Assignment Code: BECC-109/ASST/2022-23

Course Code: BECC-109

Assignment Name: Intermediate Macroeconomics - II

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) What type of inconsistency is observed in cross-sectional and time series data on consumption? Explain how the permanent income hypothesis reconciles it.

Ans) According to the permanent income hypothesis, people will spend money at a rate that is consistent with their anticipated long-term average income. The amount of anticipated long-term income is then regarded as the maximum amount of "permanent" income that can be spent without risk. In order to protect against future income declines, a worker will only save if their current income exceeds the level of expected permanent income.

When someone is told they will inherit something, the same thing can be said about them. Their personal spending may change to benefit from the anticipated infusion of money, but in accordance with this theory, they may continue to spend at their current rates in order to save the additional assets. Instead of immediately spending the extra money on perishing goods and services, they might choose to invest it for long-term growth.

Permanent Income Hypothesis

Milton Friedman, an economist who won the Nobel Prize, developed the permanent income hypothesis in 1957. The idea suggests that because changes in consumption behaviour are based on personal expectations, they are unpredictable. Regarding economic policy, this has a wide range of implications. According to this theory, economic policies may not lead to a multiplier effect in terms of increased consumer spending even if they are successful in raising income in the economy. Instead, the theory asserts that consumer spending won't increase until workers change their assumptions about their future incomes. Milton held that, contrary to what Keynesian economics suggested, people will consume based on an estimate of their future income; people will consume based on their current after-tax income. Milton's theory was based on the idea that people prefer to smooth their consumption rather than allow it to fluctuate due to short-term changes in income.

Spending Habits Under the Permanent Income Hypothesis

It is possible that if a worker knows they will probably receive an income bonus at the end of a specific pay period, their spending patterns will change in anticipation of the extra money. However, it's also possible that employees will decide against increasing their spending because of a one-time windfall. Instead, based on the anticipated increase in income, they might make an effort to increase their savings. When someone is told they will inherit something, the same thing can be said about them. Their personal spending may change to benefit from the anticipated infusion of money, but in accordance with this theory, they may continue to spend at their current rates in order to save the additional assets. Instead of immediately spending the extra money on perishing goods and services, they might choose to invest it for long-term growth.

Liquidity and the Permanent Income Hypothesis

Future income expectations may be influenced by the person's liquidity. People without assets might already have a spending habit that disregards their current or potential income. Permanent income can, however, change over time as a result of incremental salary increases or the acceptance of new, long-term positions that pay higher, sustained wages. Employees may allow their spending to increase as a result of their higher expectations.

2) Why is debt stabilisation important for an economy? On the basis of government budget constraint explain how debt-to-GDP ratio can be maintained.

Ans) The measure used to compare a nation's public debt to its gross domestic product is called the debt-to-GDP ratio (GDP). The debt-to-GDP ratio accurately predicts a nation's capacity to repay its debts by contrasting what it owes with what it produces. This ratio, which is frequently expressed as a percentage, can also be understood as the number of years required to repay debt if GDP were entirely devoted to debt repayment.

While immediate austerity is not necessary to stabilise and reduce future debt—in fact, excessive budgetary austerity during a still-sluggish recovery undermines both objectives—a firm plan must be implemented as soon as possible to stop the debt/GDP ratio from rising and to lower it over the following decades. When such a plan is necessary to prevent negative market reactions, financial markets won't give advance notice. At this point in time, confidence may quickly erode due to developments that are possibly out of our control and taking place elsewhere in the world.

What the Debt-to-GDP Ratio Can Tell You

When a nation defaults on its debt, it frequently causes financial panic in both domestic and foreign markets. Generally speaking, a country's risk of default increases as its debt-to-GDP ratio rises. Although governments aim to reduce their debt-to-GDP ratios, this can be challenging to do in times of unrest like war or a recession. Governments typically increase borrowing in such difficult economic environments to stimulate growth and increase aggregate demand. Keynesian economics is credited with developing this macroeconomic strategy.

According to modern monetary theory (MMT) economists, sovereign states that have the ability to print their own money cannot ever declare bankruptcy because they can simply print more fiat money to pay off debts. For nations that depend on the European Central Bank (ECB) to issue their currency, such as those that make up the European Union (EU), this rule does not apply.

Good vs. Bad Debt-to-GDP Ratios

According to a World Bank study, nations with debt-to-GDP ratios that have consistently exceeded 77 percent see their economies grow at noticeably slower rates. Specifically, every percentage point of debt above this level reduces a nation's economic growth by 0.017 percentage points. This phenomenon is even more obvious in developing countries, where every additional percentage point of debt over 64 percent annually slows growth by 0.02 percent.

Since the first quarter of 2009, the US debt to GDP ratio has exceeded 77%.3 To put these numbers in perspective, the highest debt-to-GDP ratio in the history of the United States was previously 106 percent, at the end of World War II, in 1946.

Debt levels gradually decreased from their post-World War II peak, plateaued between 31 and 40 percent in the 1970s, and finally reached a historic low of 23 percent in 1974. Since 1980, ratios have risen steadily. However, after the subprime housing crisis of 2007 and the ensuing financial collapse, they sharply increased.

The epochal "Growth in a Time of Debt" study, published in 2010, by Harvard economists Carmen Reinhart and Kenneth Rogoff, painted a bleak future for nations with high debt-to-GDP ratios.  5 A 2013 analysis of the study, however, uncovered coding mistakes and the deliberate omission of data, which allegedly caused Reinhart and Rogoff to draw incorrect conclusions.

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) Give a brief overview of the Romer growth model.

Ans) Romer's Endogenous Technological Change Model of 1990 identifies a research sector with a focus on idea generation. In order to generate ideas or new knowledge, this industry uses both human capital and the available body of knowledge. Romer values ideas more than natural resources. He uses Japan as an illustration, which has very limited natural resources but was receptive to new western concepts and technologies. As a result, this model not only captures endogenous growth but also has strong connections to developing nations

Romer contends that the level of a firm or industry determines the production processes. Every business operates in a market with perfect competition. This model matches perfect competition in this way, and up to this point, it closely resembles the Solow model's underlying assumptions. Romer, however, departs from Solow when he believes that the level of output at the industry level is positively influenced by the economy's stock of capital (K). At the industry level, this situation results in rising returns.

Romer accounts for knowledge level in the firm's capital stock. In essence, the knowledge component of the stock of capital is a public good (as it has been shown with A in the Solow model). This knowledge or information quickly jumps over to the other businesses. As a result, this model seeks to encourage learning through investment. As a result, the rate of economic growth in Homer's model is determined by the investment in learning or knowledge, whereas in the H-D model, the rate of economic growth is determined by the physical investment.

4) In the Solow model of economic growth, discuss the factors that determine long run living standard.

Ans) Solow considers an aggregate production function which defines the relationship between output (Y) and two inputs, viz., capital (K) and labour (L). In symbols, it is given by

𝑌 = 𝐸𝐹(𝐾, 𝐿)……………………….(I)

where E denotes the level of technology.

If the levels of the inputs (K and L) and the level of technology are constant in equation I output will be constant and there won't be any economic growth. Either input levels must rise, or technology must advance (i.e., there must be "technological progress" or "productivity growth"), or both, in order for output levels to increase. Thus, the two factors that contribute to output growth are I input growth and (ii) productivity growth. Solow asserts that there is a relationship between the rates of input growth, output growth, and productivity growth.

The "growth accounting equation" is what is known as equation (ii). Information on the sources of growth is usefully provided by growth accounting. However, it doesn't fully account for a nation's performance in terms of growth. Growth accounting cannot explain why capital and labour grow at the rates that they do because it assumes that the economy's rates of input growth are constant. While decisions made by households and businesses to save and invest lead to increases in capital stock, population growth is what drives increases in labour. Growth accounting paints a static picture by assuming that capital stock and labour are constant. The dynamics of economic growth, or how the growth process changes over time, is the subject of the following section.

Fundamental Determinants of Long-Run Living Standards

What determines how prosperous the typical person will be over time in an economy? The Solow model can be used to provide an answer. Here, we discuss the saving rate, population growth, and productivity growth as three variables that influence long-term living standards.

5) Bring out the salient features of new-classical macroeconomics.

Ans) The salient features of new classical economics are as follows:

Lucas Critique

Keynesian economics was at its height in the 1950s and 1960s, as was mentioned in the previous Unit. Policymakers thought they had a wide variety of options and had mastered the art of making policies. The 1970s stagflation, however, dashed such hope. Keynesian models were criticised by Robert Lucas because they lacked micro-foundations. These models are incredibly aggregative. When a policy is altered, the parameters of these models alter as well. Forecasts made using historical data are therefore invalid for these aggregative models.

Micro-foundations of Macroeconomics

All macroeconomic models, according to Lucas, ought to be based on micro foundations. Macroeconomic models should incorporate both the utility function of households and the production function of businesses. Let's go into more detail about this. Before households, there are two different types of trade-offs. One, there is a trade-off between spending and saving; less spending equals more saving. More money saved means more money in the future. Therefore, in a temporal framework, the decision between today's consumption and saving is the same as the decision between today's consumption and future consumption.

Given the level of expected income in the future and the real interest rate, households optimise their consumption and saving over time (i.e., intertemporal optimisation). Second, balancing work and leisure. More hours of work mean less time for leisure because there are only so many hours in a day. More time spent working equals a greater flow of income. Similar to this, businesses optimise their production choices over time based on the production function. When making production decisions, businesses take the expected rate of inflation and output gaps into consideration.

Continuous Market Clearing

The premise of new classical economists is that prices and wages are flexible. As a result, supply and demand are equal, and markets are always clear. Inconsistencies in the market are not possible, according to new classical economics.

Rational Expectations

The new classical theory assumes that economic actors have reasonable expectations. Economic agents consider all information available when forming expectations about economic variables like prices, inflation, and wages. As a result, there is no systematic error in forecasting, and over time, the actual value of a variable equals its expected value.

Assignment III

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

6) What are the various types of demand for money according to Keynes?

Ans) According to Keynes, when interest rates are higher, speculative demand for money is lower and when interest rates are lower, speculative demand for money is higher. The total demand for money is the sum of the transactional, preventative, and speculative demands.

Every person or economic agent needs money in liquid form to cover daily expenses like purchasing food, medications, transportation, and other necessities. The amount of cash one prefers to keep on hand in liquid form to cover daily expenses is determined by a person's annual personal income: the larger the income, the greater the need for money, and the number of pay days between payments: The less demand for money there is if payment is made daily

7) Explain the motives of holding inventory.

Ans) Inventory investment is defined as the net addition to the stock of inventories. Firms hold inventories for various reasons:

1. Production Smoothing: Short-term shocks to a representative firm's product demand are common. Businesses may use inventories to buffer against unplanned fluctuations in product demand. They prefer to maintain a steady rate of production rather than changing it to account for fluctuations. As a result, a business will use up its inventory during a boom and increase it during a downturn.

2. Production Scheduling: Inventories give multi-product firms the flexibility in scheduling production runs.

3. Reducing Delivery Lags: Inventory may stimulate a single firm’s demand by reducing delivery lags.

8) Bring out the important features of business cycles.

Ans) Business cycles have distinct phases like expansion, peak, recession, trough, and recovery even though they do not exhibit the same regularity. The cycle's length can range from two to twelve years. Business cycles run in unison. The majority of industries or economic sectors experience both depression and contraction at the same time. Recession spreads from one industry to the next in a chain reaction that lasts until the entire economy is affected. Similar to how industries or sectors are linked, expansion is spread through various channels.

The level of output, employment, investment, consumption, etc. all fluctuate at the same time. Investing and durable goods consumption are the two sectors most impacted by cyclical fluctuations. Keynes emphasised that because investment depends on private entrepreneurs' profit expectations, it is extremely unstable. Investments become unstable if these expectations change in any way. In the case of durable household effects, the amplitude of fluctuation is therefore greater than that of GDP.

9) Give a brief account of the policy lags that affect smooth functioning of the economy.

Ans) The impact of business cycles can be mitigated by the government by changing its spending, as was previously mentioned. Consequently, Keynesian economics suggests that the government should have a lot of latitude. However, due to some policy lags, the effect of variation in public investment to counter business cycles may not be effective. It takes some time for people to realise there is an economic problem when one arises.

Consider the scenario where inflation in the economy is about to rise. It's possible that policymakers won't be able to identify the issue right away. They might believe the price increase is due to seasonality, a supply shock, or another factor, and believe that market forces will be able to correct the situation. Furthermore, prior to acting, policymakers must receive the necessary approval. For instance, during the presentation of the annual budget, tax rates are typically changed.

10) Write a short note on the concept of Ricardian equivalence.

Ans) A government may spend more money than it brings in when it has a deficit budget. During this process, the government accrues debt that must be paid back later. The only way to make this repayment is by increasing individual tax rates. Therefore, a deficit budget implies that consumers are making a choice between their current and future consumption. We made the assumption that consumers are thoughtful and rational when dealing with the intertemporal consumption function in Units 5 and 6. When determining the level of current consumption, they take the income stream in the future into account. Since there isn't a clear and stable correlation between current consumption and current income in this framework, the Keynesian consumption function is unrealistic.