University Finance Assignment: Keynesian Model, Crisis, and Theories

This finance assignment provides detailed solutions to various financial concepts. It begins with an explanation of the Simple Keynesian Model, including its assumptions and the government expenditure multiplier. The assignment then explores the Expected Utility Theory and Prospect Theory, contrasting their approaches to decision-making under risk and uncertainty. It further delves into microeconomic theories relevant to financial investment, focusing on profitability and market analysis. The assignment also examines economic theories explaining financial crises, specifically the Asian financial crisis of 1997, discussing both first and second-generation models, as well as fundamental-driven and financial panic-driven crisis theories. Finally, it addresses the problems associated with calibrating a Taylor rule in monetary policy, highlighting its limitations and challenges in practical application.

Running head: FINANCE
Finance
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Table of Contents
Answer 1..........................................................................................................................................2
Simple Keynesian Model.............................................................................................................2
Government expenditure multiplier.............................................................................................3
Answer 2..........................................................................................................................................4
Expected utility theory and prospect theory................................................................................4
Answer 4..........................................................................................................................................5
Microeconomic theories of financial investment........................................................................5
Answer 7..........................................................................................................................................6
Economic theories on financial crisis..........................................................................................6
Answer 8..........................................................................................................................................7
Problems in calibrating a Taylor rule..........................................................................................7

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Answer 1
Simple Keynesian Model
The Simple Keynesian Model explain relationship between real GDP and aggregate
demand of an economy. The simple economic model is based on the following assumptions
 Demand creates own supply
 The aggregate price level in the economy remains fixed.
 The economy possesses excess capacity of production
 The model assumes a closed economy
 There is no scope of retained earnings
The Simple Keynesian model states that equilibrium level of national income is determined at
the point where output equals aggregate demand.
The equilibrium condition in SKM model is given as
Y = AE
Y: total output
AE: Aggregate expenditure. It has three components – consumption expenditure (C ), investment
expenditure (I) and government expenditure (G). Consumption is a function of income and is
defined as
C=a+ bY
I and G are determined exogenously in the SKM model. The figure below explains equilibrium
level on national income in SKM model.

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Figure 1: Simple Keynesian Model
The equilibrium income is YE. The equilibrium corresponds to the point E where the
aggregate expenditure schedule cuts the 450 line. At this point, income received equals to desired
expenditures.
Government expenditure multiplier
An increase in the government expenditures lead to an increase in national output. The
impact of government expenditure on national output is expansionary. The rise in national
income following an increase in government expenditure is however larger than the rise in
government spending. Government expenditure multiplier (KG) captures the change in national
income followed by a change in government spending. The multiplier is the ratio of income
change to change in government spending.
KG = ΔY
ΔG

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¿ , ∆ Y =KG . ∆ G
¿ , ∆ Y = 1
1− MPC . ∆G
The reason for expansionary impact of government expenditure on national income is
that the increase in government spending is associated with a rise in income, which in turn
increases consumption expenditure. This also adds to national income. Higher the marginal
propensity to consume larger is the increase in national income.
Answer 2
Expected utility theory and prospect theory
The theory of expected utility suggests that coherent and consistent economic choices are
made through assessing outcomes that is associated gains or losses of alternative actions along
with their probabilities. The alternative associated with maximum utility is chosen. The expected
utility theory is developed under the fundamental assumptions of decision-making process of risk
and uncertainty. The three fundamental assumptions of expected utility theory are – consistency
in preferences of among alternatives, maintenance of linearity in assigning relative weights to
available alternatives and decisions are taken relative to position of fixed assets. Depending on
the assumptions, the expected utility theory proposes that better alternative option is always
chosen.
The theory however does not permit influence of characteristics of decision context on
choices. In contrast to expected utility theory, prospect theory comprises of several choice
problems where preferences of economic agents contradicts the axioms of the theory of expected
utility. The theory suggests that instead of maximizing utility rational consumers prefer to make

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choices by simplifying then cognitively whenever possible. According to this theory, rational
consumers take their decision in following a two-stage process. In the first phase of decision-
making process, the available choices are edited and then values are assigned to possible
outcome and weights are attached to the probabilities. The second phase is similar to that of the
theory off expected utility. The alternatives edited in the first phase are evaluated in the second
phase. In the two-stage process of prospect theory, it violates three axioms of expected utility
theory. Firstly, the rational consumer adjusts the current wealth considering point of personal
preferences. They are risk averse considering the gain and risk lovers considering losses.
Secondly, decision makers have a tendency to overemphasize the unlikely events whereas likely
events are undermined in times of assigning probabilities. Finally, the decision regarding choices
are influenced by the way of presenting alternatives.
Answer 4
Microeconomic theories of financial investment
Financial investment refers to putting money with expectation of a higher return. Firms’
potential for financial investment depends on different factors. Microeconomic theories can be
used to evaluate potential of firm for financial investment. The rewards and risks associated with
investment is the first aspect to be considered for financial investment. The microeconomic
concepts of risk and uncertainty can be used to evaluate the associated risk of investment. In
finance and economics, risk aversion refers to the behavior investor and consumers who try to
lower uncertainty whenever exposed to the uncertainty. The associated uncertainty to a financial
investment depends on performance of the firm. The first aspect of investment potential of a firm
is profitability. Profit of a firm in economics is defined as the difference between total revenue
and total cost. By looking at the profitability, one can determine the performance trend of the

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firm. Firms having record of higher profitability is an attractive destination of business
investment. Revenue of the firms depends on both volume of sales and unit price. Cost of the
firm on the other hand depends on economies of scale. A firm operating with increasing return to
scale enjoys a cost advantage and hence, can enjoy a higher profit. Profitability of a firm is an
important determinant of financial investment. Another microeconomic analysis useful for
financial investment is market analysis. The market share of a company depends on specific
structure of the market. The dominance share of the market indicates firms’ ability to earn higher
profit and higher potential return of investment.
Answer 7
Economic theories on financial crisis
The East Asian countries experienced a financial breakdown during 1997. The financial
crisis began in Thailand with collapse Thai baht. The crisis gradually spread to other Eat Asian
nations such as Korea, Indonesia, Malaysia and others. There are two main economic theories
that can explain currency crisis in an economy prior to Asian crisis. These are first and second
generation model of crisis. The first generation model indicates the relation between currency
crisis and fiscal deficit. This is useful in explaining debt and currency crisis in Latin America
during 1980. The model suggests that the government having a large fiscal deficit attempts to
mitigate deficit by expansion of domestic credit. This makes it difficult to sustain a fixed
exchange rate system. As the foreign reserves go below a certain level investors starts to sell
currency following currency depreciation. In this situation, the economy cannot maintain fixed
exchange rate system. The second-generation model of currency crisis comprises the concept of
multiple equilibrium propelled by self-satisfying expectation. The model considered reversal of
fixed exchange rate system and relied on expansionary monetary policy.

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The general theory of currency crisis as described in the first and second-generation
model failed to explain completely the Asian financial crisis. During the period of crisis, most of
these economies had a fiscal surplus. Despite fiscal surplus, these countries experienced a
slowdown in economic growth. It was therefore evident that these countries did not need to take
expansionary monetary policy at the cost of domestic exchange rate policy to stimulate economic
growth. A serious problem that Thailand faced was the increase in deficit in current account.
Thai baht faced several speculative attack even prior to beginning of the crisis. Korea was
another nation that was severely attacked by the crisis. The existing theoretical model of crisis
thus failed to capture the specific reasons behind the crisis outbreak in Asia. New theoretical
model thus needs to be developed to explain the financial crisis during this time. Two theories
were developed to explain the Asian crisis in 1997 – “Fundamental-driven crisis theory” and
“financial panic-driven crisis theory”. The advocates of Fundamental-driven crisis theory noticed
that implicit guarantee on liabilities offered by government to domestic banks results in moral
hazards. The non-performing loans ultimately leads to a currency crisis. The financial panic-
driven crisis theory is based on the theory of coordination failure among banks.
Answer 8
Problems in calibrating a Taylor rule
Economists believed that monetary policy has a self-reversing effect on nominal interest
rate. It was not before Taylor rule that Central Banks had any explicit model to use for adjusting
the effect on inflation expectation on nominal interest rate. The rule though extensively used
during global financial crisis of 2007-08, the rule had some flaws. The deeper and more critical
shortcoming of Taylor rule lies in the fact that the equilibrium level of real interest rate in in long
run is unobservable. The rule makes an explicit assumption that estimation of the rule is correct

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and remains constant over the extended period. Taylor rule actually preclude any factor except
the central bank from influencing the real interest rate. One standard rationale behind this
assumption is explained by Ramsay- Cass- Koopmans model. The model assumes that all
household in the economy has same time preference, same rate of declining marginal utility and
same growth rate of population. The model thus ignores any deviation in natural rate caused
from possible discount rate in future, difference in consumption preference or differences in
wealth distribution. Another problem in calibrating Taylor rule is the difficulty in estimating the
model with regression. It is actually not known what settings would lead to a good outcome.