Assignment Code: BECC-106/ASST//2022-23

Course Code: BECC-106

Assignment Name: Intermediate Macroeconomics - I

Year: 2022-2023

Verification Status: Verified by Professor

Total Marks: 100

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

1) Derive the AS curve from the WS and PS relations. Discuss the factors that influence the position of the AS curve.

Ans) The WS and PS relations make it simple to derive the aggregate supply relation. Equation taught us that P = (1 + )W. We also discovered from the equation that W = P F(u, z). Consequently, we can formulate the equation shown below:

𝑃 = (1 + 𝜇)𝑊 = (1 + 𝜇)𝑃e 𝐹(𝑢, 𝑧)…………(I)

You should take note that Pe, and z values are provided in equation I Price level P and the unemployment rate of the economy, u, are thus inversely related. This is so because the nominal wage W is a function of u that is inverse. P must be directly related to output level, Y, if it is inversely related to u. Examining the definition of unemployment rate and the production function will demonstrate this.

Unemployment Rate 𝑢 = L-N/L where L is the labour force and N is total

employment.

Also, the production function can be written as 𝑌 = 𝐴𝑁, where A denotes labour productivity and N is employment. Recall that we assumed A = 1 (see Sub- Section 2.3.2). We continue with the same assumption. Thus, the production function can be rewritten as 𝑌 = 𝑁.

Using the above results, 𝑢 = L-N/L = (1- N/L) and 𝑌 = 𝑁, we can write the following relation:

𝑃 = 𝑃e (1 + 𝜇)𝐹(1 −Y/L, Z)………….(ii)

The equation for the AS curve is equation (ii). Price has a direct relationship with output level, Y, because it is inversely related to u. Based on the specified levels of expected price Pe, markup, and catch-all variable z, the AS equation's parameters are determined. Each of these parameters has a direct relationship with price, and any increase in these parameters moves the AS curve upward. Each level of output, Y, is correlated with a higher price P, according to a shift in the AS curve.

Remember that the supply curve explains the connection between the quantity supplied and the price level. The aggregate supply curve, which has an upward slope, is represented by curve AS in Fig. It demonstrates that as the price level P rises, so does the output level Y. The figure also demonstrates that the AS curve crosses point B, where output level Y is equal to the natural level of output (also known as the potential output of an economy), and price level P is equal to the expected price Aggregate Supply level Pe. Let's go over the justifications for this.

A rise in output implies a rise in employment (N), a decline in unemployment (u), and both. We are aware that as u declines, nominal wage W increases due to wage setting in the underwhelmingly competitive labour market. We also know that since prices are a markup over costs, higher wages encourage businesses to charge higher prices. It implies that as output increases, prices increase as well, and that the AS curve is upward sloping.

Because of the labour market's equilibrium, we know that when the price equals the expected price, or P = Pe, the equilibrium unemployment rate is equal to the natural rate of unemployment, or u = u. According to the production function, there is a distinct relationship between output level and employment level (and, consequently, unemployment). Therefore, the natural rate of unemployment (u) and the natural level of output (Yn) are the same. If the price is equal to the anticipated price, that level of output will prevail. As a result, every AS curve crosses a point where P = Pe and Y = Yn.

2) In an open economy with floating exchange rate, analyse the effectiveness of fiscal policy and monetary policy.

Ans)

Fiscal Policy

We are aware that an expansionary fiscal policy will cause the IS curve to move to the right (e.g., higher government spending and lower tax rates). A contractionary fiscal policy, in contrast to the example above, causes the IS curve to move to the left. Assume that the IS0 and LM0 initial curves have equilibrium at point E. The IS curve changes from IS0 to IS1 when government spending is increased by an amount G. The IS curve has been shifted to the right by the amount of G, or by the distance EF in Fig. Without the money market, point F would represent the new equilibrium. The output would increase from Year 1 to Year 2 while the interest rate (i0) remained unchanged. However, since we also need to include the money market, this is not possible. The financial markets' excessive demand for money is represented by point F.

This causes bond sales, a decline in bond prices, and an increase in interest rates. The economy moves to point S, where both markets are once again in equilibrium, as a result of the rise in interest rates, which brings the financial markets back into balance. However, this increase in interest rates results in a decline in investment, which lowers output (movement from F to S on the new IS curve, IS1). Point S represents equilibrium with interest rate i1 and income level Y1, respectively. It is evident that the interest rate is higher than the initial rate and that the output level, while higher than the initial level, is lower than it would have been in the absence of the money market. The overall increase in output is lower than G and equal to G. Due to investment crowding out, this has happened.

The term "crowding out" describes a decrease in private spending (in this case, investment) as a result of an increase in public spending (G). Crowding out occurs when public spending increases because doing so increases income and money demand, which in turn raises interest rates and reduces private spending like investment. Greater crowding out results in greater declines in private spending and less overall income growth. As a result, the degree of crowding out has an inverse relationship with the effectiveness of fiscal policy (in changing incomes). In other words, the parameters b, h, k, and determine how effective fiscal policy is. Let's explain this using the chain rule.

↑ 𝐺 → (𝛼) ↑ 𝑌 → (𝑘) ↑ 𝑀d → (ℎ) ↑ 𝑖 → (𝑏) ↓ 𝐼 → (𝛼) ↓ 𝑌

The parameters in brackets indicate how much have changed. For instance, fiscal policy becomes less effective ask increases. Let's examine the procedure. A higher value of k causes the demand for money to rise more rapidly. Higher values of k cause the interest rate to increase more in relation to the value of h. The increase in interest rates lowers the demand for money and helps the money market return to equilibrium. The greater fall in investment is also a result of the higher rise in interest rates (given the value of b). Given the value of a greater decline in investment causes a greater decline in income or output. As a result, crowding out is more severe and fiscal policy is less successful. You can experiment with the values of additional parameters (like h, b, and ) to see how they affect output level.

Monetary Policy

Let's apply the same strategy to monetary policy as we did above. We are aware that a contractionary monetary policy shifts the LM curve to the left or upwards, whereas an expansionary monetary policy shifts it downwards or to the right (see Unit 13 of BECC 103). How does the equilibrium between I and Y change? View the Fig. At E, the point where IS0 and LM0 intersect, there is an initial equilibrium. You should be aware that LM0 depicts the money market's equilibrium when the nominal money stock is M0, and the price level is P0.

Assume that the nominal money stock rises from M0 to M1. If the price level does not change (remains at P0), it expands the real money supply. Make LM1 the new LM curve. The point F in Fig. is where IS0 and LM1 converge to form an intersection. The output/income level increases from Y0 to Y1, while the interest rate declines from i0 to i1. As a result, an increase in the money supply raises the level of equilibrium output. It occurs because a rise in the money supply throws the money market out of balance, and a decrease in interest rates is necessary to bring the market back into balance (by increasing demand for real balances). The decline in interest rates has an effect on the goods market as a result of which investment spending and total expenditure rise. A higher equilibrium output level is the result of an increase in total expenditure. From point E to point F, the IS curve moves downward to demonstrate this. This procedure, in which the money market "transmits" its impact on income through the goods market, is known as a transmission mechanism.

The robustness of the transmission mechanism affects how well monetary policy works. The parameters, b, h, and k determine how powerful the transmission mechanism is. Let's investigate the procedure by which it occurs.

↑ 𝑀s →↑ 𝑀⁄𝑃 → (𝑘 and ℎ) ↓ 𝑖 → (𝑏) ↑ 𝐼 → (𝛼) ↑ 𝑌

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

3) How do you reconcile the vertical long run Phillips curve with the downward sloping short run Phillps curve? Explain through a diagram.

Ans) The relationship between unemployment and inflation is described by the Phillips curve, which bears A W Phillips' name. Using time series data on the rate of unemployment and the rate of increase in nominal wage rates for the United Kingdom for the years 1861–1957, Phillips, then a professor at the London School of Economics, made an attempt to establish a relationship in 1958. He used a straightforward linear equation of the form:

𝑤̇ = 𝑎 – 𝑏𝑢

where a and b are constants, w is the rate of wage growth, and u is the rate of unemployment According to Phillips, there is a stable and inverse relationship between w and u, which implies that a lower unemployment rate is linked to a higher rate of wage growth. e. Numerous economists replicated Phillips' experiments for use in other countries after he published his findings. It was later determined that there is a stable correlation between an increasing wage rate and an increasing price level. This prompted some economists to improve Phillips' straightforward equation and substitute inflation (the rate of increase in prices) for wage rate increases. e. In many instances, the scatter of the variable plot appeared to be a convex curve. The Phillips curve quickly became a crucial tool of policy analysis as empirical studies confirmed the inverse relationship between the rate of inflation and the rate of unemployment. s.

We show a standard Phillips curve. Let's say that at point A, the unemployment rate is u1 and the inflation rate is 1. The economy must be able to tolerate a higher rate of inflation (2) if the government wants to bring it down to u2.

4) Specify the equation of the IS curve for an open economy. What are the factors that cause a shift in the IS curve?

Ans) The GDP equilibrium level corresponding to each interest rate is displayed on the IS curve. When desired expenditure/aggregate demand equals actual output, Y or when injections and withdrawals are equal, the GDP is in equilibrium. Net exports are a part of aggregate demand according to the open economy IS curve. Because aggregate demand includes consumption, investment, government spending, and net exports, it is used to derive the equation for the IS curve. We can write this as an equation.

Y= C(Y–T) + I(Y, r) + G + NX(Y, Yf, R)

As a result of falling investment brought on by higher interest rates, which causes ZZ to move downward and lower equilibrium GDP, the IS curve shown in Fig. 8.3 is negatively sloped. Lower interest rates, on the other hand, lead to an increase in investment, which raises ZZ and increases equilibrium GDP. The curve appears to be almost identical to that in the closed economy, but it actually conceals a more complicated relation than before. The IS curve depicts the relationship between interest rates and the income level at which desired expenditure flows are equivalent to desired injections or desired withdrawals are equivalent to desired output in all circumstances.

A rise in exogenous spending causes the ZZ curve to move upward, which moves the IS curve to the right. In an open economy, adjustments to the real exchange rate (R), foreign income (Yf), autonomous consumption, and tax rates all affect the IS curve. The demand for domestic goods rises with a depreciation (increase in real exchange rate), shifting the IS curve out and to the right. Similar to how rising foreign income will raise net exports or demand for our goods, rising foreign spending will do the same.

5) Bring out the salient features of the monetary approach to exchange rate determination.

Ans) According to the PPP theory, over time, exchange rates and both domestic and foreign price levels should move in lockstep. It doesn't explain why any of these three variables move. We must include components in the model in order to complete the circle. This is accomplished using the "monetary approach to exchange rate determination," a theory of exchange rate behaviour. The main theory of long-run exchange rate behaviour is the monetary approach to exchange rates.

There are two key pillars that make up the monetary approach to exchange rates. Purchasing power parity comes first. The second is that, as a function of national income and interest rates, the agents in the two concerned countries have clearly defined, stable demands for real money balances. It is simple to demonstrate that the theory predicts the following equation for the exchange rate by imposing money market equilibrium and PPP:

When the supply and demand of money are equal, the money market will be in equilibrium. Households, businesses, and governments demand the money for three reasons: transactions, precautions, and speculation. Three things have an impact on the overall demand for money: The demand for money is affected by three factors: I the interest rate; (ii) the price level; and (iii) real national income. The price level and real national income both affect the demand for money. If the price level increases, agents will have to spend more money to buy the same basket than they did before.

Assignment III

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

6) Explain the concept of natural rate of unemployment. For an economy, can natural rate unemployment be zero?

Ans) The phrase "full employment," which suggests that every worker in the economy is employed, may have crossed your lips. Have you ever considered a scenario like this? Can one achieve it? Full employment does not necessarily imply that there is no unemployment when we say that an economy is operating at that level. Zero unemployment is not attainable due to market imperfections, wage and price rigidities, and various economic frictions.

7) Explain why “balance of payments always balances”.

Ans) The balance of payments will always be in equilibrium in a trivial sense. A current account deficit must be covered by either borrowing from abroad or using up foreign exchange reserves. On the other hand, if the country's current account is in surplus, it will need to export capital, such as by lending money abroad. The balance of payments will always balance in this bookkeeping sense. Current Account + Capital Account = 0

8) Explain the concept of rational expectations.

Ans) Many economists believed that theories based on rational behaviour were insufficient to explain observed phenomena in the middle of the 20th century. In contrast, Muth argued that existing economic models did not make enough assumptions about rational behaviour. By including the expectations of economic variables in models used to explain human behaviour, it is possible to ensure the rationality of economic thought. In light of the economic model, expectations are reasonable if actual and expected values of variables are, on average, equal. The rational expectations hypothesis comes in two flavours: weak and strong. The weak version makes the assumption that people only have access to a limited amount of information, but they make the best use of it.

 9) What are the effects of an expansionary fiscal policy on output and prices?

Ans) Simply put, expansionary fiscal policy is when a government begins to increase spending or decrease taxation. In the United States today, expansionary fiscal policy is frequently linked to rising national debt and deficits, but this association is not always true. A government may employ this strategy even if its finances are in the black. The crucial factor is that, regardless of budgetary surplus or deficit, it simply spends more or taxes less. Expansive fiscal policies are pursued by governments as a means of igniting economic growth and job creation. One of the more well-known and respected schools of thought in modern times, the Keynesian Theory of Economics, serves as the foundation for the theory guiding these choices.

10) Write down the equation of adaptive expectations hypothesis. Illustrate it with an example.

Ans) A theoretical idea known as adaptive expectations deals with creating expectations for the future based on experiences and events from the recent past. People will anticipate higher inflation in the current year, for instance, if it was higher in the recent past. In this context, let's say that while we predicted that the rate of inflation for the previous year would be 12%, it actually was 12%. In that case, the adaptive expectations hypothesis predicts that we won't alter our predictions for the current year's inflation rate. The current year's inflation rate is also predicted to be 12%. On the other hand, imagine that the annual rate of inflation was greater than 12%, let's say 15%.