Assignment Code: BECC-134 /TMA /2023-24

Course Code: BECC-134

Assignment Name: Principles of Macro Economics II

Year: 2023-24

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 causes and effects of inflation.

Ans) The prolonged increase in the general price level of goods and services in an economy over a period of time is referred to as inflation. Inflation is impacted by a number of different causes and has consequences that are diverse for individuals, businesses, and the economy as a whole.

Causes of Inflation:

a)     Demand-Pull Inflation: Occurs when aggregate demand surpasses the economy's ability to produce goods and services. Increased consumer spending, investment, or government expenditure without a corresponding increase in supply leads to rising prices.

b)     Cost-Push Inflation: Results from a reduction in the total supply as a consequence of an increase in the expenses of production. Supply can be reduced as a result of factors such as higher wages, rising prices of raw materials, or greater taxes, which can lead to an increase in pricing.

c)     Monetary Inflation: It is possible for central banks to implement expansionary monetary policies, which include expanding the money supply or decreasing interest rates, in order to boost borrowing and spending, which ultimately results in higher prices.

d)     Built-In Inflation: Results from expectations of future price increases. Workers demanding higher wages and businesses raising prices in anticipation of rising costs contribute to this cycle.

e)     Supply Chain Disruptions: It is possible for the availability of commodities to be restricted due to occurrences such as natural catastrophes, geopolitical tensions, or disruptions in global supply chains. This can result in scarcity and an increase in prices.

Effects of Inflation:

a)     Reduced Purchasing Power: Inflation erodes the value of money, reducing its purchasing power. Consumers find their income can buy fewer goods and services, impacting their standard of living.

b)     Uncertainty and Planning Challenges: High inflation rates make long-term financial planning difficult for individuals and businesses, leading to uncertainty about future prices and economic stability.

c)     Income Redistribution: Inflation can redistribute income and wealth, benefiting borrowers (as they repay loans in cheaper currency) and hurting fixed-income groups like retirees and savers.

d)     Impact on Interest Rates: Central banks might increase interest rates to combat high inflation, making borrowing more expensive, which can slow down economic growth.

e)     Cost-Push Effects on Businesses: Increasing production costs compel businesses to raise prices, which can have an effect on profit margins. Alternatively, they may be forced to reduce labour or output, which can have an influence on employment.

f)      International Competitiveness: When local prices increase at a quicker rate than those of trading partners, exports become more expensive, which in turn reduces a country's ability to compete in international markets.

g)     Hyperinflation and Economic Instability: An economic instability, a devaluation of the currency, and a loss of confidence in the monetary system are all potential outcomes that might result from hyperinflation, which is characterised by extremely high inflation rates.

Governments and central banks use various monetary and fiscal policies to manage inflation. Tools like controlling money supply, adjusting interest rates, fiscal austerity, and supply-side policies aim to maintain stable prices, balancing growth, and inflation. Understanding the causes and effects of inflation helps policymakers make informed decisions to maintain a stable economic environment.

Q1b) Give a brief account of cost of disinflation in the economy.

Ans) When the rate of inflation slows down, a phenomenon known as disinflation occurs. This occurs when prices continue to grow, but at a more gradual rate. A reduction in inflation may be advantageous for an economy; nevertheless, there are expenses involved with this process, including the following:

Unemployment:

a)     Real Wage Rigidity: The short increase in unemployment that can result from disinflation is a possibility. In order to retain their profitability, businesses could decide to lower their labour expenditures, which could lead to layoffs or a reduction in employment.

b)     Labor Market Frictions: Payroll and labour market adjustments are a process that takes time. As workers fight against wage cutbacks, frictional unemployment can occur, which can lead to an increase in unemployment rates until wages are brought in line with decreased inflation rates.

Output Loss:

a)     Decreased Demand: Inflationary policies have the potential to lower aggregate demand, which in turn can have an effect on consumer spending and investment. Because of this drop in demand, there is a possibility that output levels and economic growth would diminish.

b)     Lingering Effects: If the process of adjustment is protracted or if businesses delay investments due to uncertainty, disinflation may result in a prolonged period of output that is below its potential.

Debt Burden:

a)     Real Debt Costs: In the event that wages remain unchanged or decrease during a period of disinflation, the real value of debts will climb. It may be difficult for borrowers to repay debts, which can result in defaults on debt.

b)     Government Debt Servicing: There is a possibility that governments with fixed-rate debt will incur higher debt servicing costs in comparison to their declining income during periods of disinflation.

Financial Market Volatility:

a)     Interest Rate Uncertainty: It is possible that disinflation will cause uncertainty in the financial markets. It is possible for central banks to make changes to interest rates, which could result in market volatility and have an effect on bond prices as well as investment choices.

b)     Asset Price Corrections: There is a possibility that the financial markets will undergo corrections, particularly in assets whose valuations were inflated during times of higher inflation.

Social and Political Costs:

a)     Social Unrest: Societal discontent and demonstrations can be fuelled by factors such as rising unemployment, declining incomes, and economic instability.

b)     Political Challenges: There is a possibility that politicians will encounter opposition or criticism as a consequence of the effects of disinflationary actions on the economy.

Central Bank Credibility:

Credibility Risk: Central banks aiming to reduce inflation may risk their credibility if their policies do not effectively control inflation while causing economic hardships.

Structural Adjustment:

Sectoral Shifts: Disinflation might require structural changes in sectors accustomed to higher inflation, causing disruptions in industries dependent on inflationary conditions.

Disinflation can be necessary to maintain price stability and avoid the negative consequences of high inflation.

However, managing disinflationary policies requires careful balancing to mitigate its adverse impacts. Effective communication, gradual adjustments, targeted policy tools, and support mechanisms for affected individuals and sectors are essential in navigating the costs of disinflation while ensuring overall economic stability and growth.

Q2a.) Interpret the slope of an LM curve. What will happen when there is a decrease in money supply? Explain with the help of a diagram.

Ans) The LM equation, which is supplied by, can be utilised in order to ascertain the slope of the LM curve. This can be done under certain circumstances. When looking at the LM curve, the slope represents the change in interest rate that takes place as a consequence of a change in levels of income. This change is represented by the equation ∆𝑖-∆𝑦, where ∆ is a mathematical symbol that denotes a slight change in a variable. Thus,

Those of you who are already familiar with the idea of differentiation will discover that the slope of a curve can be determined by the first derivative of a function. When we take the partial derivative of the equation in such a way that,𝜕𝑖-𝜕𝑦.= 𝑘-ℎ, we are able to determine the slope of the LM curve.

From the equation, it is possible to draw the conclusion that the factor that controls the slope of the LM curve is the ratio of k to h in the equation.

As a result of the aforementioned, it can be deduced that the LM curve will be steeper when the responsiveness of the demand for money to income (k) is higher and the responsiveness of the demand for money to interest rate (h) is lower

Figure illustrates two different LM curves, each of which has a different slope. If there is a relatively low degree of sensitivity between the demand for money and the interest rate (that is, if h is close to zero), then the LM curve will take on a virtually vertical shape (, m minus 1). If, on the other hand, the demand for money is particularly sensitive to the interest rate (that is, if h is high), then the LM curve will be practically horizontal. This is because the interest rate impacts the demand for money (where n is a negative number).

Q2b.) Derive the aggregate demand curve with the help of IS-LM analysis.

Ans) Within the framework of that model, the level of output that was considered to be in equilibrium was determined by the intersection of the 450 line and the aggregate spending (C+I+G). We presumed that there would be no change in the pricing level. This meant that real expenditure was the same as aggregate expenditure.

Consider the Following Scenario: there is an increase in the price level (P), which leads to an increase in the demand for money. This causes the money demand curve to move to the right, which in turn causes there to be an excessive demand for money at the interest rate that is now in place. For the purpose of determining the aggregate demand curve, it is necessary to return to the demand for money curve.

According to our understanding, the money demand curve will move to the right if there is an increase in output Y. It may be deduced from the information presented above that there has been an increase in the interest rate (r). In the event that Y is reduced, the operation is carried out in the opposite direction.

The demand for money is dependent on Y, as we can see from this. When using the money demand model, it is important to keep in mind that the demand for money is dependent on nominal income (PY) as well as the interest rate (r). We made the assumption that P would remain unchanged, which resulted in a rise in nominal income because of an increase in real income (Y) (PY).

According to what you are aware, there are two methods in which nominal income (Y) can increase: either through an increase in real income (Y) or through an increase in price level (P). As was said earlier, an increase in nominal income causes the money demand curve to move to the right, which ultimately results in an increase in the interest rate.

It is therefore possible to assert that an increase in P causes the money demand curve to shift to the right, provided that Y remains unchanged.

Recall that fiscal policy variables of an economy are government expenditure and tax rate. Similarly, money supply is a monetary policy variable. In the money demand analysis, we assumed that fiscal and monetary policy variables, viz., government expenditure (G), taxes (T) and money supply (Ms) are constant. It implies that the government does not take any action to influence the economy when the price level changes.

Changes occur in the pricing level. Suppose there is an increase in the level of prices (P), which results in an increase in the amount of money that is considered to be nominal. A consequence of this is that there is a rise in the need for monetary resources.

During this time period, the money demand curve moves to the right. to  . It results in an excessive demand for money at the interest rate that is currently in place . We are operating under the assumption that the money supply() the rate of interest will remain constant in order to ensure that the new equilibrium in the money market will be re-established at a higher rate ().

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) What are the different kinds of exchange rate regimes? State the difference among them.

Ans) Exchange rate regimes define the framework through which a country manages its currency's value concerning other currencies or goods. The primary types of exchange rate regimes include:

Floating Exchange Rate:

a)     Definition: This system bases currency values on foreign exchange market supply and demand.

b)     Characteristic: The currency fluctuates freely, allowing economic conditions to affect it without central bank involvement.

c)     Example: The U.S. dollar operates under a floating exchange rate system.

Fixed Exchange Rate:

a)     Definition: Under this regime, a country fixes its currency's value to a specific standard, such as another currency, an asset, or a basket of currencies.

b)     Characteristic: The central bank buys and sells its currency at a fixed price to maintain the exchange rate against the chosen standard.

c)     Example: China's currency operates under a fixed exchange rate system against the U.S. dollar.

Managed Floating Exchange Rate:

a)     Definition: This system involves influencing exchange rates without specific targets, utilizing indicators like balance of payments, reserves, and market developments.

b)     Characteristic: The central bank intervenes in the foreign exchange market based on judgmental indicators, allowing adjustments through direct or indirect intervention.

c)     Example: The Reserve Bank of India follows a managed floating exchange rate system.

The differences among these regimes lie in how a country manages its currency's value:

a)     Floating allows currency values to fluctuate freely based on market forces.

b)     Fixed pegs the currency's value to a specific standard, maintaining a constant rate.

c)     Managed Floating involves influencing exchange rates without specific targets, using judgmental indicators to guide interventions without a fixed exchange rate.

Q4) Derive the IS curve with the help of the Keynesian cross. Which factors affect the position of an IS curve.

Ans) At the Keynesian cross, aggregate demand (AD) equals national income (Y). It ignores interest rates and concentrates on income's effect on consumption. The IS curve adds interest rate-based investment decisions.

Start with the Keynesian Cross:

Plot the 45-degree line (Y = AD) and the aggregate expenditure (AE) curve, considering only consumption (C) and government spending (G). The intersection of these curves determines the equilibrium (Y*, AD*).

Introduce Investment (I):

Add the investment function (I) to the AE curve, creating a new AE' curve that includes both C and I .Remember, investment depends negatively on the interest rate (r).

Shift the AE' curve based on r:

Investment drops with interest rates, moving the AE' curve left. Investment rises with decreasing interest rates, moving the AE' curve right.

Trace the possible intersections:

For each interest rate, find the new equilibrium where AE' intersects the 45-degree line.

Connect the equilibrium points:

Plot the resulting equilibrium points (Y, r) across different interest rates.

This curve connecting all equilibrium points is the IS curve.

Factors affecting the position of the IS curve:

a)     Autonomous Spending (G): Government spending raises the IS curve by shifting the AE' curve right (higher equilibrium output for all interest rates).

b)     Taxes (T): Higher taxes reduce disposable income and consumption, pushing the AE' curve left and decreasing the IS curve.

c)     Expected Future Income: Positive future income expectations stimulate current consumption, pushing the AE' curve rightward and raising the IS curve.

d)     Marginal Propensity to Invest (MPI): Firms' sensitivity to interest rates in investment decisions affects the slope of the IS curve. Higher MPI leads to a flatter IS curve (larger shifts in output for changes in interest rates).

Q5) How do you reconcile the vertical long run Phillips curve with the downward sloping short run Phillips curve? Explain with the help of a diagram.

Ans) The existence of both a downward-sloping short-run Phillips curve (SRPC) and a vertical long-run Phillips curve (LRPC) is a key paradox in macroeconomics.

Short-Run Phillips Curve:

Shows a negative relationship between unemployment and inflation. In the short run, unexpected decreases in unemployment can lead to temporarily higher inflation due to:

a)     Wage-Price Spiral: Workers with higher wages demand higher prices, and firms pass on costs to consumers.

b)     Increased Aggregate Demand: Lower unemployment boosts spending, putting upward pressure on prices.

Long-Run Phillips Curve:

Shows a vertical line at the natural rate of unemployment (NRU), where there is no trade-off between unemployment and inflation. In the long run:

a)     Inflation Expectations Adjust: Workers and firms anticipate any policy-induced changes in unemployment and adjust wages and prices, accordingly, negating the short-run trade-off.

b)     Resource Utilization Remains at Long-Run Equilibrium: The economy settles at the NRU, where labour supply and demand balance.

Imagine two SRPCs, SRPC1 and SRPC2. Initially, the economy operates at point A on SRPC1 with high unemployment and low inflation. A government policy like expansionary fiscal spending might temporarily reduce unemployment to point B, but inflation rises due to the short-run Phillips curve relationship.

However, in the long run, inflation expectations will adjust, and the economy will gradually shift vertically to point C on the LRPC, where inflation returns to the natural rate even with lower unemployment. Any attempt to further reduce unemployment below the NRU (e.g., moving to point D on another SRPC) will trigger even higher inflation, eventually forcing the economy back to the LRPC at point C.

ASSIGNMENT THREE

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

Q6i) Differentiate between adaptive expectations and rational expectations.

Ans)The difference between adaptive expectations and rational expectations:

Q6ii) Absolute and relative purchase power parity.

Ans) Absolute Purchasing Power Parity (PPP) asserts that in the absence of transportation costs and barriers, identical goods should have the same price when expressed in a common currency. It implies that the exchange rate between two currencies should equal the ratio of their price levels.

Relative Purchasing Power Parity emphasizes the change in exchange rates over time due to inflation. It suggests that the change in the exchange rate between two currencies will approximately equal the difference in their inflation rates over a certain period. Essentially, this concept states that the exchange rate adjusts to reflect the change in relative price levels between two countries.

Q7) Do you agree with the statement ‘Balance of Payments always balances” Comment.

Ans) The statement "Balance of Payments always balances" is a bit misleading. While the Balance of Payments (BoP) accounts should technically sum to zero due to the accounting principles (since every transaction has a corresponding entry), in practice, imbalances can occur.

These imbalances can be caused by errors, omissions, or statistical discrepancies in the recorded transactions. Additionally, under floating exchange rates, it is typical for BoP accounts not to perfectly offset each other due to various factors like speculative capital flows, which can lead to temporary imbalances. Hence, while the BoP is a comprehensive record of a country's economic transactions, certain factors can result in discrepancies that prevent it from perfectly balancing at all times.

Q8) Explain asset market approach to Exchange rate determination.

Ans) The asset market approach to exchange rate determination focuses on how financial assets influence exchange rates. It emphasizes supply and demand for financial assets, including bonds and stocks, influencing currency demand. If investors anticipate higher returns in a country, they demand more of its currency, increasing its value. Expectations, interest rates, risk, and economic indicators impact asset preferences, thereby affecting currency demand and exchange rates. By including financial markets into the process of currency assessment, this approach considers exchange rates to be reflections of investors' perceptions of the economic health of a country as well as their expectations regarding future events.

Q9) Explain Non-Accelerating Inflation rate of Unemployment?

Ans) The Non-Accelerating Inflation Rate of Unemployment (NAIRU) refers to the unemployment rate at which inflation remains stable over time. Operating like an economic equilibrium point, it suggests that below this unemployment rate, inflation tends to rise, while above it, inflation decreases. NAIRU implies a natural rate of unemployment influenced by structural and frictional factors in the economy. This concept is frequently utilised by policymakers in order to determine the level of unemployment that provides a balance between inflationary pressures and the conditions of the labour market. This balance is necessary in order to ensure that prices remain stable, and that economic growth is sustainable.

Q10) Why does aggregate demand curve slope downward?

Ans) The aggregate demand curve slopes downward due to the inverse relationship between the price level and the quantity of real GDP demanded in an economy. As the price level drops, consumer purchasing power increases, leading to higher spending on goods and services. This price decrease also encourages investments due to lower borrowing costs and stimulates exports as domestic products become more competitive. Consequently, a decline in the price level typically results in an increase in aggregate demand, driving the economy toward higher levels of output and employment. Conversely, an increase in prices reduces consumer spending power, lowering overall demand for goods and services.