Happiness related to Monarchy, One Party, and Democracy

Published on 12/07/2012 12:57 British Summer Time



Jeremy Bentham created an algebraic formula demonstrating the sum of utility derived from how national political system is structured. The algebraic formula is as follows:

Increasing the weight on one branch of these three decreases the weight on the other two branches. Bentham argued that the current (Contemporary) British system balances the weights among these three branches at the feasible level to maximise the utility.

Nonetheless, Bentham also insisted on abolition of sovereign = monarchy or dictator when his/her existence starts reducing the sum of utility rather than increasing it, and then the revolution shall be emerged. The coefficients of these variable, their sign (+/-), and their significance vary across different time, place (culture and civilisation), and occasion (GDP growth, etc).



At the contemporary time period when Bentham was alive, there was little objective ways to measure the sum of individuals' happiness in each nation in the world. By contrast, due to the development of the information technology, we have become able to collect some peer assessed numerical indices of various social scientific data sets. This happiness index is also collected by objective view points and survey methods under an academic peer assessment. Thus, it is interesting to assess Benthamite calculus owing to this world happiness index.

The data showing how the political system is structured in each nation in the world is quoted from "The Independent Map of the world in 2005". The binary variables are used as the indices to show how one nation's politics is structured e.g. Absolute Monarchy, One Party system, or Indirect/Direct Democracy. There is only one change from the original Benthamite algebra, which is that Aristocracy implies the executive member of a national legislature. As Bentham mentioned Aristocrats were those who have wisdom to govern, so it is equivalent to the government and bureaucratic elites. (He mentioned the House of Lord whose member is not elected from citizens. So, as the members of the legislature is directly appointed by an authoritarian legislation not by individual citizens) Then, many countries governed by one party technocratic policy is seen to be a pure aristocratic system. Absolute monarchy is assumed not to have any influential technocratic institution i.e. aristocracy. (Saudi Arabia and Morocco) whereas the constitutional monarchist nations have an influential parliament (E.g. Arab Emirates). All indirect democratic countries hold both Aristocracy = Technocratic Legislature and Democracy. They are still democratic but not the pure direct democracy. Only the nation seen to be a pure direct democratic is Switzerland in this analysis. Thus, the binary variable representing Monarchy is zero, the binary variable representing Aristocracy is 1, and the binary variable representing Democracy is 1.


**************** An important note ****************

The binary variables are usually 0 or 1, but there are some exceptions.

-> All the British Commonwealth nations have the binary variable denoting "Monarchy" that is 0.3 instead of either 0 or 1. These nations technically have a monarchy but s/he is not their own monarchy living in their countries, and his/her influence is not that strong as much as those nations having their own monarchy like Britain and Japan.

-> The "transient" democratic nations have the binary variable denoting "Democracy" that is 0.5 instead of either 0 or 1. It is still democratic but not a stable democracy. So, the effect of the variable "Democracy" is considered to be marginal.

**************** ***************** ****************

In addition, the Happy Planet Index (HPI) used as the dependent variable in this regression analysis is highly affected by the "natural climate" in these nations. Some nations in a certain latitude mark a significantly higher HPI than the others. Therefore, the absolute value of nation's latitude and its squared value, as the exogenous explanatory variables, are regressed on the HPI as same as the previously mentioned binary variables. The reason why the binomial function of Latitude, instead of a single variable (The linear function), is to demonstrate the parabolic function. The linear model (Regressing only on |Latitude|) only express either the right middle of equator or the North pole and the South pole are the happiest place to live. But, the HPI certainly shows that the optimum latitude to maximise the happiness is somewhere not far away from equator but not the zero latitude point.

All in all, the formula for the regression analysis is as follows:

*** The dependent variable is the natural log of the Happiness Planet Index (HPI) ***

The binomial function showing the climate effect (Latitude) is "the absolute value of Latitude + The squared value of Latitude".

In addition, there are the three binary variables. There are three binary variables showing the pure effect. The first one describes the pure effect of Monarchy. The second one describes the pure effect of Aristocracy. Then, the third one describes the pure effect of democracy.

The rest of variables are the binary variable denoting the interactive effect by two or three variables together. The interaction effect by "Monarchy" and "Democracy" is not assessed because there is no country having both monarchy and democracy without an aristocracy=technocratic executive branch.



The coefficients and their significance is as follows:

The coefficients of the variables showing the climate effect are 0.02256 for the coefficient of the absolute value of Latitude and -0.0004 for the squared variable of the latitude. Then, the formula shapes an upward parabola shown in the picture below.

Therefore, the place where the latitude is either +31 or -31 maximises the happiness of people living.



All the three binary variables denoting the single effect have a significant and positive coefficient. Both the interaction of Monarchy and Aristocracy and the interaction of Aristocracy and Democracy have a significant and negative coefficient. The coefficient of the interaction of all three variables is non-significant, so that the half of the coefficient value is used. The HPI derived from each different political structure is as follows:

This is a bar graph showing the policy effect on the H.P.I.:

These trends can be roughly visualised in a picture graph like this:

A nation with the direct democracy (Monarchy = 0, Aristocracy = 0, Democracy = 1 ) produces the highest HIP. But, Switzerland is the only nation with such a system in the world. So, it is not sure if it is still significant number of the sample to prove its superiority.

The absolute monarchist nations, (Monarchy = 1, Aristocracy = 0, Democracy = 0 ) is the second best. But, there are only Saudi Arabia and Morocco as the examples. Furthermore, all the other monarchist nations without any democratic structure (Monarchy = 1, Aristocracy = 1, Democracy = 0 ) showed the lowest HPI. Thus, it can be seen that, in general, monarchism without any degree of democracy is more likely to cause unhappiness rather than happiness.

The nations with one party system mark the second lowest HPI. Even though these nations are more efficient to be stablised than those lowest developed nations, the transient democratic nations, and any non-democratic monarchist nations. Nonetheless, they seem to sacrifice happiness for their stability.


Some of the constitutional monarchist nations with democracy seem to be happier than democratic republic nations. But, majority of the constitutional monarchist nations are less happier than democratic republic nations.

The democratic republic nations, though their democracy is indirect, such as the United States of America and France are the happiest nations next to Switzerland, the direct democratic nation.



All in all, Democratic Republican nations at the latitude of 31 or -31 seem to be the happiest ones. It also looks like that we can try to establish another Direct Democratic country because it looks like maxminising the happiness of individuals in a nation. Nonetheless, only the sample is Switzerland and it is never known if the similar model is applicable to increase the happiness in another country in reality. The democratic republic nations perform well among all. The performance of the constitutional monarchist nations with an indirect democracy varies.

Hence, this econometric analysis seems to be able to assist Jeremy Bentham having argued that, if monarchy start causing disutility rather than utility, then it is time for revolution! Perhaps, we have never known that there will be a revolution for the cause of Direct Democracy, the unknown ideal, in the near future? The Direct Democracy seems to maximise individuals' happiness at the optimum level (Though there is not enough number of the sample to prove in reality) by means of this statistic inference.



* It was difficult to find if the model creates heteroscedasticity: Some tests said no, but the other said yes. But, this analysis was mainly composed of the binary variables, and the dependent variable used in this analysis is not a precisely scientifically accurate variable. So, the aim of test should not be strict as much as the other econometric analyses.

Minimum wage is necessary to maintain free market economy (Monopsony)

When someone claims for imposing minimum wage, many may still tend to call this person a socialist. However, imposing minimum wage seems to be less socialistic than allowing politicised trade unions (labour unions) to hold their wage bargaining power. In order to preserve capitalist model based on free market market economy requires the reasonable level of regulation in order to sustain the fair rule of market competition, stable risk management of investment (attracting investment), symmetric information (mitigating information bias), and motivation of both employers and employees participating economy without being feared of mismatch (Rationally forming their contact with each other). Minimum wage can be considered as a form of regulation, and it provides a reason to say there is no need for a trade union intervening for avoiding exploitation of labourers.

Nowadays, involuntary unemployment and stagnating aggregate demand are still the significant socioeconomic problem. The root cause of the current economic structure seems to be the shrinking market competition due to growing power of major corporations. Unlike the earlier stage of capitalism, the current capitalistic model is more centralised and specialised in the hand of minority elite corporate executives and public bureaucrats working for the favour of these corporate elites. The market has become less competitive and less free due to this phenomenon, and the market is becoming less liquid than it used to be. Under this circumstance, it reduces the liberal wage/income bargaining of majority individuals owing to this asymmetric power balance.

In the free competitive market, the demand and the supply are more likely to meet at the equilibrium point, and the error from this equilibrium point is corrected by converging the price and the quantity to the equilibrium point. By contrast, due to the asymmetric balance of power mentioned in the aforementioned paragraphs, it is now diverging from the equilibrium point as the market becomes less competitive and the freedom of entering market is suppressed.




This graph shows how monopsony (Buyer holds power over seller). The labour market of the current capitalist economy is in this situation where the labourers (Selling their labour in the market) hold less power over their wage bargaining power whilst the employers (Buying the labour resource in the market) hold excess power.

The demand for labour can be also described as the average revenue from employing labour, and the average labour supply can be the average cost for employers for employing labour. The equilibrium point (Demand meets supply) is where the average revenue becomes equal to the average cost in the labour market. Then, the wage is set at both employers and employees (labourers) agree at the market competitive level, and the labour is employed where involuntary unemployment is reduced.

On the other hand, the most desirable point for the employer is not the equilibrium point because it does not maximise their profit for their business. Their desiring point is the level of the labour employed where the marginal revenue of hiring labour meets the marginal cost of hiring labour. At this point, employers use their influential power over the market to set the wage (their cost) lower than the equilibrium point so that they can maximise their profit. Only the labourers who are still willing to participate by using their labour in the market can be employed.

This situation pretty much explains why some labourers work way too long hours with unsatisfactory wage whereas there are many citizens unhappy to be employed. These unemployed citizens tend to be blamed for not willing to keep applying for a job. But, this is fault of not only them but also the market situation not able to afford the wage motivating them to work. In addition, already employed citizens suffer from the income shortage for propping up their cultural standard of living and for compensating their exhaustion from working.

The depreciated wage level caused by monopsony in the labour market induces the stagnation of the aggregate demand which represses the market multiplier, and this leads to the economic downturn. The aggregate supply level also eventually falls because the revenue from providing the supply declines due to the falling demand. Therefore, this monopsony has to be discouraged not only for majority citizens being employed in the labour market but also the capitalist citizens employing labourers. Some of these capitalist citizens will also start suffering from declining their activities.




Imposing minimum wage may overcome this situation of monopsony by raising the wage standard to the market equilibrium point. This will reduce the involuntary unemployment as well as stimulate the market multiplier. Reduced involuntary unemployment reduces the cost for public spending. It also increases the income of already employed citizens and reduces their frustration, and then this reduces the risk of suffering from mental disease so this also reduces the public spending cost. It will increase the aggregate demand induced by increasing the income level of majority citizens.

The typical counter-argument against minimum wage is that it sets the wage higher than the equilibrium point so it decreases the labour demand. However, the fundamental problem of the current situation is that wage is set at the considerably low enough to increase unemployment and repress the market multiplier.

At the same time, employers cannot be blamed for this situation because of the following reason. The current market economy is based on the specialisation in the global level and it requires the huge economic scale of production, and the model based on the competition among traditional small-medium sized enterprises is already an old fashioned way not able to survive in this current economic model. Therefore, it is inevitable that more selected numbers of corporations with stable fiscal situation and abundant experience, productivity, and net working survive to thrive whereas traditional small-medium sized firms suffer from their staggering business performance.

Instead of cracking down against these major corporations to revive the good old competitive market based on traditional small-medium sized firms, simply imposing the minimum wage is easier and more productive. The government intervention of reducing the power of major corporations will be costly, and will slow down the economy by sacrificing all the wisdom and virtues of major corporations. Therefore, it would be better to allow the current capitalist economic model to grow while reforming it for some optimisation.

This policy will improve the corporate structure of already existing firms. Successful corporations with good managements have enough revenue to cover the cost for minimum wage as long as it is set at the market equilibrium balancing the happiness of employers and labourers. This is also an effective tool to expel ethically misbehaving corporations which usually suffer from bad management with unstable fiscal situation. Then, unnecessary exploitation will be prevented.

This policy will also encourage work sharing among citizens. In the current economy, there are citizens working for excessively long hours. When this policy is implemented, works will be shared among more individuals, and their work and life balance will be optimised. Furthermore, it will encourage to replace some tasks relying on cheap labour with newly invented technologies such as automation by artificial intelligence (AI). There are still many firms hesitate to introduce the new technology optimising their business performances because clinging to relying on their cheap labour is still economical in the short run. All in all, this will be an opportunity to accelerate the innovation.


Having considered about monopsony in labour market, imposing reasonably high minimum wage bring aforementioned benefits. It is still questionable whether it can be ideally adjusted to the equilibrium point or it exceeds more than the equilibrium point. Nevertheless, this policy still seems to be worth off to try to implement in order to tackle with reducing involuntary unemployment and stimulating the market multiplier with relatively lower cost than the other government intervention.

The Political Compass by Country measured by Numerical Data

Published on 08/06/2019



The Political Compass inevitably relies on the author's subjective sense of judgement to measure where politicians/countries are located on each spectrum. Its author still uses the objective analysis to the certain extent as he seems to be an educated and well-informed academic. There are also various many derivational charts of political compasses invented by various individuals. However, majority seem to rely on the subjective measurement to determine how the selected policies are categorised in their chart.

This project is inspired by the Political Compass, and attempts to create a chart based on less relying on an author's subjective sense of judgement. So, the numerical data set is used to create this chart. The data were downloaded from the following sites:

Data Source:
Economic Freedom: https://www.heritage.org/index/download (2019)
Political Freedom: https://freedomhouse.org/report-types/freedom-world (2018)

By following the Political Compass, the X variable (The horizontal axis) indicates the economic freedom i.e. friendliness to free market capitalism. The way the economic freedom is measured turns to be notably different from the perspective of the Political Compass because the Heritage.org regards of the economic freedom and the development of the global capitalism as the positive optimistic element meanwhile the Political compass regards of them as relatively more oppressive and something not favoured by the mass. Yet, the main objective is to measure how each country adapts the free market global capitalism on the horizontal axis so that this does not induce it to be a significantly different analysis.

As same as the Political Compass, this chart also indicates the top side of the chart denotes more authoritarian, i.e. less politically free, and the bottom side denotes more liberal, i.e. more politically free. So, the Y variable (The vertical axis) is created by diverging the political freedom index. This is also not quit identical as what the Political Compass attempts to indicates. This index from FreedomHouse.org only ranks the countries' policies only by means of the relative measurement to the other countries in the current world situation: It compares them with neither historical examples nor the non-existent but maybe possible policies introduced in political theories.

Each variable is calculated as follows:


Both indices are powered by 0.3 in order to balance the chart (Making the candidates on the chart comparable and the chart more visible). 0.3 is used for the power because the average and the median of the variables become close to 0.5 together and the gap between the minimum and the maximum is widened by this calculus.


This chart was created by Microsoft Excel but it is not equipped with the chart label shown on the map of the chart. So, a chart-labelor was installed from www.appspro.com/Utilities/ChartLabeler.htm.

The dots of these countries are shaped and coloured dissimilarly by means of various diverse geographic and cultural regions. Unlike the original categorisation for the referred data sources, this chart scattered the original regional categories into more detailed unique ones. Western English speaking countries are categorised as Anglo-Saxon and Celtic on this chart (Blue Dia). Those in Asia-Pacific which are heavily influenced by Confucianism (Red Circle) are distinguished from the rest Asia-Pacific (Purple Circle). Those in Europe are roughly divided into three groups, West (Yellow Dia), Central (Pale Green Dia), and East (Pink Dia) in order to clarify the difference caused by historical and ethnic characteristics and the past as well as the present political factors. (It is by means of this author's subjective sense based on his knowledge because it is difficult to clear cut with a pure objective measurement)

This may help to compare and understand the economic and political attribute of various countries in a macro perspective.



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The IS-LM Model is wrong!

This was originally posted on Wednesday, October 22, 2014

* Preface *

Many students of economics may have studied about the IS-LM model, and then tackled with various homework assignments requiring to solve the excessively complex formulas and understand the theoretical reasoning behind them. These macroeconomic teachers always expect students to consume their precious time and energy to solve a ton of equations and memorise the theory to explain what these algebras denote. The mathematical formulas applied to this model are mostly linear and straightforwardly simple but all equations are interconnected to all the others. As long as they are familiar with economics in general, it should not be a big problem to understand the theoretical bases. But, these teachers require these students to interlink all the necessary theories which textbooks show to all equations. In addition, when the interpretation of these students differ from what the textbooks and the teachers expect, their mark tends to be lowered. Therefore, studying the IS-LM model is very exhausting.

Nevertheless, despite their efforts and well-understanding, there is a big scepticism about the IS-LM model. There are still many debates about whether or not this model successfully explain the real world economy. Of course, there is always a residual gap between what the prediction model estimates and what the real world phenomenon is in real. This is why the IS-LM model is a problem because of its complex tangle of a bunch of the equations. Especially in social science, when many mathematical equations are used and interlinked together, the total sum of the residuals tends to be significantly magnified, and the bias and the inconsistency of the model also tend to take place much often. Furthermore, these estimate mathematical models are not statistically tested as their formulas are merely based on the literature of economic theories. Therefore, it is really a natural fact that the IS-LM model often fails to fit into what really happens in real.

Even in the pure literature based economic theories and the logical economic theories also counter to the IS-LM model. This report introduces some significant counter-arguments against the IS-LM model as follows.


1. The Ricardian Equivalence


This theory implies that providing economic agents with extra income by the stimulus package does not successfully induce them to spend enough to stimulate their economy. When they prefer consuming/invest less and saving more at the present time to the extra consumption&investment, the extra income available by the tax cut and/or the government expenditure rather causes the negative impact on economy than the positive impact. The cost incurred by the tax cut and/or the government expenditure at the present time period has to be paid back in the future. As the economic stimulus becomes unsuccessful due to their preference of spending less than expected, the tax revenue in the future time period is lowered meanwhile the cost remains.

Those who disagree with the Ricardian Equilibrium argue that there are many economic agents with the low income insufficient to satisfy their needs and wants during the recessionary period so that they happily spend their extra income provided by the stimulus package to stimulate economy.

However, their extra income spent for consumption/investment is eventually transferred to owners of the means of production who produce the consumptions and own the assets invested. These owners will rather want to shift their income earnt from their capital investment to their assets in this downward market to either saving in their bank account or investing more active foreign markets.

When an economy become at the point that even these owners of the means of production become deprived enough to cling to the extra income provided by the stimulus package, the national government is less likely to be able to issue their bonds to incur the debt as the bond credibility is substantially lowered.


2. Liquidity Trap


The stimulus package by the monetary policy channel still does not work due to the liquidity trap. As mentioned in the Ricardian Equivalence, economic agents tend to be reluctant to spend their extra income available during the recession. Even the monetary policy is less likely to incur the cost like the previously mentioned fiscal policy channel, the result is identical to the previously mentioned scenario.

This phenomenon is explained as the liquidity trap. As shown in the graph above, although the extra money supply becomes available to transform to the extra income available for economic agents to spend, the effect is substantially low or even nothing under a very low liquidity level i.e. the investment motive is very low. The little effect on the interest rate reveals little impact of the money supply increase on economy. This means that the factors determining the interest rate such as the price indices, the business activity rate, and the value of this money currency in the foreign currency exchange market hardly changed by this monetary policy.

On the other hand, this interest rate shown in this LM graph merely implies the central bank interest rate, and this only partially affect on the banks' interest rate setting for their borrowers. The rest of this report explains the effect on these interest rates. The IS-LM model neglects explaining the following factors because the IS-LM model assumes all these factors are positively correlated to what it indicates in the model. Nonetheless, the more real economy is obviously different from this false assumption.


3. Under the Banking Monopoly in case of Risk Neutral


The supporters of the IS-LM model assume that their margin rate tends to be always positively correlated to the central bank interest rate so that the final interest rate for both investment and saving is always controlled by the central bank interest rate affected by the fiscal and monetary policy.

The IS-LM model is based on the assumption that all or majority of private banks and the other financial institutes are under the perfectly competitive market. By contrast, the real world economic situation is even not close to this assumption and actually far away from it. They are in the less competitive market due to the nature of the financial industry and market.

The interest rate is the price of money rent and borrowed. So, the private banks and the other financial institutes need to add the extra rate on the central bank interest rate after borrowing from the central bank to rend their money to their customers in order to compensate for the renders' service cost and reward.

Also, in a market economy, the characteristics and the quality of the financial service is heterogeneous to each other, and the demand is severely affected by their geographical situations e.g. access to customers and clients (both quantitative and qualitative), cultural attitudes toward finance, and the infrastructure for obtaining information and technology available there.

On the top of the service quality issue, the service users are difficult to change their service providers often as much as the mainstream economists assume due to the contract binding them together and the transaction cost to close and open their bank accounts. So, these service users are more likely to be bound to their already contracted financial services.

All in all, the market nature is far more monopolistic owing to these aspects. Then, the interest rates are set at the quantity of money invested where the marginal revenue becomes equal to the cost which is the interest payment for savers for this case. So, the quantity invested is lower than the quantity at the investment and saving intersection, and the interest rate charge for borrowing is always significantly way higher than the interest rate payment for savers.

The interest rate payment for savers may be affected by rise of the central bank interest rate increase but not often by fall of the central bank interest rate unless the market is very competitive. These financial service providers take advantage of this situation so that the interest rate payment for savers often tend to be notably lower than the interest rate charge to borrowers.

The following charts explain the different situations to set the final interest rates.

3.1. When the Central Bank Interest Rate is high


When the central bank interest rate is high, then the interest rate paid to savers is adjusted to be equal to the central bank interest rate.

The quantity of money invested is adjusted to the point where the marginal revenue from the return from investment intersects with the central bank interest rate, and then the interest rate charged for investment becomes higher as the central bank interest rate becomes higher.


3.2. When the Central Bank Interest Rate is low


When the central bank interest rate is low enough to be able to split from the investors' profit margin, then no change of both interest rates tends to take place as shown in the graph above.

This aspect completely contradicts what the IS-LM model assumes. As the market is less competitive, the monopoly power is stronger enough to maintain their high interest charge for investment payment unchanged.


3.3. The extreme case: The Central Bank Interest Rate is either zero or minus



In this extreme case which seems to occur frequently under the world economic crisis period nowadays, many central banks of this world have set their interest rate notably close to zero. Even some claim that they should set the rate zero.

Nonetheless, as shown in the previously mentioned mechanisms, the previously mentioned interest rate setting under the low liquidity, the money supply offered by the central bank with a sizably low interest rate hardly stimulates economy.

The interest payment for savers cannot be set below zero because they will no longer save in these banks or any other financial institutes setting such a negative interest rate.


4. Risk Taking Patterns

On the top of the gap between the interest rates, the IS-LM model over-simplifies the investment pattern influenced by the psychological characteristics of banks, investors, and other financial administrators.

What should be concerned is that the interest rate setting based on the investment volume is not always counter-cyclical to the business cycle, and not all economic agents are risk neutral as many mainstream macro-economists tend to assume.

The following examples are based on the situation of the fiscal and monetary policy is tightened to repress the economic boom or the recession repressing the aggregate income level.

The Y_t denotes the aggregate income invested to economy by these investors, and X_t denotes the investment safety (A higher value indicates the lower investment risk).


4.1 Risk Neutral: The IS-LM Curve assumes all agents are as such


This is the way which the risk neutral agents regularly react to the business cycle downturn causing the aggregate income shrinking.

They simply reduce the investment volume, and passively react to the investment risk change.

The IS-LM model may work as long as all the economic agents act as such.


4.2. Risk Averse


The risk averse economic agents put priority on their investment safety to their nominal income gain from their investment volume.

When their investment opportunity becomes more limited, they tend to take this situation warning of losing their business opportunity and potential collapse of their investing clients.

Even in the case where the fiscal and monetary policy represses the booming economy, they imagine about the negative side effect of the over-expansion which the policy alerts, and then they prefer preparing for the worst case scenario.

In particular during the recession, more agents tend to become the risk averse because their perspective tends to be more pessimistic about the future.

All in all, the income downturn exaggerates the investment discouragement furthermore.


4.3. Risk Lover


What the mainstream macro-economists supporting the IS-LM model ignores is this psychological characteristics of economic agents the risk loving attitude toward investment.

When the macroeconomic level of the aggregate income goes down during either the policy tightening or the recession, these risk loving investors start investing more in order to compensate for their loss by the downturn. Even though their action notably increases, they tend to be willing to invest a lot for increase the nominal investment return furthermore.

Their prior objective is to maximise the gross income growth despite the high risk reducing the average expected investment return. So, they will either maintain the current investment volume or even increase the volume in spite both the investment risk, the high central bank interest rate, and the high tax and/or the less government expenditure.

In particular during the economic bubble, an euphoria severely affects people's mind enough to lose their rationality. So, they often tend to become the risk lovers while the economic bubble.



5. Risk Premium in case of the Perfect Competition

Even in the Perfect Competition Model fails in the real investment mechanism because it ignores the interest rate influenced by the risk premium of investment. When renders invest, they add the extra interest rate charge on the top of the risk free interest rate which the mainstream economists supporting the IS-LM model use in the macroeconomic model.

The graph indicates the interest rate setting of a bank under the monopoly:

Under the monopoly or a less competitive market, these firms simply takes the cost incurred by the investment risk by spiriting the expense from their profit.

By contrast, in the perfect competition, it is very complicated to explain with only the saving=investment curves so that the graph will be a overly complicated mess if it attempts to explain the risk premium rate setting under the perfect competition.

So, this analysis introduces the cost denoted as C, which indicates the cost of attracting savers, the interest payment to the central bank, and then the risk premium all together.

The graph below sets the saving motive and the central bank interest rate as rigid so that takes account of only the investment motive and the risk premium.


In this case, the interest rate is not guaranteed to be counter-cyclical to the business cycle, and it can be acyclical or even possibly pro-cyclical to the business cycle.

Some economists argue that the risk premium factor may affect the investment cost more than the other factors such as the central bank interest rate, the saving ratio, and the aggregate income/productivity level.

So, the final interest rate influencing the investment volume may rather rise during the recession because the risk premium rises meanwhile the rate may fall due to the lower risk premium during the stable or booming period.