As per week #1, the assumptions are what make Economics the ‘School of Thumbs’. This week though in a Finance subject we looked at the ‘supply and demand’ model of interest rates. It was a curious exercise in skepticism vs. standardisation.
Basically it said, that Money Supply and Money Demand are inversely related to interest rates. The higher the interest rates, the less demand for borrowing funds, but the more funds lenders are willing to supply. So the RBA can influence interest rates to try and achieve an interest rate ‘Equilibrium’. They were suggesting that banks would get shy about lending funds as the interest rates were lowered.
This didn’t seem to reflect the real world at all, so I raised my hand and said ‘Does this model work in reality? I mean if you look at housing, the lower interest rates and higher demand push the asset prices up, so banks are more than compensated with the value of the interest rather than the interest rate?’
The (abridged) answer was ‘Ceterus Parabus’ – the model assumes that asset prices remain constant (they don’t). It actually helped me understand what Michael Hudson meant when he said ‘A house is worth what a bank is willing to lend for it.’ One could make the argument that as interest rates drop, the banks have to lend MORE money (increase supply) to inflate the asset prices to account for the drop in revenue.
My point rests though in the dangers of ‘standardisation’ in Education, that is there is no real time allocated to skeptical inquiry, most of my fellow students spend the lectures scrawling endless notes. The crucial omission that we assumed ‘Ceterus Parabus’ could very well have been missed by my diligent note taking peers – they could graduate into the real world thinking that the model actually worked.
I don’t know if I’m right or wrong, they don’t teach me that (yet), but the point is that the models and formulas and functions are emphasised often at the expense of discussing the soundness of the assumptions they are based on.