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# BECC-134 Solved Assignment Solution by Gyaniversity

Assignment Solution

Assignment Code: BECC-134 /ASST/ 2021-2022

Course Code: BECC-134

Assignment Name: Principles of Macroeconomics – II

Year: 2020-2021 (July 2021 and January 2022 Admission Cycles)

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) 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) There must be a single combination of interest rate and income level that fulfils the equilibrium in both the goods and money markets at the same time for simultaneous equilibrium in the goods and money markets. The IS and LM curves are superimposed in the diagram below. On the x-axis, we have income/output level (Y), and on the y-axis, we have interest rate I

The goods market and the money market are both clear at point E1 in the graph below. i1 is the equilibrium interest rate, and Y1 is the equilibrium level of income and output. It's important to remember that we're working with a fixed price level (P). As a result of the preceding, businesses are willing to supply any quantity of goods and services at that price. The economy is in equilibrium at E1 because both the goods and money markets are in balance. As a result, companies are willing to supply output at the Y1 level, and the equilibrium interest rate is i1. Firms are producing their expected output, and individuals are constructing their portfolios in accordance with their plans. There is no unintentional inventory increase or depletion.

Simultaneous Equilibrium in Goods and Money Markets

The equilibrium levels of income and interest rate will change if either of the two curves (IS and LM) changes. Shifts in the IS and LM curves, on the other hand, will have differing effects on equilibrium output and interest rate.

Shift in the IS Curve

In Fig. below we describe a situation where the IS curve shifts to the right. Let us consider the changes an economy goes through if such a shift takes place.

Shift in the IS Curve

Assume that investment in autonomous vehicles has increased. This causes an increase in autonomous spending(A), resulting in a simultaneous shift in the IS curve from IS1 to IS2. As a result, the equilibrium shifts from E1 to E2, indicating a greater equilibrium level of income and output, as well as a higher interest rate.

In Fig. above you can see that output increases from Y1 to Y2, and interest rate increases from i1 to i2.

Note that the extent of change in the level of income (= AG ^) is not the same as the extent of shift in the IS curve. This is because we are dealing with the money market also. Increase in Δ𝐴̅ leads to increase in income, which affects the demand for money. Supply of money remains fixed while the demand for money increases. Consequently, the rate of interest increases in the money market. This has a negative impact on the investment spending. As interest rate rises, investment falls to some extent. Hence, the final change in the income is less than 𝛼G Δ𝐴̅ .

Shift in the LM Curve

In Fig. below we describe a situation where the LM curve shifts to the right. Consider the changes an economy goes through if such a shift takes place

Shift in the LM Curve

Assuming that there is an increase in the money supply in the economy. Consequently, there is a right-ward parallel shift in the LM curve from LM1 to LM2. Consequently, the equilibrium changes from E1 to E2. As we can see from Fig. above, interest rate decreases from i1 to i2 while output level increases from Y1 to Y2.

Because we assume that the price level remains constant, an increase in the money supply leads to an increase in the supply of real balances, lowering the interest rate. A decrease in the rate of interest causes a rise in the amount of money invested in the economy, resulting in an increase in output.

Q2) Derive AD curve from the IS-LM model. What are the factors that lead to a shift in the AD curve?

Ans) The aggregate demand curve shows the inverse relation between the aggregate price level and the level of national income. Now establish this relation on the basis of the IS-LM model. Suppose we hold the nominal money supply constant. Now if the price level (P) rises, the supply of real money balances (M/P) falls. As a result, the LM curve shifts upwards to the left.

This leads to a rise in r and a fall in Y as shown in part (a) of Fig. 11.1.

We see that as the price level rises from P0 to P1 the income level falls to from Y0 to Y1. This inverse relationship between Y and P is captured by the aggregate demand curve, as shown in part (b) of Fig. 11.1.

Thus, the aggregate demand curve is a locus of points showing alternative combinations of P and Y that are consistent with the general equilibrium of the goods market and money market, i.e., equilibrium r and Y — shown by the intersection of the IS and LM curves.

The aggregate demand curve shifts due to any event that shifts the IS curve or the LM curve (when P remains constant). For instance, if M increases Y rises if P remains constant. As a result, aggregate demand curve shifts to the right as shown in part (a) of Fig. 11.2. The converse is also true. A fall in M reduces Y and shifts the aggregate demand curve to the left.

Similarly for a constant price level, an increase in G or a cut in T shifts the aggregate demand curve to the right, as shown in part (b) of Fig. 11.2. The converse is also true. A fall in G or an increase in T lowers Y or shifts the aggregate demand curve to the left.

If we repeat this for various levels of price, then we get several points indicating the intersection between price and output. If we join these points, we get the aggregate demand (AD) curve. So, the aggregate demand curve is downward sloping showing that if overall price level increases the total output in the economy falls and vice-versa. You should also note that all the points on the aggregate demand curve indicate equilibrium in the goods market as well as the money market (since these points are derived from the intersection of IS and LM curves). It means that if there is any point away from the AD curve then simultaneous equilibrium in both the markets does not exist.

Aggregate demand (AD) is the total amount of goods and services consumers are willing to purchase in a given economy and during a certain period. Sometimes aggregate demand changes in a way that alters its relationship with aggregate supply (AS), and this is called a "shift."

Since modern economists calculate aggregate demand using a specific formula, shifts result from changes in the value of the formula's input variables: consumer spending, investment spending, government spending, exports, and imports.

Main Points

1. Aggregate demand (AD) is the total amount of goods and services in an economy that consumers are willing to purchase during a specific time frame.

2. When aggregate demand changes in its relationship with aggregate supply, this is known as a shift in aggregate demand.

3. Aggregate demand consists of the sum of consumer spending, investment spending, government spending, and the difference between exports and imports.

4. When any of these aggregate demand inputs change, then there is a shift in aggregate demand.

### 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) Distinguish between demand pull and cost push inflation.

Ans Demand pull inflation arises when the aggregate demand becomes more than the aggregate supply in the economy. Cost pull inflation occurs when aggregate demand remains the same but there is a decline in aggregate supply due to external factors that cause rise in price levels.

Difference between demand pull inflation and cost push inflation

Key Differences Between Demand-Pull and Cost-Push Inflation

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.

Conclusion

Therefore, one can conclude with the above discussion the main reason for causing inflation in the economy is either by demand-pull or cost-push factors. It is often argued that which is the supreme factor for inflation, which one of the two-factor causes rise in the general price level for the first time. Experts hold that demand-pull factor the leading factor for inflation in any economy.

Q4) What is the significance of the traditional Phillips Curve? Why does the shape of the Phillips Curve change when we introduce expectations into our analysis?

Ans) The Phillips Curve is the graphical representation of the short-term relationship between unemployment and inflation within an economy. According to the Phillips Curve, there exists a negative, or inverse, relationship between the unemployment rate and the inflation rate in an economy.

Significance of the Phillips Curve

After the publication of “The General Theory” by John Maynard Keynes, most economists and policymakers believed that in order for the economy to grow, aggregate demand must be increased in the market. However, if policymakers stimulated aggregate demand using monetary and fiscal policy, the rise in employment and output was accompanied by a rapidly increasing price level. If policymakers then wanted to reduce inflation, then they would need to reduce output and employment in the short run.

In “Analytics of Anti-Inflation Policy,” Samuelson and Solow pointed out that Phillips Curve could be utilized as a tool by policymakers. The Phillips Curve shows the various inflation rate-unemployment rate combinations that the economy can choose from. After policymakers choose a specific point on the Phillips Curve, they can use monetary and fiscal policy to get to that point.

The Expectations-Augmented Phillips Curve

Monetary economist Milton Friedman chal­lenged the concept of stable relationship be­tween inflation and unemployment rates as shown in Fig. 4.5 below. Friedman argues that such trade-off, i.e., negative relationship between inflation rate and unemployment—may hold in the short period, but not in the long run. Price or inflation expectations influence the Phillips curve.

In other words, Phillips’s curve shifts or changes its position as expectations regarding price level change. If people expect that inflation in the coming period will per­sist, the Phillips curve will shift to the right or if inflationary expectations show a downward trend, the Phillips curve will then shift its po­sition to the left.

In the short run, Phillips’s curve may shift either to the right, or to the left if the relationship between these variables—infla­tion rate and unemployment rate—is not sta­ble or inflationary expectations are stable. In other words, if inflationary expectations are deemed to be stable, then there would not be any shift in the Phillips curve as such.

Regarding the shifting of the Phillips curve, Friedman considers influence of inflationary expectations. This is called the theory of ‘adap­tive expectations’—expectations that are al­tered or ‘adopted’ to experienced events. In the short run, people make incorrect expecta­tions of the price changes because of incom­plete information. That is why a trade-off re­lationship emerges.

But in the long run, ac­tual and expected price changes become equal as expectations regarding price changes be­come equal when expectations regarding price changes tend to become rational. This rational expectation’s view suggest that people guess future economic events rather correctly in the long run.

Thus, the impact of expectations, whether adaptive or rational, have an impor­tant bearing on the relationship between in­flation and unemployment rates. It is because of expectation; Friedman argues that there is no trade- off between inflation and unemploy­ment in the long run.

Q5) Explain why there could be a conflict between external and internal balance.

Ans) Countries frequently encounter policy dilemmas in which a strategy intended to address one issue exacerbates another. There is frequently a clash between the exterior and interior ideals of balance.

When the balance of payments is close to zero, there is an external balance. Otherwise, in the event of a net outflow, the central bank will deplete reserves, while in the event of a net inflow, reserves will be accumulated. When output is at full employment, internal balance exists. We can see the line BP = 0 in Fig. 10.5, which is generated from equation (10.19), and along which we have balance of payments equilibrium. The BP = 0 line is forced to be horizontal by our key assumption, which is perfect capital mobility. We can only have external balance if our interest rate is equivalent to that of the rest of the world: When domestic interest rates are higher, there is a massive inflow of capital, resulting in a capital account surplus and overall surplus.

On the other hand, if the local interest rate is lower than the foreign interest rate, the capital account deficit is unbounded.

Thus BP=0 must be flat at the level of world interest rates. Points above the BP=0 schedule corresponds to a surplus, and points below to a deficit. The full employment output level is Y*. Point E is the only point at which both internal balance and external balance are achieved. Point E1, for example, corresponds to a case of unemployment and a balance of payments deficit. Point E2, by contrast, is a case of deficit and over employment.

Figure 10.5 -  External vs. Internal Balance

Policy dilemmas can be described in terms of points in the four quadrants of Fig. 10.5. For example, at point E1, there is a balance of payments imbalance as well as unemployment. An expansionary monetary policy would address unemployment but exacerbate the balance of payments problem (a rightward shift of the LM curve would raise equilibrium output/employment while lowering the domestic rate of interest). Foreign investors will find it less profitable to invest in the domestic economy due to the lower domestic interest rate). The government would be able to finance its trade imbalance if it could find a method to raise interest rates. To attain external and internal balance, both monetary and fiscal measures would have to be utilised simultaneously.

Fig. above shows BP = 0 line along which we have Balance of Payments equilibrium. Points above the BP = 0 line correspond to a surplus and points below it to a deficit in BoP. The full employment output level is Y*.

### Assignment III

Answer the following Short Category Questions in about 100 words each. Each question

carries 6 marks. 5 × 6 = 30

Q6) Give a brief account of the factors lead to a shift in the aggregate supply curve.

Ans) Some of the factors that lead to a shift in the aggregate supply curve are described below:

1. Aggregate demand (AD) is the total amount of goods and services in an economy that consumers are willing to purchase during a specific time frame.

2. When aggregate demand changes in its relationship with aggregate supply, this is known as a shift in aggregate demand.

3. Aggregate demand consists of the sum of consumer spending, investment spending, government spending, and the difference between exports and imports.

4. When any of these aggregate demand inputs change, then there is a shift in aggregate demand.

Q7) Distinguish between nominal exchange rate and real exchange rate.

Ans) Nominal Exchange Rate: It refers to the price of foreign currency in terms of domestic currency. It shows the number of units of domestic currency one must give up getting a unit of foreign currency.

Real Exchange Rate: It refers to the relative price of foreign goods in terms of domestic goods.  In order to make a purchase, one should ideally consider the real exchange rate. Real exchange rate accounts for inflation and international competitiveness and will compare the prices of the 2 goods. An increase in the real exchange rate – that is, an increase in the relative price of domestic goods in terms of foreign goods – is called a real appreciation. A decrease in the real exchange rate – that is, a decrease in the relative price of domestic goods in terms of foreign goods – is called a real depreciation.

Q8) Explain the concept of stagflation.

Ans) Stagflation is a combination of the word’s stagnation and inflation. It describes an economic condition characterized by slow growth and high unemployment (economic stagnation) mixed with rising prices (inflation).

Stagflation is characterized by slow economic growth and relatively high unemployment—or economic stagnation—which is at the same time accompanied by rising prices (i.e., inflation). Stagflation can be alternatively defined as a period of inflation combined with a decline in the gross domestic product (GDP). Stagflation was first recognized during the 1970s when many developed economies experienced rapid inflation and high unemployment as a result of an oil shock.

Q9) In the IS-LM model, explain why the economy always moves towards the equilibrium point.

Ans) The LM curve, the equilibrium points in the money market, varies due to changes in money demand and supply. The interest rate is lower (higher) when the money supply increases (decreases), or the LM curve moves right (left). Because more money (less money) means a lower (higher) interest rate.

The LM curve will be affected by changes in money demand. Assume that stocks are riskier or that trading bonds costs more. The theory of asset demand predicts an increase in money demand (shift right). Interest rates could fall if money demand shifted left due to higher stock returns or lower risk bonds.

During panics, the LM curve shifts left, increasing interest rates and decreasing output as economic agents hunt for liquidity amid falling and volatile asset prices, particularly financial securities with positive default risk.

Q10) State the difference between absolute PPP and relative PPP.

Ans) Absolute PPP is an analysis metric used by macroeconomic analysts, that holds that exchange rates are in a state of balance when the worth of the national basket of products and services are similar amongst two states.

The PPP forecasts that market forces will lead to the exchange rate to regulate when the national basket prices are not equivalent.

Relative PPP is an economic theory in the macroeconomy that claims that exchange and inflation rates in two nations eventually equal time. This theory is not valid over short time durations. According to relative PPP, the variance between the inflation rates of two nations and the cost of commodities drives for variations in the exchange rate between the two countries.

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