Answer five of the seven essay questions immediately below. * Must Answer – Essay Question 03.
Essay Question 01. The Quantity Theory of Money. (5 points for each case/20points total). Provide a brief explaination and provide graphs for each.
What happens to the Purchasing Power of Money, Prices and the Nominal Rate of Interest in
CASE 1: the case of an increasing supply of money and credit?
CASE 2: the case of a decreasing supply of money and credit?
CASE 3: the case of an increasing demand for money and credit?
CASE 4: the case of a decreasing demand for money and credit?
Essay Question 02 The Minsky Model of a General Financial (Liquidity) Crisis
(4 points each/20 points total)
02A. The boom of the business cycle can be best defined as:
a.) the period of prosperity of the business cycle.
b.) the general attempt to expand production and of all prices to rise.
c.) at least two consecutive quarters of growth in GDP.
d.) all the immediately above.
02B. Economist Hyman Minsky believed the financial system is:
a.) stable, robust and prone to very, very long periods of saving, investment
and capital accumulation resulting in a significant increase in the general welfare of market participants.
b.) stable, robust and prone to very, very short periods of saving, investment and capital accumulation resulting in an insignificant increase in the general welfare of market participants.
c.) unstable, fragile and prone to crisis.
d.) unstable and fragile in the short run but mostly self-correcting as the short run merges into the medium- and long runs.
02C. A ‘displacement’ in the Minsky model of a general financial crisis is:
a.) a shock or innovation that is sufficiently large and pervasive enough to improve the economic outlook and profit opportunities in at least one important sector of the economy.
b.) a factor that would lead business firms and individuals to borrow in order to take advantage of the increase in the anticipated profits in the sector.
c.) a factor which would hasten (or quicken) economic growth which, in turn,
perhaps would generate a feedback of even greater optimism (or speculation).
d.) all of the above.
02D. Asset bubbles:
a.) fuel credit bubbles in the Minsky model of a general financial crisis.
b.) are a monetary phenomenon and result from rapid growth in the supply of credit in the Minsky model.
c.) is a synonym for a mania in the Minsky model
d.) are a monetary phenomenon in which the supply of credit is decreasing with asset prices decreasing, as well.
02E. Euphoria plays an important part in the human psychology of the credit expansion phase of economist Hyman Minsky’s model of a general financial crisis. What is meant by the psychological term euphoria?
a.) A feeling of being secure, well-off, or confident which has no factual basis for the individual in question.
b.) A state of ecstasy.
c.) Feelings of exaltation.
d.) Is another name, or synonym, for the psychological term mania.
**Essay Question 03. Necessary and Sufficiency Conditions: must do Essay Question 03. (20 points).
Graphically prove the following necessary condition given to us by economist Gottfried Haberler:
An increasing supply of money and credit is a necessary condition for the occurrence of a long-run boom in the business cycle (10 points).
Verbally derive the sufficiency condition that there is a sufficient rate of growth in the money supply and credit to establish and maintain the boom of the business cycle. (5 points)
What is the key assumption made in the necessary condition proof (5 points)?
Essay Question 04. The Purchasing Power Parity (PPP) and Balance-of-Payments (BOP) Theories of Foreign Exchange. (5 points each question/20 points total).
For each theory (PPP and BOP) of foreign exchange specify the sequence of events leading to a change in the exchange ratio between different kinds of money. How does the market process of speculation fit into each theory? Describe how a changing exchange ratio causes a domestic inflation of prices under the BOP Theory.
Essay Question 05. The Coronavirus Pandemic Bust and the Lender of Last Resort Function (20 points).
Economically, we have shut down a sizable fraction of productive activity. The social division of labor has been significantly reduced in size with many people losing their jobs. The supply and demand curves for many goods and services have disappeared because of the virus (shelter in place, social distancing, and lockdowns). Incomes are decreasing to alarmingly low levels. Revenues, earnings, and free cash flows have fallen out of bed. Many once supra-marginal and marginally profitable firms have become sub-marginally profitable.
Indeed, the coronavirus downturn in economic activity is mind-bogglingly unique. It is a bust without a boom. Business people are no longer attempting to expand production even though interest rates are at historic lows. Productive capacity has been reduced in the economy. Economic growth is nonexistent. Savers and investors are retrenching, many adding significant amounts of cash to their wealth and portfolio positions. The characteristic feature of a bust, capital consumption, is occurring but the amount of it right now is open for debate. Capital accumulation, the result of hard work, saving, and investing, has plummeted to a virtual standstill level. A large number of corporate dividends are likely to be cut in full, or in part, in the near term. The number and amount of investment-grade bonds downgraded to junk status (fallen angels) is increasing every day.
Many U.S. corporations have become illiquid and possibly insolvent, in part, because of the coronavirus. The other factor leading to illiquidity and possibly insolvency is the staggering debt-issuing binge embarked on by U.S. corporations from 2010 right up to the present. Corporate debt in the United States amounted to $48 trillion in 2010. In 2019, the total amount was an eye-blinding $75 trillion.
Responding to the coronavirus bust, the Federal Reserve is actively engaged as a lender of last resort to these corporations, trying to fend off liquidity and solvency issues the corporations may have. However, the low interest, easy monetary policy of the Fed over the past 10 years provided very little incentive for corporations to save, to internally finance expansion. To the contrary, low interest expense and easy money provided rich incentives for U.S. corporations to issue more new debt.
The major argument for the central bank of a country to become a lender of last resort is that in a panic the rush from securities and commodities into money cannot easily be halted. The sale of these securities by investors leads to declines in their prices with the consequence that a large number of firms that were previously solvent and well-capitalized may be dragged into bankruptcy as the prices of portfolio assets decline.
What has the Federal Reserve done to ease liquidity strains (or to ensure markets function normally)? What is the rationale for the Federal Reserve to buy commercial paper? How do market dealers arbitrage fixed-income ETFs when the underlying assets of a fixed-income ETF have a higher value than the share price of the ETF? …when the share price of the fixed-income ETF is greater than the value of the underlying assets of the ETF? _________________________________________________________________________________________
Essay Question 06. Economic Instability (20 points).
Like the coronavirus, money too is an element of change, giving us not only changing prices but also the recurrence of the business cycle. Money has a driving force of its own and every change in the supply and demand for money alters the conditions of the individual members of society. Some become richer, some poorer.
Bad investments are made in the boom of a cycle and show themselves in the bust. From the entrepreneurial standpoint, the boom is a bad period of time and the bust is a good period. The bad investments made in the boom are purged in the bust. The buying public does not support them because they do not meet the most urgent wants and needs of market participants. Labor and convertible capital from these investments hopefully will be redeployed into more profitable lines.
Downturns in the 21st century so far (e.g. the bursting of the dot-com bubble and the 2007-2009 Great Recession) have been much more severe than the post-WWII downturns of the 20th century. Capital consumption occurs on a wide scale in the bust of the business cycle. Historically, a minimum of 8% of all business is purged from the economy in the bust period. In especially severe downturns, the percentage is even greater.
Thus, new money introduces economic instability into the market economy. The present-day
liquidity and solvency issues of U.S. corporations can become so momentous that a new financial
crisis could transpire. In agreement with Hyman Minsky, Atif Mian and Amir Sufi, “Perhaps the
most important single lesson of the crisis is that beyond some point the growth in debt adds to
the fragility of the economy more than it adds to either personal welfare or aggregate demand.”
Unaccounted for by most financial analysts and economists, the number and amount of bad
Investments introduced into the economy by means of an easy monetary policy over the past 10
years (and that will disappear in a purging process) is difficult to calculate right now. The purging
of bad investments made in the boom will take some time to accomplish and will partially coincide
with recovery from the coronavirus bust.
The purging process is a significant reason why economic recovery in the current period will not be an instantaneous (V-shaped) one. Expressed differently, the current situation facing us is dynamic: two factors – the health crisis and the purging process – are at work, causing an unanticipated downturn in economic activity.
(10 points) As a student of economics and finance, do you agree with the above analysis? Why or why not?
(10 points) This analysis stems from the Austrian School of Thought. Please answer the two multiple-choice questions below. Each is worth 5 points.
07A. The Austrian Trade-Cycle Theory of the Business Cycle assumes:
a.) the recurrence of the business cycle is a monetary phenomenon.
b.) the non-neutrality of money. Money has a driving force of its own.
c.) mal-investments are introduced in the boom of the business cycle and not in
the bust of the cycle. Capital consumption is the characteristic feature of the
bust of a non-financial crisis business cycle.
d.) all of the above.
07B. Many economists and politicos criticize the Austrian Trade Cycle Theory because the
bust (or transition period) would be very, very severe: tremendous capital consumption,
unemployment and social unrest would occur threatening the tranquility, peace and
general welfare of the public. The Austrians respond to this criticism by asserting:
a.) the business cycle would be eliminated.
b.) a new and more robust general equilibrium establishes itself.
c.) unemployment eventually decreases.
d.) through hard work, saving and investing, capital accumulation and growth
occur. People are better off over the long-run.
Essay Question 08. Potential Financial Crisis (20 points).
In its editorial column of March 25, 2020 entitled “Non-bank lenders will bear the brunt of credit crisis,” the Financial Times asserts the economies of this world could face a “full-blown credit crisis.” Explain the FT’s reasoning in great depth and detail. What does the FT fear above all? Does it agree the Federal Reserve was right to launch unlimited bond purchases and a facility to lend directly to companies?
KINDLEBERGER AND ALIBER REFERENCE READ CHAPTER 12 ‘DOMESTIC LENDER OF LAST RESORT’