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r t n
a a d i

y m Re

u d l n
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e s

s t r
n oo
O b
-
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fo
d
E
we H
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w Th
w

1
 ASSIGNMENT SOLUTIONS GUIDE (2018-2019)
M.E.C.-2
Macroeconomic Analysis
Disclaimer/Special Note: These are just the sample of the Answers/Solutions to some of the Questions given in the

m
Assignments. These Sample Answers/Solutions are prepared by Private Teacher/Tutors/Authors for the help and guidance
of the student to get an idea of how he/she can answer the Questions given the Assignments. We do not claim 100%

o
accuracy of these sample answers as these are based on the knowledge and capability of Private Teacher/Tutor. Sample
answers may be seen as the Guide/Help for the reference to prepare the answers of the Questions given in the assignment.

c g
As these solutions and answers are prepared by the private teacher/tutor so the chances of error or mistake cannot be

.
denied. Any Omission or Error is highly regretted though every care has been taken while preparing these Sample

t n
Answers/Solutions. Please consult your own Teacher/Tutor before you prepare a Particular Answer and for up-to-date

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and exact information, data and solution. Student should must read and refer the official study material provided by the
university.

a d i
Note: Answer all the questions. While questions in Section A carry 20 marks each (to be answered in

a
m
about 700 words each) those in Section B carry 12 marks each (to be answered in about 500 words each).

e
SECTION-A

y R
Q. 1. Compare and contrast between the Ramsey model for the central planner and the Solow model
for economic growth (your answer should include the assumptions, important equations, phase diagram

d e
and its interpretation).

in ks
u
Ans. Planner’s Problem: In the original Ramsey model, it was assumed that the optimal growth problem is the

l
problem of a social planner who seeks to maximize the welfare of each household subject to the economy’s resource

t n oo
constraint at each point of time. All households are similar in their tastes and preferences therefore, what is true for

s O b
the representative member of the society will apply to all.

r
Intertemporal utility:

-
.e o E
∞ ∞

f
u = ∫ u(ct )Lt * dt = ∫ u (ct )e e dt
– pt nt – pt

d
0 0

b
we
p : rate of time preference. A higher p implies a smaller desirability of future consumption in terms of utility
compared to utility obtained by current consumption.
u a n
H
w Th
Properties of instantaneous utility function u (ct):
1. Increasing (u' > 0) and concave (u'' < 0)
2. Satisfies the Inada conditions: lim

w
c→ 0
u' (c) = 0.
Problem of the household: Maximize intertemporal utility subject to the budget constraint (the Hamiltonian
approach)
J = u (ct) e –(p – n)t + vt [wt + n)bt – ct]
vt: present value of the shadow price of income in utility units.
First order conditions for the maximization of the Hamiltonian are:
∂J
=0 ⇒ v = u' (c)e–(p – n)t
∂c
∂J
= –v ⇒ v = – (r – n)v
∂c
Transversality condition:
lim(vt bt ) = 0
t →∞

2
 The value of the representative household’s assets must approach zero as time approahces infinity individuals do
not prefer to hold perpetually or–if they do–these assets should have no value in terms of the objective function.
From the first-order conditions we get:

 u "(c)c  c
Euler equation: r – ρ –  
 u '(c)  c
Households choose consumption so to equate the rate of returns to savings, r, to the rate for return to consumption
(the r.h.s.).
(or: return on future consumption = return on current consumption)
l The higher r, the more willing households are to save and shift consumption in the future.

m
l The higher the rate of return to consumption is, the more willing households are to sacrifice future consumption
for more current consumption and thereby less current saving.

o
⇒ Households are indifferent between consumption and saving if the associated rates of return are equal.
Households prefer to bring some future consumption into the present

c g
l They value more current utility compared to the future one, as this is reflected by the rate of time preference

.
from the right-hand term of the Euler equation.

r t n
c
l The future conumption growth increases to marginal utility of consumption.
c

a i
Equilibrium in the Ramesy Model: In equilibrium the stock of per capita assets equals the stock of capital per

d
worker, i.e. b = k

a
m
⇒ k = f (k) – (n + δ) k – c

Re
y
Combining the problem of the firm and the Euler equation:
c 1

d
= ( f ′(k ) –  – )

e s
c θ

n
i k
u
This is a two-equation system that yields the market equilibrium.

l
t n oo
In the steady-state growth rates of per capita consumption and the capital stock per worker equal to zero (i.e. k =

s O b
c = 0) and we have:

r -
.e
c = f (k ) – (n + δ) k
f' (k ) =δ + ρ
fo E
b d
⇒ The growth rate of per capita output is also zero

we u an
Result: In the absence of technological progress the Ramsey model predicts zero growth as in the simple Solow-

H
swan model.

w Th
The ‘Social Planner’ problem
The social planner aims at maximizing households’ intertemporal utility subject to an aggregate budget constraint,

w
which shows how the economy’s output is allocated to different uses.
In a closed economy with no government, the aggregate outcome Y can then be used either for consumption C or
for investment in physical capital I:

Y = C + I ⇒ F (K, L) = C + K + δK ⇒ k = f (k) – (n + δ) k – c
The Hamiltonian associated to the social planner’s problem is:
c1– θ ( n – ρ) t
J = e + v[ f (k ) – (n + δ )k – c)
1− θ
First-order conditions with respect to consumption and capital:
∂J
= 0 ⇒ v = c – e( n – ρ) t
∂c

3
 ∂J
= v ⇒ v = v[n + δ − f' (k )]
∂k
After some manipulation:

c 1
= [f' (k) – (ρ + δ)]
c θ

Since c = k = 0 in the steady state, equations become:

c = f (k ) – (n + δ )k Same as in decentralized equilibrium

m
f '(k ) = ρ + δ Same as in decentralized equilibrium

o
The competitive equilibrium in the Ramsey model is Pareto optimal.
Dynamics in the Ramsey Model

. c g
ct

t n
dk

r
=0
dt
E

dk

a a d i
m
=0 kj
dt

e
∞
U = ∫0 u (cˆt )e – ( – n)t dt.

d y e
R
in ks
u l
The Decentralized Household Problems

t n oo
The Household in the Ramsey Model
Assumptions:

s O b
l One infinitely-lived household the maximizes intertemporal utility.

r -
.e
l The household receives wage income in exchanges for its labour services and interest income for its

o E
accumulated assets.
l

f
Population growth rate is constant (equal to n) and at time t = 0 there is only one individual in the economy

b d
we
(i.e. L0 = 1), so that total population any time t is given by Lt = ent

u a n
Budget constraint (The change in assets the sum of labour and interest income less consumption):
B = wt Lt + r1 Bt – Ct

H
w Th
Bt : assets
wt : wages rate and

w
rt : interest rate
In per capita terms: b = wt + rtbt – nbt – ct where
Bt C
bt = = ct = t .
Lt Lt
One important constraint: Households cannot borrow unlimited amounts to finance arbitrarily high levels of
consumption.
⇒ The persent value of current and future assets must be asymptotically non-negative.
⇔ households cannot borrow infinitely until the end of their economic life-cycle
⇔ the households’ debt cannot increase at a rate asymptotically than the interest rate
 – ∫ ( rs – n ) ds 
t

lim  bt e 0  ≥ 0
t →∞

4
 Effect of a Permanent Change in Government Purchases:

C
dc/dt = 0

dk/dt = 0

m
Effect of a Permanent Change in Government Purchases:

c g o
.
dc/dt = 0

r t n
a i
dk/dt = 0

a d
m
K

Re
y
Types of variables: Consumption is a ‘jump’ variable (i.e. it is allowed to take any value), whereas capital is a

d e s
‘state’ or ‘predetermined’ variable (i.e.) its current state is determined by the past level).

n
Type of equilibrium: For any capital stock level, there is a unique consumption level that drives the economy to

i k
u
equilibrium (Saddle Data)

l
t
Features of Solow Model

n oo
In Solow model, aggregate production function has been taken on some assumptions. It is assumed that a

s O b
composite goods is produced by using a technology which is same for all firms. It further assumes that factor inputs

r -
of labour and capital are homogeneous. Let us explain in detail how in this model demand for and supply of goods is

.e o E
determined.

f
Supply of Goods: Solow model determines the supply of goods on the basis of production function. The production

b d
function has three inputs (k, l, A) and one output (Y) variables and takes the form Y (t) = F (k(t), A (t), L (t),

we u an
...(i)
where Y refers to income or output

H
w Th
k is capital
L is labour

w
and t is technology of production. t is time.
Since ‘t’ is not entering the model directly, it implies that over time change in Y will take place only due to change
in inputs k, l and A.
It is important to note that ‘A’ which is referring to technology of production will change over time. It is further
important that labour and effectiveness of labours have been taken as multiplicatively such that AL means effective
labour. It implies that technological progress increases the productivity or efficiency of labour. It means that even if
the quantity of labour remains unchanged, technological progress increases efficiency of labours thereby quntity of
effective labour (AL).
The production function given in eqn. (i) is representing constant returns to scale constant returns to scale are
said to exist when inputs and output change in the same proportion i.e. double the inputs, output will get doubled.
F (a k, aAL) = a F (k, AL) ...(ii)

5
 We can use this assunption to convert the production function given in eqn. – (i) to per-effective labour terms. If
1
α = (i) , eqn. (i) can be written as
AL
 k  1
F .| = f (k , AL) ...(iii)
 AL  AL
Such a production function is called production function of intensive form. It helps us to analyse all variables in the
economy relative to the size of effective labour force.
k
Therefore, is capital per effective labour unit. Moreover,,
AL

m
 k  Y
=

o
F
 AL  AL

c g
Y

.
and is output per effective labour unit.
AL

r t n
a
F (k)

d i
a
1 MPK

m
Y

e
AL

d e
R
in ks
y K
X

u
AL

l
t n oo
In the figure above we have taken K/Al i.e. capital per unit of effective labour or x-axis, and Y/AL i.e. output per

s O b
unit of effective labour on y-axis.

r -
It is clear from the diagram that if both labour and capital are increased in the same proportion. Constant returns

.e o
to scale prevail but if only capital is increased keeping AL constant, we shall get diminishing returns to capital.

f E
The marginal productivity of capital is determined by the slope of production function. MPK is equal to extra

b d
we
k

n
output per effective labour produced when is increased by 1 unit

u a
AL

H
Symbolically,

w Th
MPK = f (k + 1) – f (k). ...(iv)
The intensive form of production function given in eqn. (iii) is assumed to satisfy following conditions.

w
1. at k = 0, f (k) = f (0) = 0
(b) When f' (k) > 0, MPK is positive
(c) When f" (k) < 0, MPK declines.
2. It also satisfies ‘Inada conditions’
(a) lim
k →0 f '(k ) = ∞ which means that when capital stock is too small the MPK is very large.

k →∞ f '( k ) = 0 which means that MPK is very small when capital stock is too large.
(b) lim
Demand for Goods: In a solow model, it is assumed that goods are demanded for consumption and investment
purposes.
Therefore,
Y=C+I ...(v)
Y C I
On dividing eqn. (vi) by AL, we get = + ⇒ y = c+i ...(vi)
AL AL Al

6
 For simplification, we have assumed the economy to be a two-sector economy.
Each year people save some proportion of their income (1 – b), then, (1 – b) is the saving rate and it lies between
0 and 1.
Saving per effective labour = (1 – b) y
∴ C = (b) y
y = by + i ...(vii)
y – by = i
(1 – b)y = i ...(viii)
The relationship between output and saving is shown with the help of following diagram:

Y Output F ( k)

m
effective labour (y)
r
n pe r
p tio la b o u
O utput per unit

o
u m e
o n s c ti v
= C n i t e f fe
}C u

c g
Investm ent

.
SF ( k)

t n
} I = Investm ent per
unit effective labour

r
O X
Capital per unit effective labour ( k)

a i
The Steady State

d
According to Solow model, an economy is in equilibrium when investment per unit of effective labour s equal to

a
m
savings per unit of effective labour.

Re
I = sY

y
Where I is investment, s is MPS and Y is income.

e s
d
Since Y is a function of capital, we can say that

n
i k
u
I = sf(k)

l
t
Where, k is existing capital stock of an economy.
It implies that
n oo
s O b ∆k = sf(k)

r -
.e
Where ∆k is change in K i.e. existing capital stock of the economy.

fo E
This equilibrium condition is true for an economy where,

b d
we
(a) Depreciation is zero;

u an
(b) Population is constant;

H
w Th
(c) Technology is given and constant.
Now let us see what happens when we relax these unrealistic assumptions.

w
The Growth of Capital and Steady State: In Solow model, it is assumed that capital depreciates at a fixed rate.
Let us denote it by δ. Therefore, every year δk amount of capital is depreciated.
Investment and depreciation act in opposite directions and the growth in capital stock is net of the two quantities.
•
k (t) = i (t) δ k (t))
Since i = sf (k (t))
•
k (t) = sf (k (t)) – δ k (t)) ...(xi)
From eqn. (xi), we can conclude that
(a) Capital stock increases when δf (k (t)) > δ k (t)
(b) Captial stock falls when δf (k (t)) < δ k (t)
(c) And capital stock remains constant when

7
 δ k (k (t)) = δ k (t)
We can show it with the help of following diagrams.
Depreciation rate
Y
δK

Rate of depreciation

m
O X

o
Capital per unit of effective labour

. c g
Y δK

t n
δK 2

r
i = δK 2 δF(k)
X

a i
i1
δK 2

a d
e m
O K1 K K2 X

R
y
Steady State of an Econom y

e
d
Population Growth and Steady State: In this section we shall elaborate on the changes in population and

in ks
u
labour force at a constant rate n. When there is a growth of labour force, we need to increase capital; to maintain

l
t
same level of k. It is essential that the economy has adequate investment to take care of depreciation (δ k) and

n oo
population growth (nk). If we introduce n in the equation (xi) above, it will be equal to

s O b
k (t) = sf (k(t) – (n + ∆) k (t) ...(xii)

r -
.e
If we want to maintain steady growth rate we need to cover depreciation which is equal to (δk) and to provide

fo E
new workers with capital equal to (nk). In this case, break-even investment will become equal to (δ + n) k. The

b d
economy will attain steady growth rate at a point where investment curve intersects (δ + n) k curve. It is shown with

we u a n
the help of following diagram.

H
w Th
Steady state capital declines
Y
(h2 + δ )K
Output per unit of

(h1+δ )K
effective labour

w
δf(K)

K1L = K
O K2 K1 X
Steady State in two countries

If k1 < k*, this means investment is greater than break-even investment and it will cause capital and output to
rise.
If k2 > k*, then k will decline until it becomes equal to k*.
Population growth gives us an explanation for steady economic growth rate. It is however, assumed that output
per effective labour remains constant. It is also seen that at steady growth rate k and y remain constant. But capital

8
stock (K) and output (Y) keep increasing at the rate of n so as to keep k and y constant. This feature explains the
cross-country disparities in income. If country one is experiencing population growth @ n1 and country two is
experiencing population growth at n2 such that n1 > n2 and if the saving rates are same in both the countries then (δ
+ n2) k with a slope greater than (δ + n1) k has been drawn.
A country with higher rate of population growth rate n2 has lower k* (the steady level of capital) and hence lower
y i.e. output per effective labour. And the country with lower rate of population n1 has a higher k* (the steady level of
capital) and hence higher y i.e. output per effective labour.
Technological Progress and Steady State: By introducing technological progress, we can explain growth n
output per effective labour in Solow model. It is assumed that technological growth is labour augmenting i.e. it
increases productivity per efficiency of labour. Therefore, with the technological progress, there will be an increase

m
in the quantity of effective labour (AL). If we assume that the rate of technological improvement is g then the change
in k over time can be written as:

o
· k (t) = sf (k(t) – (n + g + δ) k (t) ...(xiii)

c g
Steady state

.
Y

t n
( n+ g+ δ )K
O utput per unit of
effective labour

δF(k)

r
Break-even

a i
investm ent

a d
Re m
O K X

y
Capital per unit of effective labour

e s
d
Actually eqn. (xiii) is the key equation of the Solow model. We have explained this equation with the help of a

n
diagram. It is clear from the equation (xiii) that the analysis of steady state remains unaffected with the inclusion of

i k
u
technological progress but the new break-even investment becomes equal to (n + g + δ) k (t). Out of total investment,

l
t
δk will be used for recovery of depreciation, and nk amount of capital will be required to maintain capital per

n oo
effective labour at a constant rate. But with the result of technological improvement y increases at the rate of g.

s O b
Individually, n, δ, and g may be positive or negative but their sum total is assume to be positive in the model. Total

r -
.e
output will grow at the rate of (n + g). Therefore, we can conclude that introduction of technological progress leads
to an increase in output per worker.

fo E
Solow model claims that persistent rise in standard of living always owe to technological progress.

b d
we
Q. 2. Explain, through appropriate IS-LM curves, the type of monetary and fiscal policies a government

u an
should take to deal with recession in an open economy.

H
w Th
Ans. The government can make use of fiscal and monetary policies to bring about changes in IS and LM curves
and thereby changes in the level of income and rate of interest at equilibrium level. In fact, the difference between
classical and Keynesian position can be explained with the help of IS-LM curves,

w
It is shown with the help of diagram given below that when economy is operating at income level Y1, here LM
curve is perfectly elastic and hence economy is in liquidity trap. In this situation, monetary policy becomes ineffective.
If the government increases expenditures, it will not affect interest rates as there are enough idle cash balances in the
economy. Therefore, in such situations monetary policy becomes ineffective and hence, it is advisable to use fiscal
policy to bring about desirable changes.
If the economy is operating at a very high income like Y3, then LM is perfectly inelastic i.e. rate of interest is too
high and real balances in the economy are very low. When government increases its expenditure by borrowing from
the market, it competes with the private investment and therefore, r-Y does not change. This is known as classical
range.
But usually an economy operates at a moderate level of income where these policies work effectively.

9
 r LM

IS3
IS3

IS2
IS2
IS 1
IS1
O Y
Y1 Y2 Y3

m
Synthesis of Real and Monetary Sectors

o
By integrating IS-LM curves we can get such level of rate of interest and income where there is equilibrium in

c g
money market and real market simultaneously. It is shown with the help of figure shown below. Here both the

.
markets are in equilibrium at point E where IS and LM curve intersect each other. At ri and Yi both the markets are

t n
in equilibrium simultaneously.

r
r

a i
LM

a d
e m
IS′3

y
IS 3

R
d e
in ks
IS′2

u l
IS 2

t n oo
IS ′1

s O b
IS 1

r -
.e
O Y1 Y2 Y3 Y

o E
Classical and Keynesian Range

f
Government makes use of two policy instruments to intervene in the market: fiscal policy and monetary policy.

b d
we
Fiscal policy is the policy of the government related to tax and expenditure. Monetary policy is the policy of the

u a n
government related to money and credit supply. Fiscal policy of the government affects IS curve while changes in

H
w Th
monetary policy affects LM curve.
Fiscal policy and IS curve: An increase in government expenditure leads to an increase in investment and
thereby an outward shift in IS curve. Another tool of fiscal policy is tax. When government reduces taxes, it will

w
increase the consumption level and thereby lead to upward shift in IS curve. Shift in IS curve leads to establishment
of equilibrium level of income and rate of interest at a higher level. Opposite will happen when government expenditure
is reduced or taxes are increased.
Monetary policy and LM curve: When there is an increase in money supply, an increase in real balances takes
place which leads to decrease in rate of interest. When rate of interest decreases, for each level of income, there will
be a downward shift in LM curve and accordingly there will be change in new equilibrium level of Y and R opposite
will happen when a decrease in real balances take place.
It is shown with the help of following diagram:

10
 r
LM

A Y
MD

A
M = MD + MT
D

m
T
MD

o
LM Curve

c g
SECTION-B

.
Q. 3. Explain how you can reconcile the long run vertical Phillips curve with the short run downward

t n
sloping Phillips curve.
Ans. Phillips Curve: A.W. Philips gave this concept which is known as Phillips curve after his name which

r
describes the relationship between the rate of unemployment and the rate of inflation. He tried to establish a relationship

a
between the level of unemployment and changes in wage rates. His empirical work proved that the lower is the initial

d i
rate of unemployment; the greater would be the rise in the money wage rate corresponding to a given rise in the rate
of unemployment. He collected data for a period of around 100 years (1861-1957). This data got fitted into a

a
m
hyperbola. This data provided proof to his hypothesis. He made an assumption that the ratio between prices and

Re
nominal wage rates is constant in the short run. On this assumption the Phillips curve showed the inverse relation

y
between the rate of unemployment and the rate of inflation i.e. the existence of trade off between unemployment and

d
inflation.

e s
He took a simple linear equation of the following form:

n
i k
u
c′ = a–bu

l
t
Where c′ is the rate of wage increase, a and b are constant and u is the rate of unemployment. He found that

n oo
there exists an inverse relationship between c′ and u i.e. wage rate and rate of unemployment.

s O b
Later, data was collected for many other countries and the relationship held true for almost all countries. Therefore,

r -
.e
it represented a stable relation between inflation and unemployment over time, which suggested to economists that

o E
they will have to bear one problem in the economy to get rid of other and it is up to them which combination of these

f
problems they would like to choose. If we choose low rate of inflation, unemployment rate would be high and vice-

b d
we
versa.

u an
Costs of Unemployment and Inflation
For an economy inflation as well as unemployment has negative effects but Philips curve suggests that in order to

H
w Th
eradicate one problem, we shall have t bear the other one as there exist trade-off between the two.
Cost of Unemployment:

w
(a) At macro level, it is wastage of human resource. This manpower could add something to aggregate output if
it would have been employed.
(b) At individual level, it is loss of current income and fall in standard of hiring. Labour is a perishable factor of
production. If a labour does not get a job on any particular day, he can not store his energy and can not work
double shift on getting job later.
(c) Human cost of unemployment is also very high. It creates depression, increases the rate of suicides and
psychological troubles. Empirical studies indicate that the rate of suicide in 1930s when Great Depression
occurred, every 4th person in 1000 was committing suicide in USA.
(d) It also leads to increase in crime rate as it is easier to give temptation to an unemployed person to do
something wrong.
The objective of policy-makers is to see that the negative effects of unemployment are minimal and does not
exceed natural rate of unemployment.

11
 Meaning of Inflation: Inflation refers to persistent increase in general price level. A sudden rise in prices for a
short time due to some emergency or calamity is not inflation. A gradual rise in price say less than 5% per year on an
average is not inflation because a gradual rise in inflation is good for the economy. It becomes a problem if and only
if it is at a higher rate.
Cost of inflation:
(a) During inflation, there is very much a chance that government expenditure will be more than government
revenue which will make government budget to be deficit. In case there is deficit in government budget,
government will finance it through public borrowings, running down on foreign exchange reserves or deficit
financing. It may be so that the deficit has been taking place for longer and hence, it is difficult to borrow
further. It is also difficult t run down on foreign exchange reserves as these will also be limited. Hence, the

m
government chooses deficit financing which refers to printing of new currency. It increases money supply in
the market and hence increases the rate of inflation further.

o
(b) Inflation also leads to redistribution of income in favour of the rich and thereby doing harm to the economic

c g
conditions of the weaker section.

.
(c) During inflation money loses its purchasing power.

t n
(d) There is a reduction in the income of fixed salaried persons and increase in the incomes of businessmen.

r
(e) When there is price rise, borrowers gain in fixed interest rate arrangements because the real money value of
loan repaid is less than the anticipated value. On the contrary, lenders loose as the value of money received

a i
is less than the value of money they gave.

d
There is no doubt that inflation is social evil and must be eradicated. Policy makers keep on making an effort to

a
m
ensure that the rate of inflation remains below the level which creates troubles in the economy.

e
y
Non-accelerating Inflation Rate of Unemployment

R
In the late 1960s, USA experienced unemployment rates that were much higher than what was expected as per

d e
Phillips curve from the past. On the one hand, there was economic stagnation depicted by a low rate of increase in

in ks
GDP and on the other hand, there was high rate of inflation. In economics such a situation was given a term “Stagflation”.

u l
A limitation of the Phillips curve is that the decision by the workers and firms is taken on the basis of real wage and

t n oo
not nominal wage. When we enter in to a contract for future period, we adjust the wages for inflation. But in case the

s O b
rate of inflation is more than inflationary expectations, the Phillips curve will not work Milton Friedman in 1968, gave

r -
an explanation as to why the Philips curve might not represent a stable exploitable trade off between unemployment

.e o E
and inflation rate. His arguments gained a lot of popularity in later years.

f
He gave an explanation that workers are not interested in an increase in their money wage rates but in an

b d
we
increase in the real wage rate. He also gave a concept of NAIRU (Natural Rate of Unemployment). He claimed that

u a n
at natural rate of unemployment, firms as well as workers will be satisfied with the existing real wage rate and

H
w Th
equilibrium will get established at a lower real wage rate.
There may be following reasons for it:
(a) Jobs are of heterogeneous nature and firms and workers need appropriate time to search for right jobs and

w
workers.
(b) Unemployed workers may not be able to seek employment by lowering wages due to costs of mobility or
labour market imperfections.
In the short-run, Philips curve is stable but in the long-run, Phillips curve keeps shifting from one level to another.
It makes the Phillips curve a straight vertical line. Let us explain long-run Philips curve through an example taken by
Samuelson.
Let us assume that an economy is operating at natural rate of unemployment u*. Suppose economy is operating
at point A with low inflation rate I1. People expect inflation rate to remain same in next period also. Now suppose in
the next period, government follows expansionary policy so as to reduce the rate of unemployment. It will lead to
increase in competition amongst firms to hire workers. Output can not be expanded further therefore, this policy
change will lead to increase in wage rate and prices and the economy will now operate on point B on SRPC 1. But

12
their expectations about future inflation rate are still same and hence, they are operating on same SRPC1. Now if in
next period, they expect increase in inflation rate, SRPC1 will shift to SRPC2. If we suppose they expect inflation rate
to be I2or I3 which is equal to I2 then there is decline in demand for labour, the unemployment rate starts increasing
and the economy moves to point C as shown in figure given below:
Y LRPC

Rate of Inflation
I2 ,3 C
B

I1 A
SRPC 2

m
SRPC 1

o
O Unem ploym ent X

c g
The result of the above process is that the economy experiences an increase in inflation rate without any decrease

.
in unemployment. Real GDP of the economy does not change only nominal GDP changes.

t n
This natural rate of unemployment is called non-accelerating inflation rate of unemployment (NAIRU).When

r
unemployment rate is less than natural rate of unemployment, the firms which are employing more labour would be
willing to pay a real wage rate lower than what they pay at a higher natural rate of unemployment. If there is trade

a i
union or otherwise a contractual real wage rate then actual rate of unemployment will never be less than natural rate

d
of unemployment. But in reality, firms and workers enter into stipulated agreements on money wage rates and not real

a
m
wage rates. Now it would depend on the expectations of the workers and the firms regarding future prices whether

Re
real wage rate would be lower or higher. If at the time of accepting a job offer, a worker expects a lower future price

y
level than firms, then rate of unemployment will be lower than natural rate of unemployment. It is so because the
expected real wage rate for workers would be greater for workers than for firms. On the other hand, if at the time of

e s
d
accepting a job offer, a worker expects a higher future price level than firms, and then rate of unemployment will be

n
i k
u
more than natural rate of unemployment. It is so because the expected real wage rate for workers would be lower for

l
t
workers than for firms.

n oo
Q. 4. If the assumptions of the Solow model are taken to be true, explain how growth rates converge

s O b
across countries.

r
Ans. Assumptions

-
.e o
1. The simplifying assumption of the model is that the economy produces one composite goods which can either

f E
be consumed or accumulated as a stock of capital. No denial to the fact that many goods are produced in the

b d
economy but only for simplicity sake, it has been assumed that one composite or aggregate goods is produced.

we u an
2. All labour is assumed to be homogeneous.
3. Stock which is accumulated in the past (referred to as capital) and labour are the factors of production in the

H
w Th
production function.
4. Constant returns to scale are assumed to prevail, i.e. any given percentage change in inputs brings forth equal

w
increase in output.
5. MPS is constant. And Savings = sY where s is MPC.
6. Labour force is increasing at a growth rate which is exogenously determined.
7. It is a closed economy.
8. It is a laissez faire economy with no interference of the government.
Steady growth rate would be attained if:
(a) Either all variables are growing at a constant proportional rate or
(b) Not at all
But it is not necessary that all resources grow at the same rate.
Balanced growth is experienced when all variables are increasing at the same proportional rate. Balanced growth
demands that all variables involved in the model must increase the same constant proportion.

13
Absolute and Conditional Convergence
Solow model has implied two convergence hypothesis. Many empirical studies have been undertaken which have
tried to explain how the growth rate of different countries converge in the long-run. There are two versions of the
convergence hypothesis: absolute convergence and conditional convergence.
Absolute Convergence: Suppose there is a group of countries which have assess to same type of technology,
same rate of population growth and the same level of propensity to save. These countries only have a different initial
capital-labour ratio. In such a situation, according to absolute convergence hypothesis of Solow model, all economies
tend to converge to same steady state capital-labour ratio, output per capita and consumption per capita and growth
rate(n). In other words, all the countries tend to have same level of per capita income in the long- run.
It is shown with the help of following diagram. In this diagram, Y1,K1 is the income per head and capital-labour

m
ratio of poor countries; while Y2, K2 is the income per head and capital-labour ratio of rich countries. Otherwise these

o
two countries are identical in terms of population growth, technological growth and MPS. Solow Model claims that in
the long-run these two countries are expected to converge at same level of equilibrium point E with the same level of

. c g
capital-labour ratio k* as shown in the diagram. It simply implies that the rate of growth is relatively faster in poor

t n
countries and rich countries grow relatively slower so that they reach at same level in the long-run.

r
Absolute convergence is shown in fig. given below. The diagram is showing poor countries in subscript 1 and rich
countries in subscript 2. Therefore, y1, k1 is the per capita income and capital- labour ratio of poor countries. y2, k2 is

a i
per capita income and capital-labour ratio of rich countries.

y= Y

a d
e m
L

R
y
Rich C ountry s
initial level of y

de
y2
y*

in ks
y = f(k)

t
l
u
n oo
E sf(f)
y1

s O b
Poor Country s

r
initial level of y

-
.e
y

fo E k

d
O k1 k* k1

b
we n
Absolute Convergence

u a
H
Conditional Convergence: According to this hypothesis, there is practically a difference in the rate of population

w Th
growth, technological changes, MPS of different countries. Therefore, assuming diminishing returns to capital, it
states that each country will converge to its own steady rate rather than to a common steady state across countries.

w
It is more realistic; however, it also is just a prediction of Solow model.
Convergence and Growth Regression
Using the statistics collected by Maddision in 1982, Baumol examined convergence from 1870 to 1979 among 16
industrialized nations on a constant and initial income.
Log  ( y | N i ,1979 )  – log  Y/N i ,1870 
= a + b log  ( Y / N ) iˆ ,1 8 7 6  + e i
Where log (Y/N) is log per capital income e is used for error term.
i is indicating indices of countries.
If there is convergence in the economy the value of b will be negative. It means that the countries with higher
initial income will grow at a lower rate.
Value of b will lie between 0 and – 1, 0 implying no convergence and–1implying perfect convergence.

14
 Baumol’s results of the estimation can be expressed in the form of following equation
log (Y | N)i ,1976  – log (Y / N)i ,1870 
= 8.457 – 0.995 log ( Y | N )i1870 
Since the estimated value of b is very close to – 1 and the standard error of b is very small, we can say that it is
statistically significant.
But such results have been criticized by Economists like De Long. He criticized Baumol’s findings on two
grounds.
(a) Sample selection as biased.
(b) Error of estimation.
These two limitations undermine the importance of Baumol’s estimates.

m
Q. 5. Bring out the salient features of the real business cycle theory.

o
Ans. Real Business Cycle Theory: The Real Business Cycle Model criticizes on Keynesian approach that it
gives too much emphasis on the aggregate demand. This theory gives a greater emphasis on supply side and therefore,

c g
is sometimes also called ‘New Classical’.

.
However, there can be many types of external shocks. These shocks can originate on either demand side or

t n
supply side. These shocks may be caused even by monetary and fiscal policy of the government. But the focus of The

r
Real Business Cycle Model is on productivity shocks. There are different types of productivity shocks:
(a) Development of new techniques;

a i
(b) New management practices;
(c) Bumper crop or crop failure;

a d
m
(d) New suppliers coming from external economy etc.

Re
y
The Real Business Cycle Model explains productivity shocks and the extension as well as impact of these shocks
on other variables in the economy.

d e s
The Real Business Cycle Model is built upon Brock-Mirman Model of the type in which discounting is present.

n
The model explains a decision regarding labour and leisure where it is assumed that leisure also gives utility.

i k
u l
The structure of the model is similar to that of optimization under uncertainty.

t n oo
An Island Economy: Let us consider an economy with islands of local markets. Each household is producing

s O b
goods and he sells these goods to only to one of the arrays of these markets. Goods are differentiated on the basis of

r -
location, physical characteristics etc. These goods can be indexed by z where z = 1, 2 ….n. The index might specify

.e o E
a location or be associated some other specific characteristic of the goods. It may also be concerned with production

f
method. P(z) is the price of a basket of commodities of type z during period t. Therefore, the relative price is the price

b d
we
of commo-dities of location z, r type z in relation to commodities of location z’ or type z’. It is the general price level

u an
in time period t, if p,t(z) > pt, then sellers find locale z to be relatively more attractive. There will be a shift of

H
productive resources from the production of other goods to the production of goods z type. When the supply increases,

w Th
it will bring down the price of z to the average price level. In case, pt(z) < pt, then sellers find locale z to be relatively
less attractive. There will be a shift of productive resources from the production of z to the production of other goods.

w
When the supply decreases, it will push the price of z to the average price level. Therefore, given free entry and exit
in the market, the average of all prices will be an efficient estimator of the local price.
At the beginning of period t, suppose that producer of market z has a capital stock of kt–1(z). If we assume that
the production function of z satisfies standard properties of a production function then the quantity of goods produced
will be given by y’(z) = f (kt–1(z), lt(z)). The TR can be obtained by multiplying this quantity with the local price.
However, people’s choices are more frequently influenced by the level of pt. Therefore, a producer will calculate the
real value of the revenue from production. It will be given by
(p’(z)/pt). f (kt–1(z), lt(z)).
Therefore, an increase in the relative price given above means an increase in TR from sales, physical output
being same. From a producer’s perspective, this is equivalent to an upward shift in production function. Before this

15
change, the producer was considering physical marginal product of labour to decide how much to produce. But now
in order to calculate the real effect on TR, producers multiply that number by relative price to get the real value of the
marginal product of labour.
Now let us discuss what induces producers to invest. It is determined by the marginal product of capital. However,
the marginal product of this factor determines the flow of next period’s output as a result of an increase in this period’s
capital stock. There is a lag of one time period to raise investment. Therefore, the real value of the marginal product
is dependent on investment decisions. Real value of capital’s marginal product is equal to the product of this period’s
marginal product and the next period’s relative price. Symbolically, it is equal to:
Pt+1 (z)/ P t+1

m
There are two possibilities on the basis of which reactions of producers to this change in relative price will vary.

o
This change in price level may be temporary and people do not expect it to continue in the next period. In such a
situation, the change will be equivalent to an upward shift in the schedule of labour’s marginal product in t. But not in

. c g
the next periods. Two kinds of substitutions effects are working. One is the movement away from the leisure towards

t n
consumption and other is inter temporal substitution effect i.e. shifting away from today’s leisure towards tomorrow’s
leisure. The second effect implies that effect of such a change will be greater n current work and production.

r
Another possibility is that a high relative price today is an increase in the expected relative price

a i
Pt+1 (z)/ Pt+1. in such a situation, there will be a favourable effect on investment today. Producers will buy additional

d
capital from other markets which will be used for capitalizing on the higher relative price of the goods sold later in

a
m
location z. It will increase demand for local resources in location z. It will induce investors to spend at a high relative

e
price today. A high prospective relative price means that the high current relative price is no more an opportunity to

R
y
reap present rewards. It will weaken inter temporal substitution effects. Therefore, there might be a negligible effect

d e
on work effort and supply of goods today.

in ks
This is to be noted that this high relative price can not sustain for longer. The increased investment that results in

ul
increased productive capacity will increase supply of goods in the future. The augmented supply of goods in future

t n oo
will exert downward pressure on future relative prices. Therefore, a high relative price must persist for long enough

s O b
in order to generate positive effects on investment. If it is not so, then inter-temporal effects of investment will remain

r -
strong.

.e o E
Let us take nominal interest rate as a system wide variable determined on a centralized credit market. Accordingly,

f
the real rate of interest r1 is an economy wide variable as well. Buyers, who visit island z, will be deterred in their

b d
we
consumption and investment demands by high relative prices. Given a high relative price, a high real interest rate

u a n
means a greater supply of goods to the market z but the demand for consumer and investment goods will decrease.

H
Imperfect Information: Buyers and sellers have got perfect knowledge about the local price but they are not

w Th
certain of average of all prices. Let us assume that there are rational expectations in its weak form i.e. people do not
make systematic errors. The basic assumption is that local price is not assumed to different from expected general

w
price level. Another assumption is that information set of all agents is identical. The price Pt(z) will be known
empirically only after the unfolding of actual interval t. There is very less probability that this price will be equal to the
earlier estimate of the general price level because the set has at least one new element . The estimate of the general
price level can be updated with the new actual price. If the local price in period t is higher than expected price then the
average of all prices will exceed the previous average of all prices. Let us call this price to be ex-post price expectation.
Let us give weight θ to the local price level and 1–θ to the prior general price level in forming the new estimate of the
average of all prices. It implies that Pte (z) = θ p t (z) + (1– θ) Pte. People will set a high value of θ in case there is
difference in their market from other markets in terms of price space. On the contrary, the weight on the general price
level is greater when there are no aggregate shocks that bring about a change in the general price level over time.
Suppose the economic environment is buffeted by unexpected changes in money and factors that affect the demand
for money, then a limited credence will be attached to general price level.

16
 An individual’s ex-post expectations about the general price level will determine his attitude towards relative
price. It is not actual but perceived relative price that determines the demand and supply functions in market z. The
equilibrium price and output are determined by the intersection of demand and supply curves. In case there is an
increase in price ratio, it will bring about an increase in relative price. As we have updated the formula the ex-post
price expectation will rise by a fraction, θ, of the increase in local price. Therefore, the rise in perceived relative price
is less than the price ratio. Suppose the prior expectation of the price is 200 and θ is 1/3, then if local price is 220, then
Pt(z)/ Pte will be equal to 220/200 = 1.10. In such a case, Pte (z) will be equal to 1/3*110 +2/3 *200 = 170.
It means, if the weight given to local price is one third, then the perceived relative price changes by approximately
33% less than the price ratio. In general terms, we can say that there is an inverse relation between the weight and
reaction of price ratio. The local market clears when the price ratio is equal to unity. On the same logic, we can say

m
that the market clearing perceived relative price is also unity.

o
If there is an unanticipated surprise increase in the stock of money Mt and local price rises in a typical market
then given the prior price, the price ratio will go up. Hence, the perceived relative price also increases. Then typical

c g
of a consumer feels that he is operating in a market where the relative price is high. But it is not true as the general

.
price level is the average of the local prices across markets. But the problem is that the average price level and the

t n
quantity of money are not a part of information set, therefore, the representative individual overestimates the relative

r
price in his local market or to say he underestimates the increase in general price level. As a result, people increase
their supplies of goods and decrease their demand for goods.

a i
With an increase in perceived relative price, there is a rise in relative price that people expect in the local market

a d
in the coming period. Therefore, there is rise in investment demand in current period. The demand and supply curves

Re m
now combine two effects of changes in the price ratio.

y
(a) The impact on current perceived relative price makes the supply curve more positively sloped.
(b) The negative slope of demand curve reduces due to the effects from the changes in the perspective relative

d e s
price.

n
i k
If second effect is stronger than the first, then there is an expansion in investment and there are effects on real

u l
interest rates. The supply of goods will be more than demand for goods in a typical market. Therefore, in the

t n oo
aggregate, desired savings exceed net investment demand. The expected real interest rate falls until the two become

s O b
equal. It means that AD curve shifts rightward and supply curve shifts leftward. The lower expected real interest rate

r -
induces people to invest and consume more but to work and produce less.

.e o E
The higher price ratio increases supply but decreases consumption and investment demand. The anticipation of a

f
high prospective relative encourages investment and reduces the supply of current commodities. Finally, with the

b d
we
decrease in real interest rate, there is an increase in consumption and investment demand but supply decreases. In

u an
such a situation, whether output increases or not would depend on the powerful positive effect the increase in the

H
prospective relative price on the local investment demand. In such a situation, the monetary disturbance will push

w Th
local investment, output and effort.
If in an economy, the monetary authorities are capricious and changing the money supply widely from period to

w
period, then the general price level diverges sharply from the expected level. Therefore, the people will have lesser
confidence that the change in local price level is a reflection of a change in relative price. They would believe that a
high local price signaled a more than proportionate expected general price level. Therefore, demand and supply are
comparatively unresponsive to observed changes in the local price. In such a situation, monetary expansion has small
effects on output. As a result, the greater is the volatility of the time series of money, the smaller is the real effect of
monetary prices with surprisingly high general price levels. Therefore, it will be difficult for authorities to fool people
that relative prices have changed.
Basically, a great fluctuation in money supply from one interval of time to the next means that prices become less
responsive to changes in local prices. Agents make lesser mistakes if price changes reflect unexpected changes in
money and the general price level, the lesser prices become useful in conveying information par excellence. It makes

17
economy less responsive to changes in basics, shifts in tastes and technology, which requires optimum and efficient
reallocation of resources. To conclude, we can say that changes in average growth of money are neutral but changes
in predictability has real effects. Therefore, the desirable is that the monetary policy of the government should be
predictable.
Cyclical Fluctuations: When in an economy, the value of money above trend indicates an unexpectedly high
level of money in the recent past. The model predicts that this excess above trend would induce a higher level of
output, work effort and investment because all are a function of money. These predictions have been verified through
empirical evidence. It means that money, employment and trend vary pro-cyclically. On the other hand, some predictions
generated by the model fit the data less tightly. According to the theory, a monetary shock would lead to an increase

m
in general price level and a fall in the expected interest rate. The proposition of rise in price level being pro-cyclical
and the expected rate of interest being counter-cyclical is not supported the evidence. The production function is

o
assume dot be constant and capital stock is given in the short run, the increase in the employment of labour means AP

c g
and MP of labour will decrease. The theory predicts an inverse relation between labour productivity and the real

.
wage rate and volume of output and labour units consumed. It means that more is the volume of output and labour

t n
units consumed less will be labour productivity and real wage rate and vice-versa. It means labour productivity and

r
real wage rate change counter-cyclically. This is also not supported by the empirical evidence.
To conclude, we can say that it is advisable to incorporate shifts in the production function and monetary shocks

a i
to explain cyclical fluctuations as all fluctuations are not entirely driven by monetary surprises.

d
There can be many types of external shocks. These shocks can originate on either demand side or supply side.

a
m
These shocks may be caused even by monetary and fiscal policy of the government. But the focus of The real

e
business cycle model is on productivity shocks. There are different types of productivity shocks:

R
y
(a) Development of new techniques;

d e
(b) New management practices;

in ks
(c) Bumper crop or crop failure;

u
(d) New suppliers coming from external economy etc.

l
t n oo
Random Movements Periodicity of cycles

s O b
As the name suggests, these shocks are ran- These shocks tend to repeat after a particu-
dom i.e. irregular and sudden. There is no lar period of time. There is fixity of periodic-

r -
.e
fixity in these shocks. ity in these shocks.

fo E
Development of new techniques is an ex- Business cycles or seasonal variations are ex-

d
ample of random movement as we can not amples of periodicity of cycles.

b
we n
say with surety how many years it will take

u a
to get new technology.

H
w Th
It is caused by monetary and fiscal policy. It s corrected by monetary and fiscal policy.
Q. 6. What, according to Keynesian economists, are the factors that lead to rigidities in wages and

w
prices?
Ans. The New Keynesian economists consider nominal as well as real rigidities to reach at their conclusion that
nominal changes in money supply have not only nominal but also real effects on the economy. An increase in money
supply can increase aggregate output but not price level. But a fall in money supply can lead to fall in output and an a
rise in unemployment.
It is not sufficient to introduce imperfection in commodity market and menu costs in the economy. Moreover,
according to this idea, menu costs can have important macroeconomic effects only in the presence of real rigidities.
Nominal rigidities will not be affected by menu costs. If in real life scenario, the value of elasticity of labour supply and
elasticity of output demand, price setting firms have strong incentives to change prices even if they have to bear the
menu cost of changing such price. Romer, an economist showed in 2001 that for a 3% fall in output, the firm can
increase its profits by one forth of the revenue if it chooses to change the price. It simply means that firms will not

18
mind to bear even one forth of the revenue as menu cost if the elasticity of output demand is high and the elasticity of
labour supply is low. If these values are realistic, then we cannot explain nominal rigidities and the resultant
unemployment on the basis of menu costs. It must be involving some other changes which have been ignored so far.
These other factors that have been introduced to explain the rigidities are concerned with the characteristics of
the goods, labour and credit markets. The goods and labour markets have such characteristics that shift in demand
translate into a small variation in prices and a larger variation in quantities than would have happened in a competitive
market. Similarly in labour market, when there is a shift in demand for labour curve it leads to larger changes in
employment and smaller changes in real wages. Such rigidities are occurring because of the goods, labour and credit
market’s characteristics have been named as real rigidities. Let us now elaborate on how the imperfection in the
goods, labour and credit market leads to less than full employment equilibrium level of output and how it produces

m
unemployment.
Real Rigidities in the Goods Market: It is well known that perfect competition is a myth. Real life goods

o
markets are characterized by imperfect competition in which producers do have some control over prices. Imperfect
competition gives monopoly power to the producers and gives them some control over price. When they are price-

. c g
makers, it generates rigidity in real prices in relation to quantities. It is also known to you (You have studies it in Micro
Economics), that price is equal to marginal cost in perfectly competitive market but a firm under imperfect competition

t n
is able to sell its output at a price higher than its marginal cost. It is a mark-up over cost which covers fixed cost of

r
production and also includes profits. New Keynesian Economists believed that the mark-up behaves in a counter

a
cyclical fashion which means that this mark-up price decreases during booms and increases during recession. These

i
counter cyclical movements in the mark-up price lead to price rigidity in the goods market. When there is an increase

d
a
in the level of AD, it causes output and employment to increase and not the prices.

Re m
Reasons behind counter cyclical behaviour of mark-up prices:

y
(a) Thick Market Effects: It claims that higher level of economic activity during booms decreases the significance
of costs of acquiring and disseminating information. It makes the market more competitive.

d e s
(b) Difficulty in Maintaining collusion: When there are greater profits during the booms, it becomes relatively

n
more difficult to maintain collusion. It brings mark up prices down.

i k
ul
(c) Pro-cyclical Nature of Marginal costs: Mark-up price is counter cyclical because of the fact that marginal

t n oo
costs are pro-cyclical. It is so because overtime paid to the workers is highly pro-cyclical and therefore

s O b
expensive for the firms. Since prices are rigid, the mark-up price is compressed with the increase in marginal
costs. In simple words, it needs to be clarified that mark price fall over booms in spite of the fact that marginal

r -
.e
costs are rising due to price rigidity for reasons which are independent of the rise in costs.

fo E
Real Rigidities in the Credit Market: Like goods market, the imperfections in the credit market also have

d
macroeconomic consequences. Those imperfections in the credit market which bring about rigidity in the prices are

b
we u an
called rigidities in credit market.
(a) Reasons for rigidities in credit market: In the credit market, imperfections arise mainly due to asymmetric

H
w Th
information between lenders and borrowers. Borrowers are assumed and empirically seen to be better informed
about the efficacy of their investment project and the success of investment projects.
(b) These types of asymmetric information have microeconomic implications like equilibrium credit rationing,

w
need for financial intermediation and need for government intermediation.
(c) It is seen that in a monetary policy transmission mechanism credit channel is more important than money
supply channel and if we wish to implement restrictive monetary policy, credit rationing proves to be more effective
than rise in the rate of interest.
Therefore, when contractionary monetary policy reduces the volume of bank reserves, the credit creation capacity
of banks gets adversely affected. This short fall in credit may not be made up by other lenders given the imperfections
in the credit market in the form of information asymmetries between lenders and borrowers. Banks can easily
overcome these information asymmetries being financial intermediary. The process of credit rationing is more effective
in when volume of credit is reduced in decreasing AD than the process of increasing rate of interest and thereby
affecting AD.

19
 Keeping in mind the importance and imperfections of credit market, we need to be cautious that credit market
imperfections can increase and multiply the effects of real disturbances. It is very important to note that those
disturbances that would have produced mild effects in case of existence of Walsarian credit markets can lead to total
financial collapse in imperfect markets due to magnification effects.
Real Rigidities in the Labour Market: New Keynesian theories of labour market have offered an explanation
for the existence of involuntary unemployment and these theories also explain the reasons for changes in AD bringing
about larger changes in employment and comparatively smaller changes in real wages in the labour market. Real
rigidities in labour market exist due to the fourth behaviour explained in chapter 13. Some firms may also have an
opinion that by keeping wages high, it is able to ensure efficiency and the benefits that firms are getting from this
higher level of efficiency are greater than the cost of paying higher wages. These theories are called efficiency-wage

m
theories which are built on the idea that higher wages means higher efficiency and hence, it is advisable to keep
wages high. This leads to imperfection in the labour market that causes unemployment. The Wage-Efficiency model

o
of Unemployment will be discussed in detail in chapter 16.

c g
Q. 7. Write short notes on the following.

.
(a) Permanent income hypothesis.
Ans. Permanent Income Hypothesis: Milton Friedman offered an alternative explanation for the difference

t n
between cross-sectional and time series data on consumption through permanent income hypothesis. The permanent

r
income hypothesis is also based on Fisher’s theory of consumption as an inter-temporal choice. Unlike the life-cycle
hypothesis, Milton Friedman did not assume that there is any regularity or uniformity in the pattern of income over the

a i
life-cycle of an individual, he opined that there are random and frequent temporary changes in the income of the
household from time to time. Friedman categorized the income of an individual into two parts.

a d
m
→ Permanent Income (YtP )

e
y R
→ Transitory Income (YtT )
There are certain incomes which are irregular and co-incidental. These are called transitory income by Friedman.

d e
However, permanent income is that part of the income which are expected to prevail over long period of time.

in ks
u
Friedman interprets it as the long-run average income of the individual.

l
t n oo
1 T 
Yt p = T  ∑ Yt 

s O b
t =1

r
and transitory income means any deviation from this average.

-
.e o
1 T 

E
Y = Yt –  ∑ Yt 

f
T

T  t =1 
t

b d
we
A positive transitory income would make the current income of the household greater than the permanent income

u a n
and a negative transitory income would mean that current income of the houshold lower than permanent income.

H
w Th
A 1 T
 A
Since Ct = T + T  ∑ Yt  = T + Yt
0 0 T

t =1

w
The above equation makes it clear that the current consumption of a household depends only on permanent
income and any increase or decrease in transitory part of the income, which does not affect permanent income will
not bring about any changes in current consumption.
One of the biggest achievement of Friedman’s permanent hypothesis is that it solves the apparent puzzle in the
consumption data Milton Friedman has proved it systematically, that APC (Ct/ Yt) is dependent on the ratio of
permanent income to current, (YtP / yt ) Hence, when current income rises above the permanent income the average
propensity to consume falls and when current income is below the permanent income, the average propensity to
consume rises.
He further classified that when we are considering cross-sectional data of different household at any point of
time, especially the high income group will have some households with high transitory income and they will have a
lower propensity of consume than average. Similarly, in the group of low income groups these could be some households

20
who have low transitory income and hence, they will have a higher propensity to consume than average. Consequenty
we get a falling average propensity to consume as we move from the lower to the higher income group. On the other
hand, when we are considering long-run time series data, the random fluctuation tend to counter balance each other
in such a way that any change in income brings about a permanent change in the average income level. Hence, in the
long-run time series data, APC tends to become constant.
(b) Rational expectation hypothesis
Ans. When we endow micro foundations in any macro-economic model, it must incorporate the fact that individual
economic agents make decisions by considering present as well as future values of policy variables. If we wish to
predict the effect of choosing a particular current value of a policy variable, we must also consider the effect of such
a choice on expected future value of that variable.

m
If we wish to use a model to get a probability distribution for dependent variables on objectively quantifiable

o
variables, then it is incorrect to assume that expectations are an exogenous variable. It must be explained endogenously
in the model. If we assume economic agents to be rational, then they would try to maximize their utility functions

c g
subject to constraints to their choices. So, they will make decisions on the basis of objective conditional probability

.
distribution. It is called hypothesis of rational expectations.

t n
It implies that if a policy-maker wishes to evaluate a policy by using a macro-economic model, then the policy-

r
maker must know the specific values of the policy variables which the policy will target for under different future

a i
circumstances. Hence, for evaluating the effects of choosing a particular policy in the current period, the policy

d
maker must have a policy rule in his mind. It would enable to evaluate the effects of a particular current policy as well

a
m
as the effects of a particular current policy as a part of policy rule.

Re
n n

d n
i k
e s y
t u l
n oo
s r
O b
-
.e b
fo
d
E
we H
u an
w Th
w

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