Chapter 1

Question 2

To summarize the behavior of inflation and unemployment rates since 1990, it is

necessary to understand the meaning of these variables. Inflation rate is the
percent rise in the overall price level and unemployment rate measures the ratio of
the total number of unemployed persons to the total number of persons in the labor
force. In simple words, unemployment means those who are unable to find jobs
even they are willing to work and have the ability to do so as well. It is well known
that there is a very close relationship between unemployment and the increasing
inflation rate. During the period of 1960s, there was a negative relationship
between the inflation rate and unemployment rate - precisely, the years of high
inflation rate with relatively low unemployment rate. But this pattern was not visible
since 1970. In fact, during 1973 -1975, both inflation and unemployment rate rose
significantly between 1990 and 1991, inflation rate rises and along with that the
unemployment rate also rose, but this rise in inflation rate was due to the Gulf war
rather the explained unemployment -inflation relationship. Post 1991,both inflation
and unemployment rate were falling till 1999 but from 2001,we again witnessed the
negative relationship between them where inflation is falling and unemployment is
increasing The situation is similar to the period of 1960s where there was an
inverse relationship of falling inflation rate and rising unemployment rate.

Question 3

The experience of the 1950s and the 1960s had led economists into deeper
thinking to explain the phenomenal increase in inflation as a cause of too high level
of aggregate demand for output High unemployment in the economy was
considered to be the result of inadequate demand. The situation was absolutely
consistent with the negative relationship that exists between inflation and
unemployment rate during the period of 1953-69. In other words, when total
demand was high, inflation also went up and this resulted in falling unemployment
rate and vice versa. With respect to decline in the output growth rate as measured
by GDP, the output increases at an average annual rate of 3.8% during 1953-69 in
comparison with 2.7% for 1970- 81and then to 3.0o/o during 1982-95. Due to the
decline in output growth rate, economy witnessed decline in real wages as well. By
the mid-1990s, citizens in America were worried due to the shortage of jobs as a
result of decline in output However, during the 1990s, it was observed that in United
States, the slowdown of output growth was reversed. A very mild recession in 2001
was a roadway to higher growth rate in aggregate output and labor productivity
Again, the high unemployment rate is being witnessed after the deep recession of
2007-09. Growth is gradually picking but again due to quantitative easing, there is a

fear that once the economy bounce back to its potential, all the gain that has been
achieved would be supersede by inflation.

Question 5
The U.S federal budget deficits since 1953-2010 have seen several turnarounds.
The federal budgets are the excess of federal government expenditure over tax
revenues. The budget deficits during 1950s and 1960s were very small and in fact,
sometimes there was budget surplus in United States. But in 1970s, United States
witnessed somewhat high budget deficits, particularly during the periods of
recession. However, relatively very high budget deficits emerged during 1980s and
1990s. In fact, the deficits during 1985-86 and 1990-91 were approximately 5% of
GDP. From 1993 onwards, government expenses declined along with increased tax
revenues and this called for reduction in budget deficits and by 1998, the economy
was actually in surplus Later in the new century, the budget again went back into
deficit. The deep recession of 2007-09 and stimulus programs to reverse the
contractionary motion caused the deficits to move up to an unprecedented peaceful
level both in absolute and relative terms. Thus, from 2007-10, federal government
expenditures rose from20.6% to 25.5% of GDP and tax revenues declined from
18.9% to 16.7% of GDP. Merchandise trade deficit is the excess of imports over
exports of United States. The United States suffered trade deficits in 1970s but
similar to federal budget deficits, it was in 1980s, the merchandise trade deficits
hiked increasing to over $150 billion in 1988. But post that, it started declining for
some time but then again went up during the mid-1990s,rising over to $500 billion
by 2003 and then to $700 billion in 2005. However, the recent recession caused
trade deficit to fall because the import growth lowered down in comparison to
export growth Thus, trade deficits remained quite high up till 2011.

Chapter 2

Question 5

There are three major price indices that have been discussed in this chapter. It is
time to evaluate the difference between them
Consumer Price index (CPI) - It is the measure of the total basket value of goods
and services purchased It is however an explicit pricing index and is very important
for the consumers as it directly measures the movement in the weighted average
prices of the goods over time. Thus, it measures the difference between the baskets

values of the goods purchased today with the total value of the same basket from
the base year.
Producer Price Index (PPI) - This is the measure the degree of inflation with
respect to whole prices in the eyes of producers this is because any increase in the
price of a commodity gets reflected in the wholesale prices to retailers. Therefore,
looking at the inflation index in the early stages is a highly valuable index to gauge
future inflationary levels.
GDP Deflator This index has a much broader view of the changes in price of the
commodities. This is a broader measure of the overall changes in the price than the
CPI and PPI. This Index is the value of a basket of goods, services and final products
produced by the entire economy. This measure is reported quarterly whereas CPI
and PPI are reported on a monthly level.

Chapter 3

Question 1

Mercantilism is an economic system which was associated with the rise of the
nation state in Europe during the 16th and 17th centuries. According to this theory,
an economy's success depends on the supply of funds in terms of gold and silver,
and aggressive market access with their goods over the whole world. A nation can
increase its capital through the positive trade balance which means exports are
higher than imports. The best way to achieve these two goals is a protectionist role
in the economy, by encouraging exports and discouraging imports. Thus,
mercantilist policy during this period regulated trade by way of subsidizing exports
by way of enhancing inflow of gold with silver and a limited access to imports so
that the outflows are prevented as much as possible. The classical attack on the
mercantilism view for state to regulate the capitalist system had implications for
short-term macroeconomic analysis. One of the views was to ensure that there are
markets for the goods that are produced and consumption, both produced
domestically or in foreign must be encouraged that production grew significantly
across. Hence, according to mercantilism, the ruling government should call in for
such objectives by way of protectionist role in the economy as discussed above.

Question 5

According to the labor market theory, the wage rate for a labor is set where the
provisions for the labor supply equal the demand for the same level of the labor in
the given market.
The basic crux of the classical labor market theory is the assumption that the
market clears considering that there are no barriers towards the adjustment of
money The labor market is characterized by the term auction market This is
because the labor is assumed to be traded in those markets where the continuous
equilibrium situation exist and where all participants make decisions depending on
the given real wage rate.
Assumptions under such characterization are:
Wages are perfectly flexible
Perfect information about the market prices
These assumptions imply that both suppliers and buyers must have all the available
information about the market prices Such a condition requires that when labor
demand equals labor supply at a given monetary wage (W),then both workers and
employers must have a command over commodities that will result from such a
wage actually, real wage (W/P).

Question 7

In the classical system, the major determinants of the output and employment are
those that determine the positions of the labor demand and supply curves and the
position of aggregate production function. In this view of the classical system, the
level of output and employment are determined solely by the supply side factors.
The role that aggregate demand played in determining the output and employment
involves
1.

Wages and prices are perfectly flexible.

2.
Perfect information about the market prices as well as the competitive
industries.

Chapter 4

Question 1

Change in the money supply. When the supply of money is increased the MV curve
shifts to right leading to increased expenditure Due to this price level rises along the
money wages proportionately keeping the real wage constant. Thus we find that in
classical system because of increase in money supply no change occurs in real
wages (W/Pf).real employment (Lp),real output (Yp) and real interest rate.

Question 7

Any change in the autonomous components of aggregate demand such as

investment and government spending shifts the demand curve rather than showing
any movement along the aggregate demand curve. For instance, an increase in the
government spending shifts the AD curve to the right. But this increase must be
financed by taxation so taxes must be increased by way of selling additional bonds
to the public or increasing the money supply. Since money supply is fixed, any
increase in government spending is assumed to be financed by selling bonds. If
spending is higher than tax revenue then there are budget deficits wherein at initial
stage, loanable funds market must be equilibrium where budget is balanced. If this
is the situation, then total demand for loanable funds has investment and
government borrowing (G-T) The increase demand for such funds shifts the AD to
the right. Under this situation, there are excess borrowers over lenders at the
original interest rate. Because of this, interest rate shoot upto r1. This increase in
interest rate calls for two effects. One is savings will increase and the second is
investment demand declines.
The reduction in consumption as reflected in increased savings and investment
must equal the amount of increased government spending Therefore, increased
government spending pushes the interest rate enough to crowd out investment and
consumption expenditure. And it is this crowding out effect that keeps the
aggregate demand from rising due to autonomous increase in government
spending. Since aggregate demand remains unchanged, any change in autonomous
factors do not affect the price level and economy is stable.

Question 10

An increase in marginal tax rates negatively affects the output of an economy. First,
higher marginal tax rates reduces the disposable income workers derive from their
work or any other activities. Increased tax rates worsen the situation as some
people decide to trade off for leisure and forgo such overtime opportunities While

others decide to forgo the risky business opportunities. These adjustments will
shrink the effective supply of resources, and therefore will reduce output
The second way is that high marginal tax rates encourage tax-avoiding investments
and other forms of tax avoidance. But this way is not an efficient one. Taxpayers
facing high marginal tax rates will spend on luxurious, tax-deductible items such as
big offices, professional conferences held in luxurious places, and various fringe
benefits. Real output is less than its potential because resources are wasted
producing goods that are valued less than their cost of production
Therefore, an increase in the marginal income tax rate reduces the after tax real
wage. The labor supply will shift leftward due to which both employment and output
gets reduced.

Chapter 5

Question 1
An exogenous change like the greater use of credit cards in the velocity of
money causes the aggregate demand curve to shift upward. In the short run,
prices are fixed, so output will rise. If the Fed wants to keep output and
employment at their natural rate of employment, then it must decrease the
aggregate demand to offset that rise in velocity This can happen only if money
supply is decreases This decrease in money supply shifts the aggregate demand
downward restoring the equilibrium back to its original level. Thus, output,
employment and price remain constant within the classical model.

Question 4
An increase in marginal tax rates negatively affects the output of an economy.
First higher marginal tax rates reduces the disposable income workers derive
from their work or any other activities Increased tax rates worsen the
situation as some people decide to trade off for leisure and forgo such
overtime opportunities While others decide to forgo the risky business
Opportunities. These adjustments will shrink the effective supply of sources,
and therefore will reduce output. The second way is that high marginal tax
rates encourage tax-avoiding investments and other forms of tax avoidance But
this way is not an efficient one. Taxpayers facing high marginal tax rates
Will spend on luxurious, tax-deductible items such as big offices;
Professional conferences held in luxurious places, and various fringe
benefits. Real output is less than its potential because resources are wasted
producing goods that are valued less than their cost of production. Therefore,
an increase in the marginal income tax rate reduces the after tax real wage.
The labor supply will shift leftward due to which both employment and output
gets reduced.

Chapter 6

Question 1

According to Keynes theory, high unemployment rate in the industrialized countries

occurred due to the shortage of aggregate of demand. Aggregate demand was very
low because of lack of investment opportunities and subsequently its demand in the
economy. To combat this problem of high unemployment, Keynes argued for
aggregate demand stimulus. In fact, during Great Depression, he was in the favor of
expansionary fiscal policy measures, specifically increasing government spending to
increase the aggregate demand. He argued if government spending increases then
it would increase the level of income and thus consumption spending for the
employed individuals under the public force projects stimulates the need for
secondary employment. Thus, the origin of Keynesian theory supported for using
fiscal and monetary policies to regulate the aggregate demand for the economies.

Question 4

The future profitability of the investment projects is a key element in the

Keynesian theory Uncertainty about the future profitability of the particular
project is the key emphasis in his theory. This is nothing the business
expectations on which current investment demand are based upon_ The Impulse in
the Keynesian theory is expected future sales and expected future profits
insofar as these affect investment. If it is expected that the future returns
are lower, then the investment demand reduces and it shifts the aggregate
demand to the left.

The above diagram shows the impact of business expectations on the aggregate
demand and aggregate supply curve. The investment demand falls due to which
the aggregate demand shifts to the left and this leads to fall in total
equilibrium output_ This view is related to the Keynes' view that aggregate
demand would be unstable when fiscal stabilization policies are absent in the
sense when fiscal policies are absent or unstable, then this would reduce the
aggregate demand and thus reduces the output and employment. This Reduction in
income reduces the consumption expenditure and thus finally reduces the
investment as well because of the rise in interest rate.

Question 6
In Keynes theory, the process of a 1 dollar increase in autonomous expenditure
causes equilibrium income to increase to by a multiple of that 1-dollar
increase is called the autonomous expenditure multiplier. The reason that the
income increases by a multiple of that 1 dollar, or in fact more than that is
that increase in autonomous expenditure, say, investment creates an induced
increase in consumer demand as income increases.

Question 7
The tax multiplier [?Y/?T]= -b/ (1 -b) is negative because an increase in
taxes will reduce the personal disposable income of the household, which in
turn reduces the consumption expenditure. For instance, a one dollar increase
in tax reduces the personal disposable income by one dollar but also lowers
the consumption spending component of aggregate demand by factor of b dollars.
The remaining part of the decline is fetched by the fall of (I-b) dollars in
savings.
It is smaller in absolute value than the government expenditure multiplier
because not whole of the tax increase represents income which otherwise might
have been consumer by the households. Since the marginal propensity to consume
is less than one some fraction of each dollar earned gets saved; which does
not get added to aggregate demand. So, the initial change in consumption
because of Sl tax increase is
MPC x (-61) -MPC
Thus, this amount highlighted is the change in autonomous expenditure that
results from Sl tax increase and hence; we multiply this by the government
spending multiplier and get
Tax Multiplier -MPC/ (1 -MPC)

Question 8
Step 1
Given
c: 25+ OBYD
I -100

G -75
T: IOO
Where
G - government expenditure
C - consumption expenditure
YD = disposable income
T = taxes
I = investment

Step 2
a) Using the above information; one can compute the equilibrium level of
income as
Y=C+I+G
Y=25 +0.8YD+ 100+75
Y=200+0.8 (Y-T)
Y=200 + 0.8Y - 0.8xlOO
Y(1-0.8) = 200 - 80
O.2Y = 120
Y= 600 units
Therefore, the equilibrium level of income (?) is 600 units

Step 3
b) The value of the government expenditure multiplier is given by:
Government Expenditure Multiplier
Government Expenditure Multiplier
Tax Multiplier
Tax Multiplier
Tax Multiplier = 4
Therefore, the value of the government expenditure multiplier is 5 and that of
the tax multiplier is -4

Step 3
c) Suppose that investment has declined to 60 units. The new equilibrium level
of income will be:
Y=C+I+G
Y = 25+0.8Yd+60+75
Y=400 units
Therefore, the new equilibrium level of income (?) is 400 units.

Chapter 7
Question 5

The IS curve is negatively sloped or downward sloping because at a given point,

where savings equals investment, an increase in income increases the savings and
causes excess savings in the financial market. So,in order to restore equilibrium,
interest rate has to fall. This fall in interest rate reduces the savings, increases the
investment till the point where savings again become equal to investment. Thus,
the IS schedule is negatively sloped representing higher interest rate corresponding
to lower equilibrium income level.
The LM schedule is positively sloped because as income increases, households
would want to hold more money for transaction purposes. Since everyone follows
the same pattern of holding more money in their pocket, interest rate goes up since
the money supply in the economy is fixed. This increase in interest rate reduces the
speculative demand for money and further lowers the transaction demand for
money corresponding to any income level. The interest rate thus must increase until
the decrease in money demand becomes equal to the initial income induced
increase in transaction demand for money.

Question 6
The magnitude of the slope of the IS schedule depends on two factors
1.
The interest elasticity of investment - The IS schedule will be steep if the
interest elasticity is low and is flatter when the interest elasticity of investment is
higher.

2.
The marginal propensity to save - The higher value of the marginal propensity
to save (MPS) means that the small increase in income lead to high savings and low
investment This will lead to steeper IS schedule for a given interest rate. Similarly,
the lower the value of the MPS, the flatter is the IS schedule.
Question 7
There are three factors that determine the position of the IS schedule and changes
that shift the schedule:

Changes in government spending - An increase in the government spending

will shift the IS schedule to the right. This means increasing government
expenditure will increase the income at the given rate of interest. The shift in the IS
schedule for per unit increase in government spending is (1/1-b), referred to as
autonomous expenditure multiplier.

Changes in taxes -An increase in the taxes shifts the IS curve to the left. This
is because a one dollar increase in taxes reduces the disposable income by one
dollar and reduces savings by the amount of MPS (1-b) Given the level of
income,this decline in savings is less than the increase in taxes, so increase in taxes
will shift the schedule to the left.
Autonomous changes in investment - An autonomous increase (decrease) in
investment will shift he IS curve to the right (left) An increase in investment as
commanded by the favourable shift in the expectations about the future profitability
will shift out the IS curve to the right and hence the raising the income and interest
rate.

Consumption pattern also causes shift in the IS curve.

Question 8
The magnitude of the slope of the LM schedule depends on the interest elasticity
demand for money for money. The steeper LM schedule reflects the assumption of
the low interest elasticity of money demand. On the other hand, when the interest
elasticity of money demand is high, then the LM schedule is relatively flat.