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Recurrent major depressions in the world economy at the pace of 20 and 50 years have been the subject of studies sinceJean Charles Lonard de Sismondi(1773-1842) provided the first theory of crisis in a critique of classical political economy's assumption of equilibrium between supply and demand. Developing an economiccrisis theorybecame the central recurring concept throughoutKarl Marx's mature work. Marx'slaw of the tendency for the rate of profit to fallborrowed many features of the presentation ofJohn Stuart Mill's discussionOf the Tendency of Profits to a Minimum(Principles of Political Economy Book IV Chapter IV). The theory is a corollary of theTendency towards the Centralization of Profits.

In a capitalist system, successfully-operating businesses return less money to their workers (in the form of wages) than the value of the goods produced by those workers (i.e. the amount of money the products are sold for). Thisprofitfirst goes towards covering the initial investment in the business. In the long-run, however, when one considers the combined economic activity of all successfully-operating business, it is clear that less money (in the form of wages) is being returned to the mass of the population (the workers) than is available to them to buy all of these goods being produced. Furthermore, the expansion of businesses in the process of competing for markets leads to an abundance of goods and a general fall in their prices, further exacerbatingthe tendency for the rate of profit to fall.

The viability of this theory depends upon two main factors: firstly, the degree to which profit is taxed by government and returned to the mass of people in the form of welfare, family benefits and health and education spending; and secondly, the proportion of the population who are workers rather than investors/business owners. Given the extraordinary capital expenditure required to enter modern economic sectors like airline transport, the military industry, or chemical production, these sectors are extremely difficult for new businesses to enter and are being concentrated in fewer and fewer hands.

Empirical and econometric research continues especially in theworld systems theoryand in the debate aboutNikolai Kondratievand the so-called 50-yearsKondratiev waves. Major figures of world systems theory, likeAndre Gunder FrankandImmanuel Wallerstein, consistently warned about the crash that the world economy is now facing.^{[citation needed]}World systems scholars and Kondratiev cycle researchers always implied thatWashington Consensusoriented economists never understood the dangers and perils, which leading industrial nations will be facing and are now facing at the end of the longeconomic cyclewhich began after theoil crisisof 1973.

Minsky's theory[edit]

Hyman Minskyhas proposed apost-Keynesianexplanation that is most applicable to a closed economy. He theorized thatfinancial fragilityis a typical feature of anycapitalisteconomy. High fragility leads to a higher risk of a financial crisis. To facilitate his analysis, Minsky defines three approaches to financing firms may choose, according to their tolerance of risk. They are hedge finance, speculative finance, andPonzifinance. Ponzi finance leads to the most fragility.

• for hedge finance, income flows are expected to meet financial obligations in every period, including both the principal and the interest on loans.
• for speculative finance, a firm must roll over debt because income flows are expected to only cover interest costs. None of the principal is paid off.
• for Ponzi finance, expected income flows will not even cover interest cost, so the firm must borrow more or sell off assets simply to service its debt. The hope is that either the market value of assets or income will rise enough to pay off interest and principal.

Financial fragility levels move together with thebusiness cycle. After arecession, firms have lost much financing and choose only hedge, the safest. As the economy grows and expectedprofitsrise, firms tend to believe that they can allow themselves to take on speculative financing. In this case, they know that profits will not cover all theinterestall the time. Firms, however, believe that profits will rise and the loans will eventually be repaid without much trouble. More loans lead to more investment, and the economy grows further. Then lenders also start believing that they will get back all the money they lend. Therefore, they are ready to lend to firms without full guarantees of success.

Lenders know that such firms will have problems repaying. Still, they believe these firms will refinance from elsewhere as their expected profits rise. This is Ponzi financing. In this way, the economy has taken on much risky credit. Now it is only a question of time before some big firm actually defaults. Lenders understand the actual risks in the economy and stop giving credit so easily.Refinancingbecomes impossible for many, and more firms default. If no new money comes into the economy to allow the refinancing process, a real economic crisis begins. During the recession, firms start to hedge again, and the cycle is closed.

Coordination games[edit]

Main article:Coordination game

Mathematical approaches to modeling financial crises have emphasized that there is oftenpositive feedback^[34]between market participants' decisions (seestrategic complementarity).^[35]Positive feedback implies that there may be dramatic changes in asset values in response to small changes in economic fundamentals. For example, some models of currency crises (including that ofPaul Krugman) imply that a fixed exchange rate may be stable for a long period of time, but will collapse suddenly in anavalanche of currency salesin response to a sufficient deterioration of government finances or underlying economic conditions.^[36][37]

According to some theories, positive feedback implies that the economy can have more than oneequilibrium. There may be an equilibrium in which market participants invest heavily in asset markets because they expect assets to be valuable. This is the type of argument underlyingDiamond and Dybvig's modelofbank runs, in which savers withdraw their assets from the bank because they expect others to withdraw too.^[17]Likewise, inObstfeld's model of currency crises, when economic conditions are neither too bad nor too good, there are two possible outcomes: speculators may or may not decide to attack the currency depending on what they expect other speculators to do.^[18]

Herding models and learning models[edit]

Main articles:Herd behaviorandAdaptive expectations

A variety of models have been developed in which asset values may spiral excessively up or down as investors learn from each other. In these models, asset purchases by a few agents encourage others to buy too, not because the true value of the asset increases when many buy (which is called "strategic complementarity"), but because investors come to believe the true asset value is high when they observe others buying.

In "herding" models, it is assumed that investors are fully rational, but only have partial information about the economy. In these models, when a few investors buy some type of asset, this reveals that they have some positive information about that asset, which increases the rational incentive of others to buy the asset too. Even though this is a fully rational decision, it may sometimes lead to mistakenly high asset values (implying, eventually, a crash) since the first investors may, by chance, have been mistaken.^{[38][39][40][41]}Herding models, based onComplexity Science, indicate that it is the internal structure of the market, not external influences, which is primarily responsible for crashes.^[42][43]

In "adaptive learning" or "adaptive expectations" models, investors are assumed to be imperfectly rational, basing their reasoning only on recent experience. In such models, if the price of a given asset rises for some period of time, investors may begin to believe that its price always rises, which increases their tendency to buy and thus drives the price up further. Likewise, observing a few price decreases may give rise to a downward price spiral, so in models of this type large fluctuations in asset prices may occur.Agent-based modelsof financial markets often assume investors act on the basis of adaptive learning or adaptive expectations.Recurrent major depressions in the world economy at the pace of 20 and 50 years have been the subject of studies sinceJean Charles Lonard de Sismondi(1773-1842) provided the first theory of crisis in a critique of classical political economy's assumption of equilibrium between supply and demand. Developing an economiccrisis theorybecame the central recurring concept throughoutKarl Marx's mature work. Marx'slaw of the tendency for the rate of profit to fallborrowed many features of the presentation ofJohn Stuart Mill's discussionOf the Tendency of Profits to a Minimum(Principles of Political Economy Book IV Chapter IV). The theory is a corollary of theTendency towards the Centralization of Profits.

In a capitalist system, successfully-operating businesses return less money to their workers (in the form of wages) than the value of the goods produced by those workers (i.e. the amount of money the products are sold for). Thisprofitfirst goes towards covering the initial investment in the business. In the long-run, however, when one considers the combined economic activity of all successfully-operating business, it is clear that less money (in the form of wages) is being returned to the mass of the population (the workers) than is available to them to buy all of these goods being produced. Furthermore, the expansion of businesses in the process of competing for markets leads to an abundance of goods and a general fall in their prices, further exacerbatingthe tendency for the rate of profit to fall.

The viability of this theory depends upon two main factors: firstly, the degree to which profit is taxed by government and returned to the mass of people in the form of welfare, family benefits and health and education spending; and secondly, the proportion of the population who are workers rather than investors/business owners. Given the extraordinary capital expenditure required to enter modern economic sectors like airline transport, the military industry, or chemical production, these sectors are extremely difficult for new businesses to enter and are being concentrated in fewer and fewer hands.

Empirical and econometric research continues especially in theworld systems theoryand in the debate aboutNikolai Kondratievand the so-called 50-yearsKondratiev waves. Major figures of world systems theory, likeAndre Gunder FrankandImmanuel Wallerstein, consistently warned about the crash that the world economy is now facing.^{[citation needed]}World systems scholars and Kondratiev cycle researchers always implied thatWashington Consensusoriented economists never understood the dangers and perils, which leading industrial nations will be facing and are now facing at the end of the longeconomic cyclewhich began after theoil crisisof 1973.

Minsky's theory[edit]

Hyman Minskyhas proposed apost-Keynesianexplanation that is most applicable to a closed economy. He theorized thatfinancial fragilityis a typical feature of anycapitalisteconomy. High fragility leads to a higher risk of a financial crisis. To facilitate his analysis, Minsky defines three approaches to financing firms may choose, according to their tolerance of risk. They are hedge finance, speculative finance, andPonzifinance. Ponzi finance leads to the most fragility.

• for hedge finance, income flows are expected to meet financial obligations in every period, including both the principal and the interest on loans.
• for speculative finance, a firm must roll over debt because income flows are expected to only cover interest costs. None of the principal is paid off.
• for Ponzi finance, expected income flows will not even cover interest cost, so the firm must borrow more or sell off assets simply to service its debt. The hope is that either the market value of assets or income will rise enough to pay off interest and principal.

Financial fragility levels move together with thebusiness cycle. After arecession, firms have lost much financing and choose only hedge, the safest. As the economy grows and expectedprofitsrise, firms tend to believe that they can allow themselves to take on speculative financing. In this case, they know that profits will not cover all theinterestall the time. Firms, however, believe that profits will rise and the loans will eventually be repaid without much trouble. More loans lead to more investment, and the economy grows further. Then lenders also start believing that they will get back all the money they lend. Therefore, they are ready to lend to firms without full guarantees of success.

Lenders know that such firms will have problems repaying. Still, they believe these firms will refinance from elsewhere as their expected profits rise. This is Ponzi financing. In this way, the economy has taken on much risky credit. Now it is only a question of time before some big firm actually defaults. Lenders understand the actual risks in the economy and stop giving credit so easily.Refinancingbecomes impossible for many, and more firms default. If no new money comes into the economy to allow the refinancing process, a real economic crisis begins. During the recession, firms start to hedge again, and the cycle is closed.

Coordination games[edit]

Main article:Coordination game

Mathematical approaches to modeling financial crises have emphasized that there is oftenpositive feedback^[34]between market participants' decisions (seestrategic complementarity).^[35]Positive feedback implies that there may be dramatic changes in asset values in response to small changes in economic fundamentals. For example, some models of currency crises (including that ofPaul Krugman) imply that a fixed exchange rate may be stable for a long period of time, but will collapse suddenly in anavalanche of currency salesin response to a sufficient deterioration of government finances or underlying economic conditions.^[36][37]

According to some theories, positive feedback implies that the economy can have more than oneequilibrium. There may be an equilibrium in which market participants invest heavily in asset markets because they expect assets to be valuable. This is the type of argument underlyingDiamond and Dybvig's modelofbank runs, in which savers withdraw their assets from the bank because they expect others to withdraw too.^[17]Likewise, inObstfeld's model of currency crises, when economic conditions are neither too bad nor too good, there are two possible outcomes: speculators may or may not decide to attack the currency depending on what they expect other speculators to do.^[18]

Herding models and learning models[edit]

Main articles:Herd behaviorandAdaptive expectations

A variety of models have been developed in which asset values may spiral excessively up or down as investors learn from each other. In these models, asset purchases by a few agents encourage others to buy too, not because the true value of the asset increases when many buy (which is called "strategic complementarity"), but because investors come to believe the true asset value is high when they observe others buying.

In "herding" models, it is assumed that investors are fully rational, but only have partial information about the economy. In these models, when a few investors buy some type of asset, this reveals that they have some positive information about that asset, which increases the rational incentive of others to buy the asset too. Even though this is a fully rational decision, it may sometimes lead to mistakenly high asset values (implying, eventually, a crash) since the first investors may, by chance, have been mistaken.^{[38][39][40][41]}Herding models, based onComplexity Science, indicate that it is the internal structure of the market, not external influences, which is primarily responsible for crashes.^[42][43]

In "adaptive learning" or "adaptive expectations" models, investors are assumed to be imperfectly rational, basing their reasoning only on recent experience. In such models, if the price of a given asset rises for some period of time, investors may begin to believe that its price always rises, which increases their tendency to buy and thus drives the price up further. Likewise, observing a few price decreases may give rise to a downward price spiral, so in models of this type large fluctuations in asset prices may occur.Agent-based modelsof financial markets often assume investors act on the basis of adaptive learning or adaptive expectations.

Question 16.

1. Consider two economies that are identical, with the exception that one has a high marginal propensity to consume (MPC) and one has a low MPC. If the money supply is increased by the same amount in each economy, the high MPC economy will experience

2. Which of the following policy options would simultaneously increase interest rates and decrease output?

3. Suppose an economy is running a government budget deficit. Assume that C = c0 + c1(Y-T). Which one of the following will cause this deficit to become larger?

4. If the concentration rate is sophisticated in the US than in the UK, then_____________

5. Consider a small economy where the total population is 10,000. The size of the labor force is 8,000, while the number of people employed is 7,000. What is the unemployment rate in this economy?

6. Assume that C = c0 + c1(Y-T). Suppose that taxes increase and money supply increases in such a way that output is constant in equilibrium

7. ) In 2000, the nominal GDP growth of a country was 8% and the real GDP growth was 4%. What was the rate of inflation for this country?

8. Suppose the United States has no exports. The only imports of the US are 200 Mercedes Benz cars worth US$50,000 each from Germany. Germany has no imports and only exports those 200 cars to the US. Neither the US nor Germany trade with any other countries or engage in any transactions with other countries. Which one of the following statements must be true?

9. Suppose that investment (I) in the goods market is not responsive to the interest rate (that is, I does not depend on the interest rate at all). Then

10. An increase in the money supply and a drop in consumer confidence will lead to