Major Areas of Behavioural Finance - Essay Example

? Behavioural Finance final Table of Contents Introduction 3 Relation of economic crisis with public sector 3 Effective theories of public policy 4 Modern Monetary Theory 4 Mosler’s Law 5 Reverse Ricardian Equivalence 5 Role of public policy to counter crisis 6 Reference 8 Introduction This paper deals with one of the major areas of behavioural finance. Objective of this study is to assess the role of public policy to address financial crisis in the economy. This is one important areas of macroeconomic perspective. There are numbers of theories, approaches and models have been developed by the empirical researchers of different field to counter economic crisis. Different ways of reforms of financial crisis have been developed. Therefore, role of public policy will be discussed through some relevant economic theories developed by the eminent economists. These are Modern Momentary Theory, Moslers’s Law and Reverse Recardian Equivalence. These theories will be applied to identify the best possible ways in light of public sector to address financial crisis. Recommendations from these theories will be analysed in the light of endogenous money theory. Relation of economic crisis with public sector Economic crisis is worst case scenario of an economy which has subsequent effect on the world economy. Worldwide globalization has linked up the economies of all the countries with open economy. Different financial activities of people across the world have substantial or major contribution in economic crisis. Financial institutions especially banks are the major participants in economic crisis which represents financial stability of an economy through the participation of public in various financial instruments. There are many different types of root causes behind the recessions or financial crisis took place mainly in the developed countries in USA and United Kingdom and spread in the world economy. For example, global financial crisis of 2007 to 2009 started in USA mainly because of collapse of housing market in the country. Recent debt crisis in United Kingdom is also has major influence of financial activities of individual as well as business institutions. To come out from these economic crises, different reforms have been developed by the government in all economies in the world through monitory, fiscal, regulatory and legal policies. General tendency of people is to invest their savings into some sectors that shows future potential and growth to provide more than expected return and i.e. much higher government bond return. But, future growth of a private sector in terms of growth in revenue is depends on the increase in income level as well purchasing power of public in the economy. Therefore, if both are not in a equilibrium position in future, a dramatic bubble occurs in the expected potential sectors and major decline in revenue starts which affect both the equity return as well businesses not able to pay the major creditors like banks (Callan, Nolan & Walsh, 2010, p.15). Effective theories of public policy There are numbers of economic theories developed by the eminent economists who have provided recommendation through their theories. These recommendations are highly related with the financial activities of public sector to address economic crisis. Following three economic theories are most relevant with the ways of reforming financial crisis. Modern Monetary Theory It is a descriptive economic theory that deals with consequences and procedures of using monetary tokens issued by government and it is acts as a unit of money i.e. fiat money. This theory can be applied to analyse modern economies where it acts as national currency of an economy which is issued and regulated by the government. According to this theory of economics, money enters into the market for circulation through the government spending. Taxation is employed in the economy to value the fiat money as currency. It controls the demand and supply of money in the market. Modern Monetary theory maintains a standard equilibrium level of taxation relative to government spending or austerity measures. Therefore, public policy or government policy can control different economical stages like recession, inflation etc. Mosler’s Law Moslers’s law has summarized the modern monetary theory with an integrated and applied approach. According to this theory of economics, public policy has enough power to control financial crisis in an economy through sufficient reduction in tax rate or increasing government spending. Financial crisis can not be so deep that it cannot be addressed by these public policies. Therefore, fiscal policies are imposed by the government in an economy which can control the income level of people through government spending and sufficient tax reduction. It proves that public policies have substantial role in reforms of financial crisis. Reverse Ricardian Equivalence According to Ricardian Equivalence, people of an economy internalize government’s budget constraint. It results, no effect in the level of spending or consumption level of the people at time of changes in tax. When government tries to stimulate the demand through increase in debt financing, it remains unchanged. But, according to Reverse Recardian Equivalence, austerity measures of government or government expenditure has substantial influence in public spending. For current government expenditure, people start savings for future tax payment. People save money now to pay future tax that will be imposed by the government to pay off debt. Role of public policy to counter crisis Both Mosler’s law and Reverse Recardian Equivalence represents and proved that public policy regarding financial activity of people in an economy has substantial control over financial crisis in that economy. Economic crisis represents a substantial decrease in national income of an economy. National income is equals to sum of consumption, government expenditure, investment, trade surplus and tax. Therefore, all these component needs to be in growth stage which leads to increase in national income. Again, public policies are developed to control these components of national income. But the main problem is that all these major components of an economical growth are not positively related to each other. For example, if an economy is in a financial crisis, the government raise austerity to increase the income level of people which increase the demand of in the market. More production will be started that leads to trade surplus and crisis stats recovering. Decrease in sufficient tax also increase in the money in hand of the people which also leads to increase in demand in the market. Therefore, Mosler’s law is satisfied with respect to reform of economic crisis by public policies like monetary and fiscal policies. If the role of public policy can be seen through Reveres Recardian Equivalence perspective, austerity measures or reduction in government spending positively influences current consumption level of public because they expect that future tax will be lower. This encouragement for private spending leads to expansion in economy through higher demand and more production, more employment in the private sector etc. Again role of public policies or public sector can be analysed through endogenous theory of money. According to this theory, increase in money supply in the market decreases the actual worth of money whereas increase in expected productivity increases the actual worth of money. Therefore, monetary policy of an economy can control the money supply to control inflation level and it will increase the trade surplus as value of currency will be increased with the increase in production. Both Mosler’s law and reverse Recardian Equivalence supports for increase in production due to increase in public spending. Therefore, this also leads to increase of actual value of money which is a major signal of economic growth of a country. Apart from, fiscal and monetary policy, other types of public policies like regulatory and legal policies also have contribution in control of economic crisis. Legal policy regarding transparency in financial disclosure of private firms results sustainable business operation. Again, regulatory policy is maintaining asset to liability ratio of private firms i.e. private firms needs to have sufficient assets and this determines its external finance. From the above analysis, it can be recommended that public sectors needs focus on equivalent level of public consumption and government expenditure. Public policies have enough power to address economic crisis if policies are well accepted by the people and they follow regulatory and legal policies. Reference Callan, T., Nolan B. & Walsh, J. 2010. The Economic Crisis, Public Sector Pay, and the Income Distribution. [Pdf]. Available at: http://ftp.iza.org/dp4948.pdf. [Accessed on 10 October, 2012]. Read More