It is said t
hat when there is a predetermined return based on interest rates in an economy, there will always be Classical Dichotomy. Classical Dichotomy appears as the manifestation of modern economy where anything is salable, including derivatives. It shows the separation of market into real sector and monetary (financial) sector as a consequence of the existence of interest rates. With the existence of interest rates, these two markets theoretically move independently. Even sometimes when the real sector is devastated, monetary sector can survive. There is a belief in the monetary sector that when prices are fluctuated and volatile, the market is getting more and more interesting. And this particular condition, in turn, shall ruin the economy of a developing country.
Classical Dichotomy is seen in the IS-LM model. In 1936/37, an economist named Sir John Hicks invented the IS-LM model which tells about the equilibrium of money market and goods and services market, symbolized by the crossing of both IS and LM curves where the X axis represents the goods and services market (the real sector) and the Y axis represents the money market (the monetary sector). In other words, the horizontal axis real sector represents the national income or the GDP and the vertical axis monetary sector represents interest rates.
In that first quadrant of the Cartecius diagram, there are two curves that intersect each other at the point that designates the equilibrium
point of both markets in a Classical Dichotomy condition. The upward sloping curve is the LM curve, where the initials stand for "Liquidity preference/Money supply equilibrium." And the other one, IS, has the initials standing for "Investments/Saving equilibrium." As a whole, this model is mostly seen by modern macro economists as being at best a first approximation for understanding the real world. But is it true?
The slope of both curves is influenced by interest rates. However, both don't correspond to the same rate. The IS curve tends to use credit rate and the LM curve tends to use saving rate as its corresponding rate. By simple logic we can say that when Classical Dichotomy is present, there will never be a condition where credit rate equals saving rate because if that happens then intermediaries will not receive spread profit. This is unacceptable since most financial institutions rely on this type of earning. Therefore, when there is a Classical Dichotomy condition, IS and LM will never cross each other. There will never be an intersection between the two and consequently there is no equilibrium between money market and goods market, or the monetary sector and the real sector.
Another approach on actualizing the model is through the Loan Fund Supply paradigm. In this paradigm, economist Joseph E. Stiglitz provides the view that the LM curve is considered to represents the movement pattern of loan funds or funds that are to be distributed from the surplus sector to deficit sector. Accordingly, the curve will cross the IS curve in time since both correspond to the same rate, which is credit rate. However, this condition is still not able to reflect the real situation in the real world. It is true that the IS and LM curve is able to cross each other because they both move according to the movement of credit rate. But the thing is, the investors are getting return based on saving rate, which tends to be lower than credit rate. Therefore, the real movement pattern of LM will never be reflected if the curve is considered to be corresponded to credit rate. By nature, the position of the LM curve is supposed to be below the IS curve. And supposedly also, they appear in two different Cartecius diagram.
Another proof showing that IS & LM meet no equilibrium is shown by the fact that the transaction volume in monetary sector amounts USD 1.6 trillion per day and that of the real sector is USD 6 trillion per year. Is there any equilibrium? In this case, does the IS/LM is actually able to reflect or approximate the real world? Well, I don't think so. But on the other hand, I want to understand the argument opposing this theory.
Anyone, please?
Image source: www.personal.psu.edu
hat when there is a predetermined return based on interest rates in an economy, there will always be Classical Dichotomy. Classical Dichotomy appears as the manifestation of modern economy where anything is salable, including derivatives. It shows the separation of market into real sector and monetary (financial) sector as a consequence of the existence of interest rates. With the existence of interest rates, these two markets theoretically move independently. Even sometimes when the real sector is devastated, monetary sector can survive. There is a belief in the monetary sector that when prices are fluctuated and volatile, the market is getting more and more interesting. And this particular condition, in turn, shall ruin the economy of a developing country.Classical Dichotomy is seen in the IS-LM model. In 1936/37, an economist named Sir John Hicks invented the IS-LM model which tells about the equilibrium of money market and goods and services market, symbolized by the crossing of both IS and LM curves where the X axis represents the goods and services market (the real sector) and the Y axis represents the money market (the monetary sector). In other words, the horizontal axis real sector represents the national income or the GDP and the vertical axis monetary sector represents interest rates.
In that first quadrant of the Cartecius diagram, there are two curves that intersect each other at the point that designates the equilibrium
point of both markets in a Classical Dichotomy condition. The upward sloping curve is the LM curve, where the initials stand for "Liquidity preference/Money supply equilibrium." And the other one, IS, has the initials standing for "Investments/Saving equilibrium." As a whole, this model is mostly seen by modern macro economists as being at best a first approximation for understanding the real world. But is it true?The slope of both curves is influenced by interest rates. However, both don't correspond to the same rate. The IS curve tends to use credit rate and the LM curve tends to use saving rate as its corresponding rate. By simple logic we can say that when Classical Dichotomy is present, there will never be a condition where credit rate equals saving rate because if that happens then intermediaries will not receive spread profit. This is unacceptable since most financial institutions rely on this type of earning. Therefore, when there is a Classical Dichotomy condition, IS and LM will never cross each other. There will never be an intersection between the two and consequently there is no equilibrium between money market and goods market, or the monetary sector and the real sector.
Another approach on actualizing the model is through the Loan Fund Supply paradigm. In this paradigm, economist Joseph E. Stiglitz provides the view that the LM curve is considered to represents the movement pattern of loan funds or funds that are to be distributed from the surplus sector to deficit sector. Accordingly, the curve will cross the IS curve in time since both correspond to the same rate, which is credit rate. However, this condition is still not able to reflect the real situation in the real world. It is true that the IS and LM curve is able to cross each other because they both move according to the movement of credit rate. But the thing is, the investors are getting return based on saving rate, which tends to be lower than credit rate. Therefore, the real movement pattern of LM will never be reflected if the curve is considered to be corresponded to credit rate. By nature, the position of the LM curve is supposed to be below the IS curve. And supposedly also, they appear in two different Cartecius diagram.
Another proof showing that IS & LM meet no equilibrium is shown by the fact that the transaction volume in monetary sector amounts USD 1.6 trillion per day and that of the real sector is USD 6 trillion per year. Is there any equilibrium? In this case, does the IS/LM is actually able to reflect or approximate the real world? Well, I don't think so. But on the other hand, I want to understand the argument opposing this theory.
Anyone, please?
Image source: www.personal.psu.edu
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