Posted by: Dirk | June 17, 2013

Neo-classical vs Keynesian theory: John Law and the Mississippi bubble

Yesterday I presented the above video to my students and stopped after certain facts were announced in the video and asked the following questions:

  1. What kind of theory could describe the bank that has been created by John Law?
  2. What kind of theory could describe the bank after the monarch started running hot at the printing press?
  3. What happens to the economy when the monetary aggregate increases?
  4. What happens when people turn from pauper to millionaire and start building houses to live in?
  5. What happens when the monetary aggregated decreases and housing collapses when people realize that they are poor?

Take the IS/LM model and a neo-classical model (labour market, production function, capital market) and it will be interesting to see how most of the story is invisible in the neo-classical model. Only the inflation story when money runs hot and people realize that it is not worth much can be shown in a nice way. The IS/LM model allows for expansionary monetary policy to be effective with respect to GDP, and the investment boom fires up the economy some more, and vice versa for the collapse of the economy. It confirms the view that business cycles and financial crises are not easily explained with neo-classical tools, whereas the old Keynesian apparatus works out quite nicely.

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