mon_econ_weeks6-8 - The University of Sydney Faculty of...

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The University of Sydney Faculty of Economics and Business MONETARY ECONOMICS {6 credit points} ECOS3010 — 2009: S EMESTER 2 Tony Aspromourgos WEEKS VI–VIII : THE THEORY OF ‘THE’ INTEREST RATE—KEY POINTS 6.1 orthodoxy: a ‘real’ theory of interest 6.2 Keynes’s ‘monetary’ (or conventional) theory of interest 6.3 a reconstruction of Keynes & the problems of orthodoxy 6.4 interest & central bank beliefs READING: C. Rogers (1989) Money, Interest and Capital: a study in the foundations of monetary theory , Cambridge: Cambridge University Press; ch. 2 (‘Wicksellian monetary theory’: 21–44). T. Aspromourgos (2007) ‘Interest as an Artefact of Self-Validating Central Bank Beliefs’, Metroeconomica , vol. 58 (no. 4): 514–35. 6.1 orthodoxy: a ‘real’ theory of interest In previous weeks the only suggestion that has been made, as to what determines the level of interest rates, was the idea of monetary policy setting the level of (at least a very-short-rate of) interest. In fact, the orthodox theoretical view is that the overall level of interest rates is ultimately explained by ‘real’ forces . From a commonsense point of view, observing the markets for interest-bearing securities, one would conclude that the prices of interest-bearing securities – and hence their yields – are determined by the interplay of demand and supply for those securities, from day to day. Orthodoxy doesn’t deny this; rather, it proposes that these are merely the proximate causes of interest: there are deeper underlying real forces which ultimately regulate the overall demands for and supplies of interest-bearing securities. Traditionally, these real forces have been described by the shorthand, ‘productivity and thrift’ – where the former refers to the marginal productivity of capital and the latter, to the propensity to save (or intertemporal preferences). Below (this section) we give this idea a precise, albeit simple, illustration – in terms of the equilibrium level of the interest rate as that interest rate which equilibrates or balances planned aggregate investment expenditure with the level of aggregate planned saving associated with the full employment level of aggregate output or income . These deeper forces are understood as ‘real’ phenomena, in the sense that they are understood to be factors independent of monetary magnitudes – independent of monetary aggregates, nominal values (money prices) etc. To be clear, it is the level of the real rate of interest which in equilibrium is understood to be entirely determined by real forces. (The equilibrium nominal rate of interest will then be the equilibrium real rate plus the underlying trend inflation rate – where the latter can be construed as an equilibrium inflation rate, under certain conditions.) Here is a simple illustration of this fundamental orthodox idea, employing a macroeconomic theoretical framework which should be fairly familiar. Consider the accompanying diagram [file:
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mon_econ_weeks6-8 - The University of Sydney Faculty of...

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