Question

Briefly answer the following questions;

1. Why when the goods market is at equilibrium, the money market also must be at equilibrium?

2. Elaborate the concept of financial wealth according to Keynes.

3. Explain the relationship between the interest rate and the price of bond.

4. What is a capital loss and a capital gain and how this concept can be used to speculate the future interest rate?

Answer 1

1). The equilibrium in Goods Market can be shown through IS curve i.e Investment-Saving curve. Since here the Money Market also must be at equilibrium, It can be shown by LM curve which shows M_D = M_S (demand for money= supply of money)

Talking about Goods market Equilibrium:-

• Equilibrium of Goods Market when I=S or Investmemt= Saving or Aggregate Demand = Aggregate Supply.
• The equilibrium is shown by IS curve which shows at every point of the curve I= S.
• The IS curve is downward sloping from left to right.

Money market eq shown by LM curve which is upward sloping from left to right.

2) According to Keynes , Financial Wealth refers to money. Let us have a look over it.

Keynesian Economics came into forefront during 1930's - The Great Depression period . It departed from free economy proposition and called for Govt's intervention during depression period. Keynes in his book " The General Theory of Employmemt,Money and Interest " gave a Theory of "Quantity Theory of Demand". This Theory talks about money being financial wealth. The crux is as follows :

• Money is demanded for 3 purposes :

a) Transaction Motive

b) Precuationary Motive

c) Speculation Motive.

• Money is not merely a medium of exchange but also it acts as a store or value ( which is the keynes concept of financial wealth)
• It is considered a store of value becuase it is an asset in which individual can store his/her wealth.
• To Keynes, individual's total wealth consists of Money and Bonds.
• Bonds refer to all risky assets other than money.

There as other points in the theory but the info mentioned above is required to answer the question.

3). There is an inverse relationship between bond prices and interest rate.

• When interest rates rise,bond prices fall because investing in other prosepects can yield higher return due to higher interest rate.
• When interest rate fall, bond prices increase as investors tend to invest more in bonds due to lower interest rates in otjer prospects.

4)Capital Loss - means a decrease in the value( due to change in interest rates or fall of market value) of an capital asset or a long term investment .

Capital Gain - means an increase in the value of capital asset or investment or profit earned on sale of such assets.

How these concepts can be used to speculate the future interest rates?

Ans- Since there is an inverse relationship between interest rates and demand for money, it implies that :

• High interest rates means high opportunity cost of holding money.
• At high interest rates, future bond prices are expected to fall ( due to inverse realtion). This means future capital gains on bonds are expected to fall or there can be a situation of capital loss due to decrease in earnings or value.
• At lower interest rates, future bond prices are expected to rise leading to a situation of capitAl gain due to increase in value of bonds .

Hence, the interest rate changes help us to speculate capital loss/gain.