Research Assignment: Keynes Analysis of the Stock Market (Essay Sample)
ESSAY PROMPT: "Outline Keynes’s analysis of the stock market as set out in Chapter 12 of his General Theory of Employment, Interest and Money. To what extent does Keynes view the stock market as a source of economic instability? Carefully identify the policy conclusions he reaches as a result of his analysis."
WORD LIMIT: 2250 (The bibliography is not included in the word count) Attached there are 3 required readings for the coursework (that NEED to be used). Further sources besides the 3 I have attached MUST be added. I have also attached the essay prompts, I have chosen the first one. Thank you
KEYNESâ€™S ANALYSIS OF THE STOCK MARKET
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Stock Market Analysis
John Maynard Keynes made a foremost contribution to analysis and understanding of the stock market. His writings on the same subject are well known. One of his writings, The General Theory of Money and Interest, discusses at length how stock market may influence the operation of a macro economy. Keynesâ€™ observations regarding the â€œanimal spiritâ€ (Akerlof and Shiller, 2009), of the stock market continue to provide inspiration to many behavioral economists in the same field up to present, to invite further studies on the stretch of investment in markets with anomalous stock returns and to expect explanations for the current stock market bubbles (Greenwood and Nagel, 2009). Warren Buffett (1986â€“2005), David Swensen (2001, 2007) and George Soros (1987, 2011) are some of the modern investment giants (Chan, 2010) that have invoked Keynes ideas relating to the stock market in support of their beliefs, understanding, and strategies for investment.
In the Keynesâ€™ â€œGeneral Theory of Employment, Interest, and Money,â€ Chapter 12 delves deeply into the financial aspect of the stock market. Therefore, it is rich and contains various discussion the same subject. Keynes focuses on specific aspects of capital markets, (1) notion of uncertainty, (2) the formation of enduring expectations and investment choices in goods markets ( the position of the animal spirits and effects of stock mark market on investment decisions), (3) the concept of state expectations and the difference between confidence and expectations and (4) the formation of behavior and expectation in stock markets (Keynes, 2007). In his contribution regarding the investorsâ€™ long-term hopes, Keynes notes that it is irrational for investors to form their expectations or attach heavy weights to matters about which they are not certain.
Notably, it is important for investors in the stock market to concentrate and be guided, in their decisions, by facts about which they are confident even if they may appear less decisively relevant (Peukert, 2012). Thus, for this reason, the truth about the current situations of a market becomes an important aspect to consider before an investment decision is made. That is the formation of long-term expectations which Keynes refers to as the current projection of a stock market investor. A conventional economic agent must have adequate knowledge and familiarity with the market. Investment decisions solely based on cold calculations rarely take place. However, it is human nature to feel often the temptation of taking chances. Keynes refers to this characteristic as Animal Spirits. A spontaneous desire to act rather than remain inactive regardless of the size of the benefits, outcomes or risks involved (Greenwood and Nagel, 2009). The primary source of animal spirit in an average entrepreneur is the political and social atmosphere which signals the â€œdelicate balanceâ€ of both optimistic and pessimistic phases for cultural evaluation of an individualâ€™s mental prerequisites of the dot-com bubble.
According to Keynes, a stock market must have the element of ambivalence. Undeniably, the idea aforementioned is because as much as it may appear efficient and free of failure, it may concentrate on facilitating investments emphasized by the mainstream economists while disregarding the instability it causes to in the system. The long-term anticipations in the stock market may diverge from the candid expectations of the investors causing decline in the real implicit market knowledge.
In his analysis, Keynes actively compares the stock market to a strange beauty contest pageant of his time. The pageant would publish newspapers with arrays of photos of the participants, and the readers were placed in a contest of choosing the faces that would most likely be chosen by other participants or entrants (Keynes, 2007). Choosing a photo that matches oneâ€™s personal taste would definitely be irrelevant since there was a high probability that the entrantâ€™s selection would differ with the chosen photo. The selection was, therefore, based on trial and error, which appears to be the same situation for participants in the stock market. In most cases, they are hardly in a position to estimate the likely returns from their investments attempts. Only evident is the ability to predict the possible behavior changes in the market.
Consequently, this makes more sense from the perspective of a buyer than that of a seller. With the advantage of market knowledge, the buyer may suspect an investor has made wrong prospects for the future as a result of which stock prices might hike. Stock purchases will increase in the current period to avert inconveniences in the future, thereby fueling the growth of bubble in the economy, as others buyers will still make purchases in anticipation of a further future rise in prices.
The fetish of liquidity
Keynes also questions the mainstream theoretical assumption that financial markets should be more liquid, complex and enlarged. In his language the assumption mentioned above is best described as the â€œfetish of liquidityâ€ (Keynes, 2007). Following Keynes scrutiny, he understands that aspect of liquidity is double sided, and thus, besides enhancing real investments can as well augment wrong speculations, thereby causing the illusion of unlimited and unproblematic liquidity.
From the book, â€œThe General Theory,â€ Keynes argues that financial instability, unemployment, and substandard growth directly result from the fetish for liquidity. As a matter of accuracy, this is driven by the desire for a liquid position that remains anti-social as it does not apply in an aggregate system. Stock markets, therefore, may make title liquid for an individual â€œstakeholderâ€ but because all the equities have to be held by someone, the sellerâ€™s decision to sell-out relies on the buyerâ€™s willingness to buy-in.
Keynesâ€™ investment approach
For effective investment strategy, Keynes suggests unconscious investment is made of three solid elements. First, the present guides the future, investors always rely on the judgment of the mainstream and third, most investors thinks whatever is reflected in stock markets valuations is true, and no further analysis is necessary (Dempsey, 2016). Keynes sums these allegations as mere assumptions that are irrational and as a result, he suggests an investment approach with the social construction of reality propositions on mainstream postulates as an efficient way to tame uncertainty.
Bubble and the Real Economy
The bubble is used to represent continuous fall in prices of stocks. Keynes major concern was that daily revaluation stocks certainly exert a decisive effect on the investment rates at present. This fluctuation in effect the activity of the real economy (Chambers, Dimson, & Foo, 2015. Increasing stock makes it easy for a business unit to raise capital cheaply through placement and issuance of shares. It has an economic effect similar that of falling interest rates. It stimulates investment in some project which at the high cost of capital would not have to be considered because of small profit margins. Plummeting stock prices, however, have similar economic to increasing interest rates. They reduce the real investment ability of a business unit as the capital becomes more expensive to raise.
Reduction in stock prices affects the real economic activity in two ways. First, individualsâ€™ consumption spending is determined by both their wealth and levels of income. An increase in peopleâ€™s wealth raises their ability to spend. Reduction of wealth, on the other hand, curtail spending. In the General Theory, Keynes affirms this phenomenon by asserting that consumption of the wealth-owning may tacitly effect changes in the money-value of their wealth. Stock market bubble inevitably fuels consumption in the economy (Windolf, 2016). Many people resort to active spending because of the implied feeling of financial security. Some people may even end up borrowing against the value of the stocks, often for consumption spending. At the times of reduction in asset values, the consumption rate cuts back dramatically.
Second, fall in the stock market may detonate a major financial crisis. Financial institutions may bet heavily rising stock prices and start extending financial mobilization to buy huge amounts of securities. When stock prices downsize, and financial security costs skyrocket, financial institutions may be left holding a huge stock of assets that have already plummeted in value and are unsellable. In effect, this may curtail further financial lending as the lending as an institution will be busy trying to improve their cash reserves to avoid instances of bankruptcy. Therefore, the implication is that firms and consumers will not be able to borrow, reducing their ability to spend and consume heightening the possibility of an economic recession.
Keynesâ€™s perception of economic instability is that it derives from two different sources (Lawson and Pesaran, 2009). The first source is the significant changes in consumption and investment that affect the aggregate demand in the economy, causing inflation or recession. The second source is the adverse ...
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