Assignment #2 - Noor Javid Prof Debora Econ 215 M\/W 5PM Assignment#2 Question#1 Classical Theory and Keynesian Theory have different approaches to

Assignment #2 - Noor Javid Prof Debora Econ 215 M/W...

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Noor Javid Econ 215 Prof. Debora M/W 5PM Assignment #2: Question #1: Classical Theory and Keynesian Theory have different approaches to the demand for money. Classical Theory says that one part of the economy will adjust and the equilibrium will go back to full employment, but Keynesian Theory says that markets could fail (that equilibrium could be achieved with underemployment). In the Classical Theory, we find that there are three variations of how money is measured. One variation is the “Equation of Exchange”, where money is related to transactions velocity, the price on the transactions, and the number of transactions. The classical approach views money as a medium for exchange. The value of all goods and services must be equal to the value all the transaction that have taken place. The second way is an income based variations where relates money to income, along with the velocity of money and price. The last variation is the Cambridge Approach, where we see that the fraction of spending that is made in money balances. We learn that the role of money is neutral. Money has only one effect and it is on pricing. More demand than supply will lead to a need for production and more supply than demand will lead to a need to reduce production and lower prices. Classical Theory says that there is a point where they meet, but that money only affects prices. In addition, Classical theory views government intervention as having a negative effect on the economy. Also that workers are willing to take lower wages and companies will lower their prices until equilibrium is once again achieved. This, however, is debunked by economist Keynes. John Meynard Keynes came up with a theory we refer to as Keynesian Theory. One way Keynesian theory differs from Classical theory is that it looks at the markets in the short-run, because in the “long-run we are all dead.” In addition, Keynes believed that wages and prices
are more rigid than believed in Classical theory. That people would not be willing to take lower wages to stay employed, and that companies would not sell goods at a lower price just to get rid of surplus inventory. Instead, Keynes argued that equilibrium would not be at full employment. In Keynes’ money demand theory, there is a demand for cash and “bonds”. By this theory, when interest rates are high, demand for bonds is high and demand for cash is low. When interest rates are low, demand for bonds is low and demand for cash is high. The theory lays down some factors as the reasons for holding money. First, the transactions motive which is comprised of the transactions by households firms, and individual. Secondly, the precautionary demand which indicates that the public will hold money to serve uncertainties in future. Thirdly the speculative demand whereby the public will hold cash in the face of bonds that earn interest. There are two

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