Assignment Code: BECC-133 /TMA /2023-24

Course Code: BECC-133

Assignment Name: Principles of Macroeconomics-I

Year: 2023-2024

Verification Status: Verified by Professor

ASSIGNMENT ONE

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

Q1a) Explain the changes in the consumption function when government sector is introduced in the National income model.

Ans) The introduction of the government sector in the national income model leads to notable changes in the consumption function, altering the dynamics of the overall economy. The consumption function represents the relationship between aggregate consumption and disposable income. When the government is incorporated, it introduces additional components and influences on the economy, impacting consumption patterns.

Disposable Income and Consumption:

In the presence of the government sector, disposable income now includes not only personal income but also transfers from the government (like social security benefits, unemployment benefits, etc.).

Consumption is influenced by both personal income and government transfers. The total disposable income is the sum of personal income and government transfers.

Taxation:

Government plays a crucial role in taxation. Taxes are deducted from personal income to calculate disposable income.

The level of taxation affects disposable income and, consequently, consumption. Higher taxes result in lower disposable income and vice versa.

Government Expenditure:

The government engages in various forms of expenditure, such as infrastructure development, defense, education, and healthcare.

Government expenditure directly contributes to the overall income and employment in the economy, influencing the level of disposable income.

Induced Consumption:

Changes in disposable income due to variations in personal income, taxes, or government transfers lead to induced changes in consumption.

The marginal propensity to consume (MPC) reflects the proportion of any change in income that is spent on consumption. It includes both induced and autonomous consumption.

Autonomous Consumption:

Autonomous consumption represents the part of consumption that does not depend on the level of income. It includes basic necessities that individuals and households must consume regardless of income changes.

The introduction of government transfers may contribute to autonomous consumption as individuals may spend a portion of these transfers on necessities.

Multiplier Effect:

Government expenditure contributes to the multiplier effect. An increase in government spending leads to an increase in income, which, in turn, leads to increased consumption.

The multiplier effect highlights the magnified impact of changes in autonomous spending on the overall economy.

Equilibrium Level of Income:

The equilibrium level of income is determined by the equality of aggregate expenditure and income. Government expenditure, along with consumption and other components, contributes to this equilibrium.

Equilibrium occurs when aggregate expenditure equals aggregate income, considering the influence of government.

Fiscal Policy:

Government adjusts its fiscal policy, including taxation and spending, to achieve macroeconomic goals like full employment, price stability, and economic growth.

Changes in fiscal policy can have direct implications for the consumption function, influencing disposable income and consumption patterns.

Q1b) How does Aggregate Demand curve changes when there is change in government spending? Does it also change equilibrium level of income and output?

Ans) Changes in government spending can have a significant impact on the Aggregate Demand (AD) curve and, consequently, the equilibrium level of income and output in an economy. Understanding these dynamics is crucial for analyzing the effects of fiscal policy on overall economic activity.

Aggregate Demand Curve:

The Aggregate Demand curve represents the total quantity of goods and services demanded at different price levels in an economy. It is composed of four components: consumption (C), investment (I), government spending (G), and net exports (exports minus imports, denoted as NX). The AD curve is expressed as AD = C + I + G + NX.

Effect of Change in Government Spending:

When there is a change in government spending, it directly affects the 'G' component of the AD curve. An increase in government spending leads to an upward shift in the AD curve, while a decrease results in a downward shift.

Increase in Government Spending:

An increase in government spending stimulates economic activity. It directly adds to the total demand for goods and services.

This upward shift in the AD curve leads to higher aggregate demand at every price level.

As a result, firms experience increased demand for their products, leading to higher production levels and potentially higher employment.

Decrease in Government Spending:

A decrease in government spending has the opposite effect. It reduces total demand for goods and services.

The AD curve shifts downward, reflecting lower aggregate demand at each price level.

Firms may experience reduced demand, leading to lower production levels and, potentially, lower employment.

Equilibrium Level of Income and Output:

The equilibrium level of income and output occurs where aggregate demand equals aggregate supply in the economy. This equilibrium is determined by the intersection of the AD curve and the Short-Run Aggregate Supply (SRAS) curve.

Increase in Government Spending:

An increase in government spending raises the AD curve, leading to a new equilibrium with higher income and output levels.

The multiplier effect amplifies the impact of the initial increase in government spending, as higher incomes result in increased consumption and further rounds of spending.

Decrease in Government Spending:

A decrease in government spending lowers the AD curve, leading to a new equilibrium with lower income and output levels.

The multiplier effect can also work in the opposite direction, causing a reduction in incomes, consumption, and overall economic activity.

Overall Impact on the Economy:

Positive Multiplier Effect: Increased government spending can lead to a positive multiplier effect, stimulating economic growth and potentially reducing unemployment.

Negative Multiplier Effect: Decreased government spending can lead to a negative multiplier effect, contributing to economic contraction and potentially increasing unemployment.

Q2a) What are the precautions taken while calculating National income by value added method and income method?

Ans) When calculating national income by the value-added method and income method, several precautions are taken to ensure accuracy and reliability in the measurements. These precautions help in avoiding double counting and ensure that all economic activities are appropriately accounted for. Below are some key precautions taken in both methods:

Precautions in the Value-Added Method:

Avoiding Double Counting: One of the primary precautions is to avoid double counting of intermediate goods and services. This is achieved by considering only the value added at each stage of production. Value added is the difference between the value of outputs and the value of intermediate inputs.

Including Only Final Goods and Services: Only the value of final goods and services is included in the calculation to prevent duplication of value. Intermediate goods and services, which are used as inputs for further production, are excluded.

Identifying Production Boundaries: Clear delineation of production boundaries is necessary to determine which economic activities should be included in the calculation. Activities such as household production and informal sector activities might need special attention to ensure they are appropriately captured.

Precautions in the Income Method:

Avoiding Transfer Payments: Transfer payments, such as social security benefits and unemployment benefits, are excluded from the calculation to avoid overestimation of national income. These payments do not represent productive economic activity.

Accounting for Depreciation: Depreciation of capital assets must be accurately accounted for to reflect the true income earned by factors of production. Gross national income is adjusted by subtracting depreciation to arrive at net national income.

Including All Forms of Income: All forms of income, including wages, rents, interests, and profits, must be included to ensure comprehensive coverage of income generated within the economy.

Adjusting for Indirect Taxes and Subsidies: Indirect taxes such as sales taxes and subsidies are adjusted to arrive at the net income received by factors of production. This adjustment ensures that only the income generated from productive activities is included.

Overall, adherence to these precautions ensures that national income calculations accurately reflect the economic activities and income generation within a country, providing valuable insights for economic analysis and policy formulation.

Q2b) Calculate Net Domestic income.

Ans)

Calculating Net Domestic Income

Based on the provided particulars, here's how to calculate the Net Domestic Income (NDI):

Formula:

NDI = ∑ Income Components - (Consumption of Fixed Capital + Subsidies)

Step 1: Sum the Income Components:

Compensation of employees: ₹2,000 crores

Rent and interest: ₹800 crores.

Indirect taxes: ₹120 crores

Corporation tax: ₹460 crores

Dividend: ₹940 crores

Undistributed profits: ₹300 crores

Net factor income from abroad: ₹150 crores

Mixed Income: ₹200 crores

Total Income = ₹5,970 crores

Step 2: Subtract Consumption of Fixed Capital and Subsidies:

Consumption of fixed capital: ₹100 crores

Subsidies: ₹20 crores

Total Deductions = ₹120 crores

Step 3: Calculate NDI:

NDI = ₹5,970 crores - ₹120 crores

NDI = ₹5,850 crores

Therefore, the Net Domestic Income in this scenario is ₹5,850 crores.

ASSIGNMENT TWO

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

Q3) Derive the labour demand and labour supply curves. Explain the relationship of labour with output in the short run as per classical view.

Ans) Labour Demand and Supply Curves:

Labour Demand Curve:

Downward sloping

Higher wages decrease quantity demanded (substitution effect)

Factors affecting slope: productivity, technology, product price

Labour Supply Curve:

Upward sloping

Higher wages increase quantity supplied (income effect)

Factors affecting slope: population, leisure preference, non-labour income

Equilibrium:

Intersection of curves determines equilibrium wage and employment

Graph:

Classical View on Labour and Output in the Short Run:

Supply-side focused: Output determined by available labour, not demand

Diminishing Marginal Returns: Each additional unit of labour adds less output than the previous

Fixed wage rate: Wages determined by subsistence level

Short-run flexibility: Businesses can adjust output by changing labour

Relationship:

Positive, but with diminishing returns

Short run: Increasing labour increases output, but at a decreasing rate

Long run: Output limited by other factors (capital, technology)

Limitations:

Ignores demand

May not hold in modern economies with flexible wages

Q4) Explain the following:

a) Stock and Flow

Ans) In economics, "stock" and "flow" are terms used to differentiate between variables that are measured at a specific point in time (stock) and those measured over a period (flow). These concepts are crucial for understanding economic dynamics and analyzing various economic phenomena.

Stock:

A stock represents a quantity that is measured at a specific point in time. It is analogous to a snapshot or inventory at a particular moment. Examples of economic stocks include the total money supply in an economy, the amount of capital goods, or the existing level of debt.

Example: The total amount of money held in bank deposits as of December 31st.

Flow:

A flow represents a quantity that is measured over a period of time. It is a rate of change or movement. Flows can be inflows or outflows. Examples of economic flows include the annual income of households, the rate of investment, or the flow of goods and services in the Gross Domestic Product (GDP).

Example: The monthly income earned by an individual.

Relationship:

Stocks can change through flows. For instance, savings (stock) can increase through the flow of income saved over time. Similarly, the stock of capital in an economy can change through the flow of investment.

Equation:

The relationship between stocks and flows can be expressed using an equation: Stock at Time t = Stock at Time t-1 + Inflows - Outflows. This equation reflects how stocks accumulate or deplete over time through various inflows and outflows.

Dynamic Analysis:

Understanding both stocks and flows is crucial for dynamic analysis in economics. It helps economists and policymakers analyze changes over time, make predictions, and formulate policies that consider the accumulation and movement of economic variables.

Policy Implications:

Policymakers often focus on both stocks and flows to design effective economic policies. For instance, managing the money supply involves understanding the existing stock of money and adjusting the flows (monetary policy) to achieve economic objectives.

Investment and Depreciation:

In the context of capital goods, the stock represents the existing capital stock, while the flow is the investment in new capital goods minus the depreciation of existing ones. This dynamic relationship influences the overall productive capacity of an economy.

b) Measures of Money supply in India.

Ans) In India, the money supply is categorized into various measures, known as money aggregates or M-money. The Reserve Bank of India (RBI) monitors these measures to analyse and regulate the money supply in the economy. The primary measures of money supply in India are:

M0 (Reserve Money):

M0, also known as reserve money or high-powered money, represents the total currency in circulation (including currency with the public and cash in banks' vaults) and the deposits that commercial banks hold with the central bank (RBI). It is the most liquid form of money and serves as the basis for other measures.

M1 (Narrow Money):

M1 includes M0 and demand deposits of the banking sector. It represents the most liquid assets available for transactions. M1 provides a broader measure of money compared to M0 as it includes demand deposits held by the public and businesses in commercial banks.

M2:

M2 includes M1 and savings deposits with the banking sector. It represents a broader measure of money supply and includes assets that are less liquid than those in M1. Savings deposits are interest-bearing and have certain withdrawal restrictions.

M3 (Broad Money):

M3 is the broadest measure of money supply and includes M2 along with time deposits with the banking sector. Time deposits have a fixed tenure, and individuals receive interest upon maturity. M3 represents the total money available in the economy for various purposes.

M4:

M4 is an additional measure that includes all components of M3 along with certificates of deposit (CDs) issued by banks. CDs are negotiable instruments with a fixed maturity period and are typically issued by scheduled banks.

These measures of money supply are essential for the RBI in formulating monetary policies and regulating the money flow in the economy. The central bank uses various tools, such as open market operations, reserve requirements, and policy rates, to manage money supply and control inflation.

c) Production possibility curve.

Ans) A Production Possibility Curve (PPC), also known as a Production Possibility Frontier (PPF), is a graphical representation that illustrates the maximum output combinations of two goods or services an economy can produce, given its level of technology and available resources.

Scarcity and Choice:

The PPC assumes that resources are limited, leading to the necessity of making choices about what to produce. It highlights the concept of scarcity.

Two Goods or Services:

The curve typically depicts the trade-off between two goods or services. For instance, consider a simplified scenario with guns and butter, where the economy must decide how many resources to allocate to each.

Opportunity Cost:

The slope of the PPC represents the opportunity cost of producing one good in terms of the other. As more resources are devoted to producing one good, the opportunity cost of not producing the other increases.

Efficiency and Inefficiency:

Points on the PPC indicate efficient resource allocation where the economy is using all available resources. Points inside the curve represent underutilization of resources, while points outside the curve are unattainable with the current resources.

Law of Increasing Opportunity Cost:

The concave shape of the PPC reflects the law of increasing opportunity cost. As an economy specializes in the production of one good, the opportunity cost of producing additional units of that good increases.

Shifting the Curve:

Changes in technology, resources, or efficiency can lead to shifts in the PPC. An outward shift indicates economic growth and increased production possibilities, while an inward shift may result from factors like resource depletion or inefficiency.

Full Employment:

The PPC assumes full employment of resources. Changes in the quantity or quality of labor, capital, or technology can impact the position of the curve.

Unattainable Points:

Points outside the PPC are unattainable with the current resources and technology. Points inside the curve suggest an inefficient use of resources.

d) Liquidity preference curve.

Ans) The Liquidity Preference Curve is a concept in Keynesian economics that represents the relationship between the interest rate and the quantity of money demanded by individuals for speculative purposes. Proposed by John Maynard Keynes, this curve is a key element in his theory of interest and money.

Three Motives for Holding Money:

Keynes identified three motives for holding money: transactions motive (to facilitate everyday transactions), precautionary motive (as a reserve for unforeseen contingencies), and speculative motive (to take advantage of expected changes in the interest rate).

Speculative Motive:

The Liquidity Preference Curve focuses on the speculative motive, which arises from the expectation that the interest rates may change. Investors hold money instead of interest-earning assets when they anticipate a fall in bond prices and an increase in interest rates.

Inverse Relationship:

The Liquidity Preference Curve depicts an inverse relationship between the interest rate (on the vertical axis) and the quantity of money demanded for speculative purposes (on the horizontal axis). As interest rates rise, the quantity of money demanded for speculative purposes decreases, and vice versa.

Shape of the Curve:

The curve is typically drawn as downward-sloping, indicating that individuals demand more money for speculative purposes when interest rates are lower. This reflects the trade-off between the opportunity cost of holding money (foregoing interest income) and the expected capital gains or losses on interest-earning assets.

Factors Influencing the Curve:

Shifts in the Liquidity Preference Curve can be influenced by changes in expectations about future interest rates, risk perceptions, and overall economic conditions. Positive expectations about falling interest rates may shift the curve to the right, indicating a higher quantity of money demanded at each interest rate.

Interaction with the Money Supply and Interest Rate:

The Liquidity Preference Curve, when combined with the Money Supply Curve, helps determine the equilibrium interest rate in the money market. The intersection of the Liquidity Preference Curve and the Money Supply Curve establishes the equilibrium interest rate and the corresponding quantity of money held for speculative purposes.

Q5a) Differentiate between economic growth and economic development.

Ans) Differentiate between economic growth and economic development are:

Q5b) Differentiate between money flow and real flow.

Ans) Differentiate between money flow and real flow are:

ASSIGNMENT THREE

Answer the following Short Category questions in about 100 words each. Each question carries 6 marks.

Q6) What is investment multiplier? Find out the value of investment multiplier if mpc=0.6

Ans) The investment multiplier measures the extent to which an initial increase in investment spending leads to an even larger increase in total spending and income within an economy.  It's like a ripple effect, where one injection of spending creates multiple rounds of spending and income generation.

Here's the formula:

Multiplier (k) = 1 / (1 - MPC)

MPC stands for Marginal Propensity to Consume, which is the fraction of each additional dollar of income that is spent on consumption.

If MPC = 0.6, then the investment multiplier is:

k = 1 / (1 - 0.6) = 1 / 0.4 = 2.5

This means that an initial increase in investment spending of $1 will lead to a total increase in spending and income of $2.50.

Q7) Explain how equilibrium is attained in the money market. How does an increase in nominal income affect the money market equilibrium?

Ans) Equilibrium in the money market is achieved when the quantity of money demanded equals the quantity of money supplied. The interest rate adjusts to balance the demand for money (motivated by transactions and precautionary motives) with the money supply (determined by the central bank).

An increase in nominal income typically leads to an increased demand for money due to higher transactions. To restore equilibrium, the interest rate rises, making holding money more costly, and individuals adjust their portfolios. This process continues until a new equilibrium is reached, ensuring that money demand matches the increased money supply associated with higher nominal income.

Q8) Explain Keynesian theory of demand for money.

Ans) Keynesian theory of demand for money, formulated by John Maynard Keynes, asserts that individuals hold money for three main motives: transactions, precautionary, and speculative.

Transactions Motive: People hold money for daily transactions, facilitating the exchange of goods and services.

Precautionary Motive: Money is kept as a precaution for unforeseen expenses or emergencies.

Speculative Motive: Individuals may hold money instead of investing it, anticipating future opportunities for profitable investments.

The total demand for money is the sum of these motives. Keynes argued that the interest rate influences the speculative motive, and changes in interest rates can affect the overall demand for money in the economy.

Q9) Explain how is equilibrium output determined in an open economy?

Ans) Equilibrium output in an open economy results from the balance between aggregate demand (AD) and aggregate supply (AS), considering both domestic and external factors:

AD: Includes domestic spending (consumption, investment, government) and net exports. Higher exports and lower imports boost AD.

AS: Similar to a closed economy, influenced by domestic factors like resource availability and technology. However, international trade factors like foreign price levels and exchange rates can also impact production costs and competitiveness.

Equilibrium occurs at the point where total spending (AD) equals total output (AS). Shifts in either curve due to domestic or external factors (e.g., changes in foreign demand, exchange rate fluctuations) can disrupt equilibrium, leading to changes in output and trade balance.

Q10) Discuss various instruments of monetary policy.

Ans) Monetary policy employs several instruments to regulate the money supply and achieve economic objectives. Key instruments include:

Open Market Operations (OMO): Central banks buy or sell government securities to control the money supply.

Discount Rate: The interest rate at which commercial banks borrow from the central bank influences lending and borrowing activities.

Reserve Requirements: Central banks mandate the percentage of deposits that banks must hold as reserves, affecting their lending capacity.

Forward Guidance: Central banks communicate future policy intentions to guide market expectations.

Quantitative Easing (QE): Large-scale purchases of financial assets to inject money into the economy during crises.