Assignment Code: ASST/BECC 103/ 2023-24

Course Code: BECC-103

Assignment Name: Introductory Macroeconomics

Year: 2023-2024

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) Point out the salient features of classical approach to macroeconomics. Why did it fail to explain the Great Depression? What are the changes suggested by Keynes to the classical approach?

Ans) The classical approach to macroeconomics, rooted in the ideas of economists like Adam Smith, David Ricardo, and John Stuart Mill, was predominant until the early 20th century. This approach is characterized by several key features:

1. Self-Regulating Markets: The classical theory posited that free markets, without government intervention, naturally gravitate towards full employment equilibrium, guided by the 'invisible hand'.

2. Say's Law: Central to classical economics is Say's Law, which states that "supply creates its own demand." Essentially, it means that whatever is produced in an economy will ultimately be consumed.

3. Flexibility of Prices and Wages: Classical economists believed in the flexibility of prices and wages. They argued that prices and wages adjust in response to surpluses or shortages, ensuring market clearance.

4. Loanable Funds Theory of Interest: According to classical economists, the interest rate is determined by the supply and demand for loanable funds. Savings represent the supply, while investment represents the demand.

5. Quantity Theory of Money: The classical approach held that changes in money supply only affect prices and wages, not real output or employment. It is often summarized by the equation MV = PT (where M is money supply, V is velocity of money, P is the price level, and T is the volume of transactions).

6. Laissez-Faire Approach: A minimal role for government intervention was advocated. The economy was expected to self-correct through natural adjustments in prices, wages, and interest rates.

Failure to Explain the Great Depression

The Great Depression of the 1930s exposed significant weaknesses in classical macroeconomic theories:

1. Persistent Unemployment: The Great Depression witnessed prolonged and widespread unemployment, contradicting the classical notion of self-adjusting markets that always clear.

2. Ineffective Self-Correction: The economy did not self-correct as quickly or efficiently as classical theory would predict. Deflation and falling prices failed to stimulate demand sufficiently.

3. Inflexible Wages and Prices: Contrary to classical beliefs, wages and prices were not as flexible downwards, partly due to labour union activities and other institutional factors.

4. Underconsumption: The reality of the Great Depression showed that it was possible for goods to be produced at a level that exceeded the aggregate demand, disproving Say's Law.

Keynesian Revolution

John Maynard Keynes challenged the classical approach with his landmark work, "The General Theory of Employment, Interest, and Money." Keynes introduced several critical ideas:

1. Demand-Driven Economy: Keynes argued that it is aggregate demand that drives economic activity and employment, not supply.

2. Active Government Role: He advocated for active government intervention to manage economic cycles, suggesting fiscal policy as a tool to influence aggregate demand.

3. Sticky Prices and Wages: Contrary to classical beliefs, Keynes noted that wages and prices are “sticky” downwards due to factors like contracts, minimum wages, and menu costs.

4. Liquidity Preference Theory of Interest: Keynes proposed that the interest rate is determined by the demand for and supply of money. He emphasized the role of liquidity preference in determining interest rates.

5. Multiplier Effect: Keynes introduced the concept of the multiplier, where an increase in investment or government spending leads to a more than proportionate increase in income and output.

6. Uncertainty and Expectations: Keynes highlighted the role of uncertainty and expectations in economic decision-making, affecting investment and consumption.

Q2) What are the objectives of monetary policy? In order to achieve these objectives, what are the policy instruments adopted by the Central Bank?

Ans) Monetary policy refers to the actions undertaken by a nation's central bank to control the money supply and achieve macroeconomic goals that promote sustainable economic growth. The objectives and instruments of monetary policy can vary depending on the country and its specific economic context, but some common objectives and instruments are widely recognized.

Objectives of Monetary Policy

• Price Stability: Perhaps the most crucial objective, price stability involves controlling inflation. High inflation erodes purchasing power and can create uncertainty, while deflation can lead to decreased economic activity.

• Full Employment: Central banks often aim to achieve a high level of employment. Although not directly responsible for job creation, through monetary policy, central banks can influence economic conditions that support employment.

• Economic Growth: Stimulating and sustaining economic growth is a key objective. By managing interest rates and controlling the money supply, central banks can influence investment and consumption, which drive growth.

• Balance of Payments Stability: Managing the exchange rate and controlling inflation can help maintain a stable balance of payments, crucial for external sector stability.

• Financial Stability: Ensuring the stability of the financial system is increasingly recognized as a core objective, especially after the global financial crisis of 2008.

• Income Redistribution: While not a primary objective, monetary policy can indirectly influence income distribution through its impact on different sectors of the economy.

Policy Instruments

Central banks have several tools at their disposal to achieve these objectives:

• Open Market Operations (OMO): This is the most used instrument and involves the buying and selling of government securities in the open market. When a central bank buys securities, it injects liquidity into the economy, lowering interest rates and stimulating economic activity. Selling securities does the opposite, reducing the money supply and potentially cooling an overheated economy.

• Bank Rate Policy: The bank rate is the rate at which the central bank lends money to commercial banks. A lower bank rate can stimulate borrowing and economic activity, while a higher rate can help cool down inflationary pressures.

• Reserve Requirements: Central banks regulate the amount of funds that commercial banks must hold in reserve. Lowering reserve requirements increases the funds available for banks to lend, boosting economic activity, while raising them can help control excess liquidity and inflation.

• Interest Rate Policy: Central banks influence short-term interest rates to control economic activity. Lowering interest rates makes borrowing cheaper, encouraging investment and spending, while raising rates can slow down an overheating economy and control inflation.

• Credit Control Measures: These include selective credit controls that target specific sectors or types of credit to either stimulate or restrain them.

• Moral Suasion: This involves informal requests or guidelines to commercial banks, urging them to adhere to the central bank's policy direction.

• Exchange Rate Mechanisms: By influencing exchange rates, central banks can impact foreign trade, which in turn affects economic growth and inflation.

• Quantitative Easing (QE): This is a more recent tool where the central bank buys government securities and other financial assets to inject money directly into the economy. QE is typically used when traditional monetary policy tools become ineffective, especially in near-zero interest rate environments.

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) In the IS-LM model, why does an economy move towards equilibrium if it is in disequilibrium? Explain. Use appropriate diagram to substantiate your answer.

Ans) In the IS-LM model, an economy moves towards equilibrium through the interaction of the goods market (represented by the IS curve) and the money market (represented by the LM curve). The IS curve plots the relationship between the interest rate and the level of income that equates investment and saving (hence the name IS: Investment = Saving), while the LM curve represents the equilibrium in the money market, where money supply equals money demand.

Here's how the economy adjusts to reach equilibrium:

Adjustment in the Goods Market (IS Curve): If the economy is at a point where investment is greater than saving (above the IS curve), this implies an increase in aggregate demand, leading to higher output and income. As income rises, so does saving, moving the economy back towards the IS curve. Conversely, if investment is less than saving (below the IS curve), aggregate demand falls, reducing income and output, and moving the economy upwards towards the IS curve.

Adjustment in the Money Market (LM Curve): If the economy is at a point where the demand for money exceeds the supply (to the left of the LM curve), interest rates will rise. This will reduce investment and bring the economy back towards the LM curve. If the money supply exceeds the demand (to the right of the LM curve), interest rates fall, stimulating investment and moving the economy towards the LM curve.

At the intersection of the IS and LM curves, both the goods and money markets are in equilibrium, with saving equal to investment and money supply equal to money demand. Any deviation from this point triggers adjustments in interest rates and income levels that bring the economy back to this equilibrium.

Q4) Explain how equilibrium level of output is determined in the Keynesian model.

Ans) In the Keynesian model, the equilibrium level of output is determined at the point where aggregate demand equals aggregate supply in the economy.

Aggregate Demand and Aggregate Supply

Aggregate Demand (AD): Aggregate demand in the Keynesian framework consists of consumption (C), investment (I), government spending (G), and net exports (NX). The formula is AD = C + I + G + NX. Keynes argued that consumption is primarily driven by income and that investment is influenced by factors like interest rates and business expectations.

Aggregate Supply (AS): It is often depicted as a horizontal line at the level of potential output in the Keynesian model, indicating that firms will meet any level of demand at a given price level up to full capacity.

Determining Equilibrium Output

The equilibrium level of output is where AD = AS. At this point, the total spending (demand) in the economy matches the total production (supply). If aggregate demand is less than aggregate supply, it leads to underutilization of resources, resulting in unemployment and output levels below the economy's potential. In such a case, Keynes advocated for increased government spending, lower taxes, or lower interest rates to boost demand.

Conversely, if aggregate demand exceeds aggregate supply, it leads to inflationary pressure. Here, Keynesians would recommend measures to reduce demand, such as decreasing government spending, increasing taxes, or raising interest rates.

Adjustment to Equilibrium

Keynesians assert that prices and wages are "sticky" downwards, meaning they don't easily adjust to clear excesses or shortages in the market. Therefore, the adjustment to equilibrium primarily occurs through changes in output and employment rather than price changes. This adjustment is facilitated by fiscal and monetary policies that influence components of aggregate demand.

Q5) Give a brief account of the demand for money in the Keynesian system.

Ans) In the Keynesian system, the demand for money is an essential component of macroeconomic theory, conceptualized by John Maynard Keynes in his seminal work "The General Theory of Employment, Interest, and Money." Keynes proposed that the demand for money in an economy is driven by three primary motives:

• Transactional Motive: According to Keynes, the demand for money for transactional purposes is closely related to the level of income; as income increases, so does the amount of money people need for transactions. This relationship is relatively straightforward – the higher the income, the more money needed for day-to-day transactions.

• Precautionary Motive: This refers to holding money to safeguard against unforeseen events and emergencies. Individuals and businesses prefer to have liquid assets available to deal with unexpected expenses or financial opportunities. Like the transactional motive, the demand for money under the precautionary motive is influenced by the level of income, but also by the degree of uncertainty in the economy. In times of economic uncertainty, the demand for liquid money for precautionary reasons tends to increase.

• Speculative Motive: The speculative demand for money arises from the desire to hold liquid funds to take advantage of future changes in the interest rates for bonds and other financial instruments. When interest rates are low, people expect them to rise in the future, leading to a fall in bond prices. Thus, they hold more money to buy bonds later when their prices drop. Conversely, when interest rates are high, people expect them to fall in the future, making bonds more attractive. Therefore, they convert money into bonds, reducing their money holdings.

Assignment III

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

Q6) Describe the impact of inflation on various segments of society.

Ans) Inflation, defined as a general increase in prices and fall in the purchasing value of money, impacts various segments of society in different ways:

• Consumers: Inflation erodes the purchasing power of consumers, particularly affecting those with fixed incomes, like retirees. As prices rise, their income buys fewer goods and services, leading to a decrease in real living standards.

• Borrowers and Lenders: Inflation can favor borrowers if they repay loans with money that's worth less than when they borrowed it. However, it harms lenders in the opposite way, as the money they receive back has diminished purchasing power.

• Businesses: Companies face increased costs due to rising prices for raw materials and labour, which can squeeze profit margins. Inflation can also create uncertainty, discouraging investment and expansion.

Q7) For a three-sector economy the following is given: C=50+0.75Y, I=30, G=20; where C = consumption, I = investment, and G = government expenditure. Find out the equilibrium output level.

Ans) To find the equilibrium output level in a three-sector economy, we need to use the expenditure-output approach. The equilibrium output occurs when total spending (expenditure) equals total output (income). In other words, when Y (output) equals the sum of consumption (C), investment (I), and government expenditure (G), we have reached equilibrium.

The given equations are:

C = 50 + 0.75Y

I = 30

G = 20

We can express total spending (expenditure) as:

Total Expenditure (E) = C + I + G

Substituting the values of C, I, and G:

E = (50 + 0.75Y) + 30 + 20

Now, combine like terms:

E = 50 + 30 + 20 + 0.75Y

E = 100 + 0.75Y

Now, we want to find the equilibrium output level, which is the value of Y when total expenditure (E) equals total output (Y). So, we set E equal to Y and solve for Y:

Y = 100 + 0.75Y

Now, subtract 0.75Y from both sides to isolate Y:

Y - 0.75Y = 100

0.25Y = 100

To solve for Y, divide both sides by 0.25:

Y = 100/0.25

Y = 400

So, the equilibrium output level in this three-sector economy is 400 units.

Q8) Define investment multiplier. What are its limitations?

Ans) The investment multiplier is a key concept in macroeconomics that helps us understand how changes in investment spending can have a magnified impact on an economy's overall output and income. It's based on the idea that when a business or entity increases its investment in things like machinery, factories, or infrastructure, it not only creates jobs and generates income for those directly involved but also sets off a chain reaction of additional spending.

Here's the formula for the investment multiplier:

Investment Multiplier (K) = 1 / (1 - Marginal Propensity to Consume, MPC)

Where:

The Marginal Propensity to Consume (MPC) is the fraction of an additional dollar of income that people choose to spend on consumption rather than saving.

The investment multiplier is a useful concept in economics, but it has its limitations:

• Simplified Assumptions: The multiplier assumes a constant Marginal Propensity to Consume (MPC), which may not hold as people's spending behaviour can change due to various factors.

• Time Lag: The multiplier effect takes time to work through the economy, and the actual time it takes for successive rounds of spending can vary.

• Leakage: It assumes that all income generated is spent within the economy, but some may be saved, spent on imports, or taxed, reducing the multiplier's impact.

• Real-World Complexity: The real economy is more complex, with factors like inflation, interest rates, and international trade influencing the multiplier's magnitude.

• Diminishing Returns: As the multiplier progresses, each round of spending may be smaller than the previous one, reducing its overall impact.

Q9) Write a short note on the various types of inflation in an economy.

Ans) The types of inflation in an economy are:

• Demand-Pull Inflation: This occurs when demand for goods and services outstrips their supply.

• Cost-Push Inflation: Cost-push inflation arises from increased production costs, such as rising raw material prices or higher wages.

• Built-In Inflation: This is a self-perpetuating cycle where workers demand higher wages to cope with rising prices, and businesses, in turn, raise prices to cover increased labor costs.

• Structural Inflation: This results from structural changes in the economy, affecting the pricing of goods and services.

• Monetary Inflation: Monetary inflation stems from a rapid expansion of the money supply, often due to central bank policies.

• Open Inflation: Influenced by international factors, open inflation can result from exchange rate fluctuations and changes in import prices.

Q10) Write a short note on the function of money in an economy.

Ans) Money serves as a cornerstone of modern economies, fulfilling various crucial functions that underpin economic activity.

• Firstly, it acts as a medium of exchange, simplifying transactions by providing a universally accepted means of payment.

• Secondly, money serves as a unit of account, offering a standardized measure of value that enables individuals and businesses to compare the prices of goods and services efficiently.

• Third, while inflation can erode its purchasing power, money remains a reliable way to store wealth for future use, fostering savings and investment.

• Fourth, it acts as a standard of deferred payment, enabling transactions involving future payments, such as loans and credit agreements.

• Lastly, money's liquidity ensures that individuals and businesses can quickly convert it into goods and services, offering accessibility and flexibility in daily transactions and unforeseen circumstances.