanding higher wages to keep up their living standard and whole spiral cycle starts causing more and more inflation. Modern economists, therefore, recommend that inflation can be reduced just by telling people and assuring them their future are safe and purchasing power of money is not going to decrease in future. In a nutshell, inflationary pressures can be controlled by molding people’s expectations more rational and more optimistic. 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