Fundamental Analysis Classical vs. Keynesian

Similarities Both the classical approach and the Keynesian approach are macro models and, hence, examine the interaction between asset, money, and labor markets. Both the classical approach and the Keynesian approach are macro models and, hence, examine the interaction between asset, money, and labor markets. Both models depend on the “fundamentals” (GDP, price levels, etc) Both models depend on the “fundamentals” (GDP, price levels, etc)

Differences Classical Analysis Keynesian Analysis

Differences Classical 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 Analysis

Differences Classical 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 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 Slowdown During the Mid 1970’s, productivity growth dropped from its long run average of 1.5% to -.27%. During the Mid 1970’s, productivity growth dropped from its long run average of 1.5% to -.27%.

Classical Analysis How would this drop in productivity influence capital markets? How would this drop in productivity influence capital markets?

Classical Analysis How would this drop in productivity influence capital markets? How would this drop in productivity influence capital markets? Investment demand would most likely drop as firm’s face lower profit expectations. Investment demand would most likely drop as firm’s face lower profit expectations.

Classical Analysis How would this drop in productivity influence capital markets? How would this drop in productivity influence capital markets? Investment demand would most likely drop as firm’s face lower profit expectations. Investment demand would most likely drop as firm’s face lower profit expectations. Lower productivity,means shrinking personal income. What happens to personal savings? Lower productivity,means shrinking personal income. What happens to personal savings?

Classical Analysis How would this drop in productivity influence capital markets? How would this drop in productivity influence capital markets? Investment demand would most likely drop as firm’s face lower profit expectations. Investment demand would most likely drop as firm’s face lower profit expectations. Lower productivity,means shrinking personal income. What happens to personal savings? Lower productivity,means shrinking personal income. What happens to personal savings? Temporary drop in income tends to lower savings Temporary drop in income tends to lower savings Permanent declines in income tend to lower consumption Permanent declines in income tend to lower consumption

Classical Analysis Recall that at a (fixed) global interest rate, the current account balance is the difference between domestic savings and domestic borrowing (public and private) Recall that at a (fixed) global interest rate, the current account balance is the difference between domestic savings and domestic borrowing (public and private)

Classical Analysis Suppose that, initially trade was balances at the global interest rate of 10%. Suppose that, initially trade was balances at the global interest rate of 10%.

Classical Analysis Suppose that, initially trade was balances at the global interest rate of 10%. Suppose that, initially trade was balances at the global interest rate of 10%. A drop in investment demand in a closed economy would lower the domestic interest rate A drop in investment demand in a closed economy would lower the domestic interest rate In an open economy, the economy runs a trade surplus In an open economy, the economy runs a trade surplus

Classical Analysis How would this drop in productivity influence money markets? How would this drop in productivity influence money markets?

Classical Analysis How would this drop in productivity influence money markets? How would this drop in productivity influence money markets? Recall, the demand for money is equal to Recall, the demand for money is equal to M = kPY A drop in income (Y) without a corresponding drop in money supply creates rising prices A drop in income (Y) without a corresponding drop in money supply creates rising prices

Classical Analysis What happens to real/nominal exchange rates? What happens to real/nominal exchange rates?

Classical Analysis What happens to real/nominal exchange rates? What happens to real/nominal exchange rates? Recall, P=eP* (PPP) Recall, P=eP* (PPP) Assuming no change in the foreign price level, a rise in the domestic price level causes an equal rise (depreciation) in the nominal exchange rate Assuming no change in the foreign price level, a rise in the domestic price level causes an equal rise (depreciation) in the nominal exchange rate PPP implies a constant real exchange rate PPP implies a constant real exchange rate

Summary Current account improves Current account improves No change in domestic (real) interest rates No change in domestic (real) interest rates A rise in the domestic price level A rise in the domestic price level A depreciation in the nominal exchange rate A depreciation in the nominal exchange rate A constant real exchange rate A constant real exchange rate

Keynesian Analysis As before, begin in capital markets. As before, begin in capital markets. Investment drops while savings remains constant Investment drops while savings remains constant With excess demand for credit, interest rates fall and income falls (lower income lowers savings) – IS shifts left With excess demand for credit, interest rates fall and income falls (lower income lowers savings) – IS shifts left

Keynesian Analysis The shift in IS reflects two opposing forces in the balance of payments: The shift in IS reflects two opposing forces in the balance of payments:

Keynesian Analysis Lower income improves the current account, but lower interest rates worsen the capital account Lower income improves the current account, but lower interest rates worsen the capital account

Keynesian Analysis With a high rate of capital mobility, the interest rate effect dominates and a BOP deficit results With a high rate of capital mobility, the interest rate effect dominates and a BOP deficit results A BOP deficit forces a currency depreciation A BOP deficit forces a currency depreciation

Keynesian Analysis We know that the long run impact is a currency depreciation We know that the long run impact is a currency depreciation However, lower domestic interest rates imply a future currency appreciation (Interest Parity) However, lower domestic interest rates imply a future currency appreciation (Interest Parity)

Keynesian Analysis We know that the long run impact is a currency depreciation We know that the long run impact is a currency depreciation However, lower domestic interest rates imply a future currency appreciation (Interest Parity) However, lower domestic interest rates imply a future currency appreciation (Interest Parity) Therefore, the initial currency depreciation must be larger than the long run result (overshooting) Therefore, the initial currency depreciation must be larger than the long run result (overshooting)

Summary Current account improves (by more in the short run due to the sharp depreciation) Current account improves (by more in the short run due to the sharp depreciation) Domestic real interest rates fall Domestic real interest rates fall No change in domestic prices No change in domestic prices A sharp depreciation (both real and nominal) followed by an appreciation A sharp depreciation (both real and nominal) followed by an appreciation

Savings:

Consumption:

Investment:

Interest Rates:

Current Account:

GDP:

Prices:

Exchange Rate:

Example: Government Deficits Currently, the US deficit is around $500B dollars (projected to be $550B in 2004) Currently, the US deficit is around $500B dollars (projected to be $550B in 2004)

Classical Analysis Suppose that the government runs a $500B deficit Suppose that the government runs a $500B deficit

Classical Analysis Suppose that the government runs a $500B deficit Suppose that the government runs a $500B deficit A rise in demand for loanable funds increases the interest rate A rise in demand for loanable funds increases the interest rate

Classical Analysis Suppose that the government runs a $500B deficit Suppose that the government runs a $500B deficit However, with higher anticipated future taxes, households increase their savings However, with higher anticipated future taxes, households increase their savings

Classical Analysis Suppose that the government runs a $500B deficit Suppose that the government runs a $500B deficit These two effects offset each other, leaving savings, investment, and the interest rate unchanged. These two effects offset each other, leaving savings, investment, and the interest rate unchanged.

Summary The current account is unaffected as are domestic interest rates The current account is unaffected as are domestic interest rates Assuming that the deficit has no effect on GDP, money markets are unaffected leaving prices and exchange rates (real and nominal) unchanged. Assuming that the deficit has no effect on GDP, money markets are unaffected leaving prices and exchange rates (real and nominal) unchanged.

Keynesian Analysis Suppose that the government deficit increases. Suppose that the government deficit increases. The long run impact should be zero. The long run impact should be zero.

Keynesian Analysis However, in the short run, the IS curve shifts right – output increases and interest rates rise. However, in the short run, the IS curve shifts right – output increases and interest rates rise. In this example, the worsening of the trade deficit is more than offset by higher interest rates attracting foreign capital. A balance of payments surplus is created. In this example, the worsening of the trade deficit is more than offset by higher interest rates attracting foreign capital. A balance of payments surplus is created.

Summary In the short run, a BOP surplus is created causing a currency appreciation In the short run, a BOP surplus is created causing a currency appreciation However, interest parity suggests that higher domestic interest rates imply a currency depreciation However, interest parity suggests that higher domestic interest rates imply a currency depreciation