Keynesian Model for Economics and Neo-Classical Growth Model - Assignment Example

1 The Keynesian model for economics is a model that has been successful in describing the of the economy and the relation between the factors of the economy. With the developments in the financial world, the Keynesian model has been modified to conform to the current state in the markets. One of the modifications includes Hall’s modification of the IS-LM curve, which aims to describe the effects of prices on the Phillip’s curve. The model developed by New Keynesian economists is very successful in predicting recession in the long-run, since the economists believe that the changes in money supply on the long-run remain unchanged; therefore, prices do not change.

However, the Keynesian model assumes sticky wages and prices, so in the short run, decreasing money supply causes a subsequent reduction in interest rates, therefore, it is expected that output will increase and unemployment will decrease. This is in the short-run, yet the long-run will be faced by inflationary expectations if the level of employment is increased, inflationary monetary policy. The main reason why the model described by Hall cannot be used to describe recession in the short-run is its basis on the rational expectations of consumers.

This basis on rational expectations described implies that consumption in the future is based on present consumption, which means that people expect to smooth the income model and predict their future consumption. The level of consumption is then expected to remain at a level that keeps wealth constant over a long time, which means that the expected wealth will remain at a constant rate in the short or medium-term. This can be described as a forecast error since the model cannot explain inflation or price changes in the short-term; therefore, the model cannot be used to describe recession in both the short-term and medium-term.

2 The use of economic models to describe the state of an economy is based on the assumption that the growth model will be able to explain all the components in it and relate these components to the economic situations being faced. The use of an economic model to describe a real-world situation is also important in determining the usefulness of the model. One such economic model is the neo-classical growth model, developed in the 1950s, to explain the growth process in relation to the different aspects of the population and growth in the said population dynamics.

The neo-classical growth model is mainly based on the usefulness of technological processes and the productivity of the labor force in determining the growth potential of the economy. This implies that the dynamics of the growth process are directly affected by several factors, key among them being population growth, technological advancement, and changes in capital formation (Diamond and Spencer, 2008). The use of the neo-classical growth model is restricted to the factors mentioned above; therefore, components like the 19.

5 hours of work per population, which is a factor of the productivity level, are ignored. As already mentioned, neo-classical growth models are used to model long-run economic growth, therefore, three main assumptions can be implied. The first assumption of the model is that increasing the amount of capital relative to the availability of labor will increase productivity; therefore, the number of hours worked by the population should not remain constant. The second assumption is that less capita per person in any country will lead to an increase in the investment level, since the investment in capital per person will produce more results than the investment in countries with more resources.

The last assumption of the model is that the economy will reach a point that an increase in capital does not necessarily increase the growth of the economy; therefore, the constant level of work per population can be ignored. The factors of the neo-classical model imply that the work/population is an obsolete measurement of economic growth (Diamond and Spencer, 2008). 3 The composition of the Federal Balance Sheet is affected by many factors, key among these factors being the amount of money being created and the apparent inflationary effect of the wealth being created.

This is probably the main factor why the adjustment of the Fed balance sheet did not include TARP, since an increase in the amount of money used to bail out banks and other financial institutions would serve to increase the money supply, which would mean that inflationary practices are increased. An increase in the TARP would only serve to increase new money in the economy; therefore, it is completely acceptable that the fed would not increase the amount of TARP. According to the Federal Reserve (2011), the main addition to the federal balance sheet was the decision to sell off holdings in treasury securities without the creation of new money, which was achieved by the use of Term Auction Facilities and Currency Swap Lines.

These two additions to the federal balance sheet are meant to increase the amount of loans available without increasing the amount of ne money in the market. This adjustment in the asset side of the balance sheet was done by selling a large piece of treasury securities and replacing them with the loans and asset bases mentioned above. In the case of the term auction facility, the Federal Reserve sold term funds to banks, financial institutions, and all institutions that qualify as depository institutions.

The currency also served the same purpose since there is no increase in the amount of new money in the economy. 4 The rise in housing prices prior to the recent recession was justified to some extent by changes in the real return of the 10-year treasury bill, a fact that can be proven by considering the effect of changing treasuries on housing and mortgage prices. The discussion of changing mortgage prices should be focused on two main factors, the Treasury bill rate, and the change in mortgage prices.

The economy in the country is made up of many interconnected factors, some of them being the housing market, and rate of interest paid on treasury bonds (Weller, 2011). This connection determines mortgage rates, therefore, the argument that the rise in housing prices is justified. The first factor in this explanation is that any increase in the treasury rates will lead to an increase in mortgage rates, which will remain at a high point for a long time. This is because the treasury rates are the benchmark for the determination of all other interest rates, since the treasuries’ interest rate is risk-free.

The increase in these rates will mean that investors will need to be compensated for the additional risk that they take on; therefore, it is expected that other forms of debt will increase their rates. An increase in the mortgage rates will, in turn, increase housing prices, since the lender will want to consolidate the prices earned and increase the return on the risk of default (Weller, 2011). This is because an increase in the mortgage rate will increase the chance of default; therefore, it is expected that a lender will want to consolidate their position in the market for the mortgages.

The increase in mortgage rates will not be offset in a short time, meaning that these rates will remain at a high for a long time. This is a result of a shock to the treasury rates, meaning that the mortgage rates will lead to a drop in home sales. Contrary to common opinion, the change in interest rates will increase the prices of housing in the short run, since the cumulative loss in income will eventually lead to an increase in supply and a loss of demand, which will sharply decrease housing prices.

References Dimand, R., and Spencer, B. (2008). Trevor Swan and the Neo-Classical Growth Model. NBER Working Paper Series, 13950. Federal Reserve. (2011). Federal Reserve Statistical Release. Retrieved on October 30, 2011 from: Weller, C. (2011). Don’t Raise the Federal Debt Ceiling, Torpedo the U.S. Housing Market. Retrieved on October 30, 2011 from: