Assignment Code: MEC-002/TMA/2022-23

Course Code: MEC-002

Assignment Name: Macroeconomic Analysis

Year: 2022-2023

Verification Status: Verified by Professor

Answer all the questions.

Section A

Answer the following questions in about 700 words each. 20x2

Q1) Explain the concept of steady state growth in the Solow model with appropriate diagram. Show that the golden rule of Phelps is not a steady state.

Ans) According to the Solow model, existing capital depreciates at a rate of . Thus, each year K amount of capital is depreciated. The expansion of the capital stock is the net result of the opposing effects of investment and depreciation.

From Eq.(1) we infer that capital stock rises when  falls when  and remains constant when

The figure below depicts Eq.(1) graphically:

The two curves, saving and depreciation curves, intersect at point X, where capital stock is k* and depreciation equals investment. At this point there is no growth in capital. stock hence output also remains steady. k* is therefore known as the steady state level of capital. The steady state has two distinctive characteristics:

1. Until some other variable changes, the economy will continue in a stable state.

2. The economy will always tend to stabilise.

For example, if the economy starts at k1 level of capital, where k1 < k*, investment exceeds depreciation. As a result, capital stock k, along with output f(k) rises till k reaches k*. On the other hand, if the economy starts at k2 level of capital, which is greater than k*, investment is less than depreciation. Consequently, there is a decline in capital stock and output in the economy until steady state capital, that is, k* is reached.

Once the economy reaches its steady state, there is no longer any demand for k to rise or fall, therefore the economy remains there. Solow's model cannot account for long-term economic growth. In comparison to a nation with a low rate of saving, an economy with a high rate of saving will have higher levels of output and capital. Savings rate is crucial in determining an economy's capital and production. This helps to explain the gap in productivity between nations to some extent. The development of financial markets, tax laws, cultural differences, retirement plans, political stability, and political institutions are just a few of the many factors that might cause savings rates to differ between nations.

The correlation between high saving/investment rates and high levels of income per person is supported by empirical evidence provided by Mankiw when comparing income per person with investment as a proportion of output for 84 nations. He does, however, bring up the example of Mexico and Zimbabwe, which have comparable investment rates yet Mexico's per-person income is triple that of Zimbabwe's. This raises the question of whether there are other possible factors that affect living standards in addition to saving and investing. Below, we examine two of them: population growth and technological change.

The golden rule of Phelps is not a steady state:

Let us assume that saving rate rises while , , and  remain unchanged. Since  there will be higher investment which in turn will lead to capital accumulation and output growth and the economy will eventually reach to a new steady state with higher capital and output.

When saving rate rises from s1 and s2 the investment curve shifts up from s1f(k) to s2f(k). Thus, the economy reaches a new steady state  after going through the process of capital accumulation as described above.

We may conclude from this that a high rate of saving is always advisable because it increases capital stock and output. We can believe that if we save 100% of our income, the economy will have the highest output and capital stock. Different stable states are reached at different values of "s" with differing rates of capital accumulation. The "golden rule level of capital" is the degree of capital accumulation that is considered to be ideal.

The level of s at the amount of capital described by the golden ratio is such that at steady state, consumption per effective labour is at its highest. This is thus because the people who make up the economy don't care about its entire production or capital stock. The volume of output that they consume is what matters to them. The optimum steady state, known as the "golden rule level," is the one that maximises consumption per unit of effective labour.

The income (which is equal to output) is allocated on consumption and saving (which is equal to investment), that is, Y = C + 1. Steady state consumption is output net of investment.

Thus,

c* = y* - i*

We can write the above as,

C* = f(k*) – (n+g+δ)k*                                                         Eq.(2)

Increasing steady state capital has a conflicting impact on steady state consumption since it increases output, which boosts consumption but also raises break-even investment (n+g+δ)k.

The figure below illustrates steady state y and break-even investment as a function of steady state capital, k*.

Q2) Differentiate between adaptive expectations and rational expectations. Explain why the shape of the Phillips curve changes when we introduce expectations in our analysis.

Ans) The differences between adaptive expectations and rational expectations are as follows:

When people base their expectations on past behaviour, expectations are said to be adaptive. When expectations are created using all available knowledge, they are considered to be rational. This presumption holds that expectations are never skewed.

The adaptive expectation is a theory of economics that holds that decisions made by individuals in the economy are entirely based on historical data, such as previous inflation rates, and that the data can be changed in such a way (based on their expectations) that future rates can be predicted. The actualized concept is that people in an economy may in part affect future events by their rational expectations. However, only past and projected inflationary changes are used to construct adaptive expectations. According to the rational expectation economic theory, people in the economy make decisions based on their logical viewpoint, the information at hand, their prior experiences, and their forecasts regarding the outcomes of current and upcoming procedural steps. The theory suggests that the recent economic expectations will lead to changing reality in the future.

Adaptive expectations are when you make forecasts of future values of a variable using only past values of the variable. Rational expectations are when forecasts of future values are made using all available information.

The main difference between adaptive expectations and rational expectation is that adaptive expectation uses real time data while rational expectation uses historical data.

Increases in effective demand were clearly acknowledged by Keynes in the General Theory as causing increases in output as well as the money wage rate and price level. Therefore, it followed that measures to lower unemployment would also result in some degree of inflation in the economy. If one knew that a given change in the unemployment rate would be accompanied by a given change in the rate of wage inflation, setting policy would be easier. In that situation, one may choose whether it was worthwhile to pursue a programme of lowering unemployment given its costs in terms of an elevated rate of inflation.

Phillips was interested in exploring the idea that businesses would need to raise wages more quickly to recruit new employees and keep hold of existing ones the lower the unemployment rate was. Additionally, he made the assumption that the rise in the rate of wage inflation that would be associated with a given increase in the rate of unemployment would be greater the lower the original rate of unemployment. For a lengthy period of almost a century, Phillips fitted a hyperbola linking the pace of nominal wage inflation to the rate of unemployment for the UK economy. The results were extremely well fitted, supporting the hypothesis. It should be emphasised, however, that Phillips left out periods of high inflation from his calculations and analysis since, in his opinion, wage inflation during these times would be better explained by an increase in the cost of living than by a decrease in the unemployment rate.

According to this interpretation, the Phillips curve shows a consistent correlation between the pace of wage inflation and the rate of unemployment throughout any given business cycle. The curve was also considered as presenting the relationship between the rate of price inflation and the uncommon unemployment rate based on the assumption that the ratio between prices and nominal wage Nate is constant in the near run. As soon as this interpretation of the curve was accepted, Phillips ewes were estimated for almost all of the variables for which data were available, and they all produced inverse connections between inflation and unemployment that were nearly identical. As a consistent relationship between inflation and unemployment over time, the Phillips curve was so depicted, offering a range of policy options. Either relatively high unemployment and relatively low inflation, or relatively low unemployment and relatively high inflation, are options for an economy.

Section B

Answer the following questions in about 400 words each. 12x5

Q3. Policy rules are better than discretionary policies. Justify the above statement in light of new classical macroeconomics.

Ans) Choice between alternative policies in models with micro foundations and assuming rational expectations on the part of economic agents takes the form of choice between alternative policy rules. These alternative sequences must be definable simply and precisely in order for the public to be able to associate an objective probability distribution with the potential sequence of relevant events and to know the desired policy sequences corresponding to those alternative sequences. Therefore, if policy guidelines must be obeyed, the prospect of government policies being created very explicitly in response to conditions or in response to qualitative assessments of the economy is also eliminated.

Although the rigidity produced by the application of policy regulations has clear negative effects, some economists have suggested that this rigidity may also have positive effects. Decision-makers are motivated to tweak the economy, responding to any momentary or minor disturbance. When there are significant gaps in time between the need for intervention and its eventual effects on the economy, as well as when there is significant uncertainty regarding the scope and timing of the effects of many alternative policies, this could be expensive. Friedman argues that because of the uncertainty surrounding policy outcomes, arbitrary policy decisions themselves might start to cause sporadic economic disruptions.

A rational assessment of the likelihood that a government would uphold a policy rule in the future is just as important to the credibility of a policy rule as past experience with a government's capacity to keep its word. According to this viewpoint, governments, like private agents in the economy, have goals that they try to accomplish through policy decisions. Suppose we define a policy rule as being time-consistent or dynamically consistent if, at each instant over a given time horizon, the policy chosen under the rule is optimal for the remaining part of the time horizon, taking as given the policies at that instant have been chosen and assuming that at each subsequent instant, policy will be similarly optimally chosen. A proclaimed policy norm will not be believable unless it is time-consistent if governments have the authority to change policy at later points in time. It will not always be best for the government to implement the policy prescribed by a rule if it is not time-consistent. The government will then gain by breaking the law at that particular time.

The fact that the policy rule is time inconsistent may present a problem even though it is best over the whole time horizon. In addition to allowing for more optimal results than discretionary policy choices over time, optimal policy norms require that the use of discretion in policymaking be constrained in some way. Adopting legislation that makes breaking the rule expensive in the future is a clear approach for the government to commit to a certain policy rule. However, if unanticipated circumstances emerge that urgently demand deviating from the rule or if it is discovered that significant assumptions made in drafting the rule are incorrect, it could be challenging and time-consuming to alter this legislation. The government could assign responsibility for this policy to some autonomous organisation that the public perceives as having a different objective role in order to establish credibility for an optimal policy guideline without sacrificing the ability to use discretion in emergency situations.

Q4. Explain in brief the salient features of political business cycle theory.

Ans) The salient features of political business cycle theory are as follows:

A government spending program could ensure full employment in a capitalist regime if sufficient unutilised capacity to employ the labour force existed. However, business would be averse to government intervention designed to deliver full employment. The opposition to government intervention by the capitalist class is not comprehensible at first glance. Because profits rise with full employment output. Additional government spending is unaccompanied by increased taxation. However, the fear of strengthening worker voice and of inflationary pressures is overpowering.

Under a capitalist system, business has an edge over government because private investment, and the level of employment it determines, depends on the state of confidence. However, once the government establishes itself as an employer of last resort, it can be indifferent to investor optimism and pessimism. Thus, budget deficits are viewed with hostility by the capitalist class. There is no complaint against policies that strengthen profit-making activity like protectionist tariffs, regulation of trade unions and so on.

Short-lived and moderate cycles would emerge from a situation where the government would stimulate the economy only to withdraw at the first signs of an upswing under the guise of an unviable financial position and then re-enter when unemployment approached alarming levels. Thus, there would be a swing between combating employment and inflation.

The cycle is related to politics. The effects of the stance become eventually evident in growing unemployment. Discontent resurfaces and the possibility of defeat at the next election looms large. A sharp policy reversal is the result. In sum, the stop-go cycle consists of two moments: overacting too late as a consequence of doing too little earlier.

Increasing government encroachment in the areas traditionally devoted to private enterprise. Initially, the government would enter spheres that did not impinge on private activities like physical and social infrastructure. There would be no protests from businessmen as the returns on private investments would not be affected. However, the capitalist class feared that the next step would be the takeover or nationalisation of transport and public utilities. Again, businessmen would not be averse to government support of consumption by means of family allowances, price subsidies for basics, children’s allowances and so on. Private enterprise is not affected. However, a regime of permanent full employment would be resisted strenuously. The confidence and demand of the working class would grow. While it is true that with full employment, profits would rise, The capitalist class would take a cut in profits in favour of power over the working class. An additional reason is tacit: A purposeful stance towards full employment might entail a redistribution of income. Incomes policies, then, would be energetically opposed.

Q5. Bring out the factors that lead to rigidity in wages and prices.

Ans) The factors that lead to rigidity in wages and prices are as follows:

The existence of imperfect competition is the main element linked to true rigidity in the products market. Producers can set prices thanks to the lack of perfect competition, which also causes real price rigidity in proportion to quantity.

Price under imperfect competition is established as a markup over cost rather than as the same as the marginal cost. The markup pays for fixed production costs, including profits. One of the key tenets of New Keynesian economics is that the mark-up behaves countercyclically, that is, it goes down during booms and up during a business cycle's downturn. Rigidity in product prices is a result of these countercyclical swings in markup. A rise in total demand results in higher production volumes and, thus, higher employment rates rather than higher prices.

Increased economic activity during booms lowers the importance of information acquisition and dissemination costs, increasing market competition. Thick market effects are what have been called for in the literature to describe this. Increased economic activity may make it more difficult for oligopolists to retain their collusion since incentives are created to break free of oligopolistic arrangements. Markups are under pressure to decrease as a result.

Additionally, it has been asserted that markup functions as a countercyclical factor to procyclical marginal costs. Because overtime paid to employees is very pro-cyclical and therefore costly to businesses, marginal expenses are thought to be pro-cyclical. But this raises the issue of why prices are fixed in the market for goods. The claim made in this instance appears to be that since prices are inflexible, the mark-up shrinks as marginal costs increase. We have been seeking to provide an explanation for the rigidity of prices by hypothesising that mark-ups decline during booms despite rising costs (and not as a result of rising costs), for reasons unrelated to the increase in costs.

The impact of an increase (reduction) in aggregate demand is carried by quantity, which results in a rise (decrease) in aggregate production and employment when price rigidities prevail in imperfectly competitive goods markets. One of the hypothesised causes of unemployment in the labour market is that firms voluntarily pay higher real wages to the employees on their rolls than the market-clearing wage in an effort to increase their productivity and/or to give them incentives not to avoid work in circumstances where the employees' level of effort cannot be perfectly monitored. Unemployment is a result of the resulting labour market flaws.

Q6. Explain with appropriate diagrams why an economy with fixed exchange rate cannot pursue an independent monetary policy.

Ans) Economists contend that a nation's economy cannot simultaneously pursue a free-floating capital market, a fixed exchange rate, and independent monetary policy.

The trilemma, sometimes known as the impossible trinity, is the belief that an economy cannot simultaneously pursue autonomous monetary policy, preserve a stable exchange rate, and permit unrestricted capital movement across its borders. Economists claim that every economy can only choose to pursue two of the three aforementioned policy options at once in the long run. Early in the 1960s, the concept was independently put forth by British economist Marcus Fleming and Canadian economist Robert Mundell.

In the real world, where capital can travel freely and easily across borders, authorities must decide between keeping a fixed exchange rate and pursuing independent monetary policy. The type of monetary policy that can be implemented in the long run will be constrained if policymakers decide to peg or preserve the value of their currency against a specific level. This is due to the potential for central bankers' domestic monetary policy stance to be constrained by the choice to peg the exchange value of the currency.

For instance, if a nation's policymakers want their currency to strengthen or appreciate against other currencies, they cannot accomplish this objective and maintain the currency's external strength for an extended period of time without adopting a tight domestic monetary policy stance that will reduce domestic demand. This is because a loose monetary policy will encourage the value of the nation's currency to decline. Therefore, decision-makers will have to decide between preserving the value of their currency and sustaining nominal demand in the domestic economy, which is significantly influenced by monetary policy.

Q7) Write short notes on the following.

i) Inter-Temporal Utility Maximization

Ans) Certain aspects of the economy are presumptively constant in all macroeconomic models. The issue with the aforementioned type of econometric policy evaluation can be attributed to a few unique characteristics that are also present in the aforementioned experiment. First, equations equating the behaviour of various aggregate variables are included in the macro econometric model used to evaluate policy. Second, the numerous choices made by diverse individual agents in this economy have led to the real behavioural relationships between distinct aggregate variables.

As a result, the true relationship between total consumption spending and disposable income in the economy is the outcome of individual consumption choices made by various households. Third, individual economic agents' choices have an intertemporal component. In other words, decisions are taken now while taking into consideration goals and limitations pertaining to future periods in time. For instance, while choosing what to consume now, consumers may want to weigh the trade-offs between present-day utility and future utility generated from consumption, as well as assess the total consumption options by accounting for both present-day and future disposable income.

Therefore, how predicted future values of variables vary with existing values will determine the relationship between various aggregate variables. These relationships, in particular, depend on how changes in the current values of the policy variables alter expectations about their future values. Assume that the same change in a policy variable's current value can have two distinct consequences on the expectations of private economic actors about the variable's future values. The behavioural relationships, which include the policy variable and other aggregate variables, may then vary over time.

The implication is that the parameters of the behavioural equations, which make up the model's structure and are typically supposed to be constant over time, are not, in fact, constant over time.

ii) Real business cycle theory

Ans) The real business cycle theory has been evolved out of the American new classical school of 1980s. Aggregate economic variables as the outcomes of the decisions made by many economic agents acting to maximize their utility subject to production possibilities and resource constraints. Their views mainly relate to technology shocks, labour market, interest rate, role of money, fiscal policy, prices and wages in business cycles.

A real business cycle is generated in a steady state economy when there is a positive exogenous and permanent technological shock. This leads to increase in productivity. As a result, the aggregate production function shifts upward.

The real business cycle theory emphasises that there is intertemporal substitution of labour in the labour market. When a technology advance leads to a boom, the marginal product of labour increases. There is increase in employment and real wage. In response to a high real wage, workers reduce leisure.

On the contrary, when technology is unfavourable and declines, the marginal product of labour, employment and real wage rate are low. In response to a low real wage, workers increase leisure. Thus, an important implication of real business theory is that the real wage is procyclical.

The real business cycle theory assumes than wages and prices are flexible. They adjust quickly to clear the markets. There are no market imperfections. It is the “invisible hand” that clears the market and leads to an optimal allocation of resources in the economy.

The real business cycle theory is based on the following assumptions:

1. There is a single commodity in the economy.

2. Prices and wages are flexible.

3. Money supply and price level do not influence real variables such as output and employment.

4. Fluctuations in employment are voluntary.

5. Population is given. So, there is fixed labour force.

6. There are rational identical economic agents in the economy.

7. These agents make optimising decisions.

8. Everyone has the same preferences which depend only on consumption in each year.

9. More consumption is preferred to less so that the marginal utility from consumption diminishes.

10. The economy is subject to irregular (random) real supply side shocks.

11. It is a single sector economy.

12. There are substantial changes in the rate of technology that affect the whole economy (which is viewed as a single sector).

13. There is constant return to scale production-technology.

14. The economy is in a steady state.