Assignment Code: BECC-103/ ASST/2021-22

Course Code: BECC-103

Assignment Name: Introductory Macroeconomics

Year: 2021-2022

Verification Status: Verified by Professor

Assignment I

Answer the following Descriptive Category Questions in about 500 words each. Each question carries 20 marks. Word limit does not apply in the case of numerical questions. 2 × 20 = 40

Q1) Explain how the circular flow of income and output in a three-sector economy take place. Draw appropriate diagram to substantiate your answer. Point out the leakages from the circular flows.

Ans) The circular flow of income is an integral concept in economics as it describes the foundation of the transactions that build an economy. However, the basic model of the circular flow of income considers only two sectors – the firms and the households – which is why it is called a two-sector economy model.

Let’s understand the meaning of these terms and the whole concept in simple steps.

1. Firms are the producers of goods and services, and therefore, they require various production or societal resources to produce goods and services.

2. The factors of production are land, labor, building, stock, stationery, etc.

3. Households provide the resources or factors of production. For example, a household provides land and labor to carry out business operations

4. in exchange for the money paid in rent, wages, etc.

5. So, the money flows from the firms to the household in rent, wages, etc.

6. The households utilize wages and rent to purchase certain goods and services to fulfill their needs and wants.

7. When the households pay for these goods and services, the money flows back to the firms, completing the circular movement of money.

Example

1. We can take the example of a Nutella factory to explain the circular flow of income.

2. Here, the Nutella factory is the firm that is the producer of jars of Nutella spread. Some of the factors of production include cocoa beans, land for housing the factory, the building, and laborers for carrying out the production process.

3. The household that has rented out its land to establish the factory will enjoy monetary compensation or rent in exchange. Simultaneously, the labor will be compensated with wages in exchange for their hard work to produce jars of the chocolate spread.

4. The logistics team will be paid further for delivering the Nutella jars to stores and e-commerce warehouses.

5. The household will purchase the Nutella jar utilizing the money it earned as wages or rent.

6. When households pay for the Nutella jars, the money will reach the factory owners, completing the money’s circular flow.

Circular Flow of Income in a Three-Sector Economy

The three-sector economy model includes the role of government when determining the flow of money. In this type of economy, the government plays an essential part.

A three-sector economy model rectifies some of the drawbacks of the two-sector model by introducing the following.

1. The government plays a pivotal role in consuming a major portion of the money flow in taxes.

2. Hence, the flow of money follows from the firms and households to the government in taxes.

3. The government utilizes taxes to develop infrastructure and other services like healthcare, education, etc. So, the government pays back in terms of incentives and purchases goods from the firms.

4. The government pays the households interest rates in government securities, pay revisions, government jobs, etc.

5. Together, it all completes the circular movement of money.

6. If the government’s income from the taxes is less than its expenditure, it is said to have a deficit budget.

As such, the role of government cannot be ignored in any economy because of such a huge control it possesses over the economic cycle. Consequently, governmental interference affects the overall economic performance of a country. A three-sector economy does not consider the role of foreign markets, which has become even more prevalent in the current globalized world.

Outflows of Cash

Just as money is injected into the economy, money is withdrawn or leaked through various means as well. Taxes (T) imposed by the government reduce the flow of income. Money paid to foreign companies for imports (M) also constitutes a leakage. Savings (S) by businesses that otherwise would have been put to use are a decrease in the circular flow of an economy’s income.

A government calculates its gross national income by tracking all of these injections into the circular flow of income and the withdrawals from it.

Q2) Describe the IS-LM model of simultaneous equilibrium in goods and money markets. What do the points outside the IS and LM curves indicate? Use appropriate diagrams to substantiate your answer.

Ans) The IS-LM curve model emphasises the interaction between the goods and money markets. The goods market is in equilibrium when aggregate demand is equal to income. The aggregate demand is determined by consumption demand and investment demand. In the Keynesian model of goods mar­ket equilibrium we also now introduce the rate of interest as an important determinant of investment. With this introduction of interest as a determinant of investment, the latter now becomes an endogenous variable in the model.

When the rate of interest falls the level of investment increases and vice versa. Thus, changes in the rate of interest affect aggregate demand or aggregate expenditure by causing changes in the investment demand. When the rate of interest falls, it lowers the cost c’ investment projects and thereby raises the profitability of investment. The businessmen will there­fore undertake greater investment at a lower rate of interest. The increase in investment demand will bring about increase in aggregate demand which in turn will raise the equilibrium level of income. In the derivation of the IS Curve we seek to find out the equilibrium level of national income as deter­mined by the equilibrium in goods market by a level of investment determined by a given rate of interest.

Thus IS curve relates different equilibrium levels of national income with various rates of interest. As explained above, with a fall in the rate of interest, the planned investment will increase which will cause an upward shift in aggregate demand function (C + 7) resulting in goods market equilibrium at a higher level of national income.

The lower the rate of interest, the higher will be the equilibrium level of national income. Thus, the IS curve is the locus of those combinations of rate of interest and the level of national income at which goods market is in equilibrium. How the IS curve is derived is illustrated in Fig. 24.1. In panel (a) of Fig. 24.1 the relationship between rate of interest and planned investment is depicted by the investment demand curve II. It will be seen from panel (a) that at rate of interest Or0 the planned investment is equal to OI0. With OI0 as the amount of planned investment, the aggregate demand curve is C + I0 which, as will be seen in panel (b) of Fig. 24.1 equals aggregate output at OY1 level of national income.

Therefore, in the panel (c) at the bottom of the Fig. 24.1, against rate of interest Or2, level of income equal to OY0 has been plotted. Now, if the rate of interest falls to Or2 the planned investment by businessmen increases from OI0 to OI1 [see panel (a)]. With this increase in planned investment, the aggregate demand curve shifts upward to the new position C + 11 in panel (b), and the goods market is in equilibrium at OY1 level of national income. Thus, in panel (c) at the bottom of Fig. 24.1 the level of national income OY1 is plotted against the rate of interest, Or1.

With further lowering of the rate of interest to Or2, the planned investment increases to OI2 (see panel a). With this further rise in planned investment the aggregate demand curve in panel (b) shifts upward to the new position C + I2 corresponding to which goods market is in equilibrium at OY2 level of income. Therefore, in panel (c) the equilibrium income OY2 is shown against the interest rate Or2. By joining points A, B, D representing various interest-income combinations at which goods market is in equilibrium we obtain the IS Curve. It will be observed from Fig. 24.1 that the IS Curve is downward sloping (i.e., has a negative slope) which implies that when rate of interest declines, the equilibrium level of national income increases.

Assignment II

Answer the following Middle Category Questions in about 250 words each. Each question carries 10 marks. Word limit does not apply in the case of numerical questions. 3 × 10 = 30

Q3) Why did the classical economists fail to explain the Great Depression? What is the Keynesian explanation for the same?

Ans) The Great Depression discredited classical economics by casting a doubt on how the market was able to regulate the economy. After 1929 a doubt was cast over the classical economic theory according to which government should not intervene in the economy. The 1929 crisis brought deflation,banks going bankrupt and massive unemployment with businesses shutting down in masses.

In 1936 John Maynard Keynes published the "General Theory", in this book he advocated a certain amount of state intervention to stimulate consumption. Transfering money from the wealthy to the poor was one of the main means to achieve that goal. After WWII the Keynesian remedies were applied in the economy as the 1929 crisis had discredited classical liberalism. It was henceforth thought that market economy would bring instabilty and that government could stabilize the economy.

Classical economic thought stressed the ability of the economy to achieve what we now call its potential output in the long run. It thus stressed the forces that determine the position of the long-run aggregate supply curve as the determinants of income. Keynesian economics focuses on changes in aggregate demand and their ability to create recessionary or inflationary gaps. Keynesian economists argue that sticky prices and wages would make it difficult for the economy to adjust to its potential output.

Because Keynesian economists believe that recessionary and inflationary gaps can persist for long periods, they urge the use of fiscal and monetary policy to shift the aggregate demand curve and to close these gaps. Aggregate demand fell sharply in the first four years of the Great Depression. As the recessionary gap widened, nominal wages began to fall, and the short-run aggregate supply curve began shifting to the right. These shifts, however, were not sufficient to close the recessionary gap. World War II forced the U.S. government to shift to a sharply expansionary fiscal policy, and the Depression ended.

Q4) What according to Keynes are the components of aggregate demand? Describe how equilibrium output is determined in the simple Keynesian model.

Ans) Aggregate demand is the sum of four components: consumption, investment, government spending, and net exports. Consumption will change for a number of reasons, including movements in income, taxes, expectations about future income, and changes in wealth levels. Investment will change in response to its expected profitability, which in turn is shaped by expectations about future economic growth, the creation of new technologies, the price of key inputs, and tax incentives for investment. Investment will also change when interest rates rise or fall. Government spending and taxes are determined by political considerations. Exports and imports change according to relative growth rates and prices between two economies.

Formula for Equilibrium Output

The equilibrium condition Y = AD can also be written as:

Equilibrium level of output and income Y0, will be equal to Y0 =

The mpc is found in the denominator, with a negative sign. This indicates that Y and c have a positive relationship. Clearly, Y and A have a good relationship. Given the intercept, a greater mpc, or steeper aggregate demand, will result in higher income and output levels (Fig. 5.4). Similarly, while the mpc remains constant, a greater intercept (implying larger autonomous expenditure) leads to a higher equilibrium production and income level (Fig. 5.5).

Simply put, if individuals spend a bigger proportion of their increased income, their income level will rise and their production level will rise. Higher consumption expenditures signal to producers that more products and services are being used, necessitating an increase in output. As a result, a greater mpc number leads to increased output and income.

5) Give a brief account of the various instruments of monetary policy.

Ans) The various instruments of monetary policy are:

Reserve Requirement: The Central Bank may require Deposit Money Banks to  hold a fraction (or a combination) of their deposit liabilities (reserves) as vault  cash and or deposits with it. Fractional reserve limits the amount of loans banks  can make to the domestic economy and thus limit the supply of money. The  assumption is that Deposit Money Banks generally maintain a stable relationship  between their reserve holdings and the amount of credit they extend to the  public.

Open Market Operations: The Central Bank buys or sells ((on behalf of the  Fiscal Authorities (the Treasury)) securities to the banking and non-banking  public (that is in the open market). One such security is Treasury Bills. When  the Central Bank sells securities, it reduces the supply of reserves and when it  buys (back) securities-by redeeming them-it increases the supply of reserves to  the Deposit Money Banks, thus affecting the supply of money.

Lending by the Central Bank: The Central Bank sometimes provide credit to  Deposit Money Banks, thus affecting the level of reserves and hence the  monetary base.

Interest Rate: The Central Bank lends to financially sound Deposit Money Banks  at a most favourable rate of interest, called the minimum rediscount rate (MRR).  The MRR sets the floor for the interest rate regime in the money market (the  nominal anchor rate) and thereby affects the supply of credit, the supply of  savings (which affects the supply of reserves and monetary aggregate) and the  supply of investment (which affects full employment and GDP).

Direct Credit Control: The Central Bank can direct Deposit Money Banks on the  maximum percentage or amount of loans (credit ceilings) to different economic  sectors or activities, interest rate caps, liquid asset ratio and issue credit  guarantee to preferred loans. In this way the available savings is allocated and  investment directed in particular directions.

Moral Suasion: The Central Bank issues licenses or operating permit to Deposit  Money Banks and also regulates the operation of the banking system. It can,  from this advantage, persuade banks to follow certain paths such as credit  restraint or expansion, increased savings mobilization and promotion of exports  through financial support, which otherwise they may not do, on the basis of their  risk/return assessment.

Prudential Guidelines: The Central Bank may in writing require the Deposit  Money Banks to exercise particular care in their operations in order that specified  outcomes are realized. Key elements of prudential guidelines remove some  discretion from bank management and replace it with rules in decision making.

Exchange Rate: The balance of payments can be in deficit or in surplus and  each of these affect the monetary base, and hence the money supply in one  direction or the other. By selling or buying foreign exchange, the Central Bank  ensures that the exchange rate is at levels that do not affect domestic money  supply in undesired direction, through the balance of payments and the real exchange rate. The real exchange rate when misaligned affects the current  account balance because of its impact on external competitiveness. Moral  suasion and prudential guidelines are direct supervision or qualitative instruments. The others are quantitative instruments because they have  numerical benchmarks.

Assignment III

Answer the following Short Category Questions in about 100 words each. Each question carries 6 marks. 5 × 6 = 30

Q6) Distinguish between demand pull and cost push inflation.

Ans) The differences between Demand-pull and cost-push inflation can be drawn clearly on the following grounds

1. Demand-pull inflation arises when the aggregate demand increases at a faster rate than aggregate supply. Cost-Push Inflation is a result of an increase in the price of inputs due to the shortage of cost of production, leading to decrease in the supply of outputs.

2. Demand-pull inflation describes, how price inflation begins? On the other hand, cost-push inflation explains Why inflation is so difficult to stop, once started?

3. The reason for demand-pull inflation is the increase in money supply, government spending and foreign exchange rates. Conversely, cost-push inflation is mainly caused by the monopolistic groups of the society.

4. The policy recommendation on demand-pull inflation is associated with the monetary and fiscal measure which amounts to the high level of unemployment. Unlike, cost push inflation, where policy recommendation is related to administrative control on price rise and income policy, whose objective is to control inflation without increasing unemployment.

   
   

Q7) For a three-sector economy the following is given:

C = 30 + 0.75Y, I = 30, G = 40

where C = consumption, I = investment, and G = government expenditure.

Find out the equilibrium output level. Find out the value of investment multiplier.

Ans) Equilibrium output level

Y=C+I+GY=C+I+G

Y=30+0.75Y+30+40Y=30+0.75Y+30+40

0.25Y=1000.25Y=100

Y= 100/0.25=400Y

Investment Multiplier, k = ∆Y/∆I

It is the ratio of the change in national income induced by a $1 change in investment.

Given the consumption function,

C = 30 + 0.75YC=30+0.75Y

0.75 is the marginal propensity to consume (MPC)

Since MPC + MPS = 1

=> MPS = 1 - MPC

= 1 - 0.75

= 0.25

k = ∆Y/∆I = 1/MPS

= 1/1-0.75

= 1/0.25

= 4

Q8) With an example, explain the concept of double counting.

Ans) Double counting is an error caused as a result of illogical calculation. This term is used in economics to refer to the faulty practice of counting the value of a nation's goods more than once. Since goods are produced in stages, through specialized channels of production, many intermediate goods are used to produce a final good. If the values of each of these intermediate goods is added together, without subtracting expenditures incurred during the production process, the error of double counting will be committed.

An error that occurs when a total is obtained by summing gross amounts instead of net amounts. For example, finding the total product of an economy by adding up the gross sales of each enterprise, without subtracting purchases of inputs from other enterprises, involves double counting. As firms buy large amounts of fuel, materials, and services from one another, simply adding gross outputs results in double, or multiple, counting of output. Double counting is avoided by subtracting purchased inputs from gross output to get value added for each enterprise. The national product is total value added.

Q9) What type of fiscal policy the government should adopt during recession. Justify your answer.

Ans) Expansionary fiscal policy is used to kick-start the economy during a recession. It boosts aggregate demand, which in turn increases output and employment in the economy. In pursuing expansionary policy, the government increases spending, reduces taxes, or does a combination of the two. Since government spending is one of the components of aggregate demand, an increase in government spending will shift the demand curve to the right. A reduction in taxes will leave more disposable income and cause consumption and savings to increase, also shifting the aggregate demand curve to the right. An increase in government spending combined with a reduction in taxes will, unsurprisingly, also shift the AD curve to the right. The extent of the shift in the AD curve due to government spending depends on the size of the spending multiplier, while the shift in the AD curve in response to tax cuts depends on the size of the tax multiplier. If government spending exceeds tax revenues, expansionary policy will lead to a budget deficit.

Q10) In the IS-LM model, explain why the economy always moves towards the equilibrium point.

Ans) According to the theory, liquidity is determined by the size and velocity of the money supply. The levels of investment and consumption are determined by the marginal decisions of individual actors. The IS-LM graph examines the relationship between output, or gross domestic product (GDP), and interest rates. The entire economy is boiled down to just two markets, output and money; and their respective supply and demand characteristics push the economy towards an equilibrium point. The intersection of the IS and LM curves shows the equilibrium point of interest rates and output when money markets and the real economy are in balance. Multiple scenarios or points in time may be represented by adding additional IS and LM curves