Sem-II Book INTRODUCTORY MACROECONOMICS

UNIT - 1
INTRODUCTION TO MACROECONOMICS AND

NATIONAL INCOME ACCOUNTING
Introduction to Macroeconomics (Abel – Ch. 1)
Review Questions
1. How have total output and output per worker changed over time in the
United States? How have these changes affected the lives of typical
people?
2. What is a business cycle? How does the unemployment rate behave over
the course of a business cycle? Does the unemployment rate ever reach
zero?
3. Define inflation and deflation. Compare the behavior of consumer prices

in the United States in the years before and after World War II.
4. Historically, when has the Federal government been most likely to run
budget deficits? What has been the recent experience?
5. Define trade deficit and trade surplus. In recent years, has the U.S.
economy had trade deficits or trade surpluses? What was the U.S.
experience from 1900 to 1970?
6. List the principal professional activities of macroeconomists. What role

does macroeconomic research play in each of these activities?
7. What steps are involved in developing and testing an economic theory or

model? What are the criteria for a useful theory or model?
8. Might tow economists agree about the effects of a particular economic

policy but disagree about the desirability of implementing the policy?
Explain your answer.
9. Compare the classical and Keynesian views on the speed of wage and
price adjustment. What are the important consequences of the
differences in their views?
10. What was stagflation, and when did it occur? How did it change
economists’ views about macroeconomics?
Bliss Point Studies 1 Ravindra N. Jha

011-45076221 9811343411
Numerical Problems
1. Here are some macroeconomic data for the country of Oz for the year
2008 and 2009.
2008 2009
Output 12000 tons of potatoes 14300 tons of potatoes
Employment 1000 workers 1100 workers
Unemployment 100 workers 50 workers
Total labor force 1100 workers 1150 workers
Price 2 shekels/ton of potatoes 2.5 shekels/ton of potatoes
As the data suggest, Oz produces only potatoes, and its monetary unit is
the shekel. Calculate each of the following macroeconomic variables for
Oz, being sure to give units.
(a) Average labor productivity in 2008 and 2009.
(b) The growth rate of average labor productivity between 2008 and
2009.
(c) The unemployment rate in 2008 and 2009.
(d) The inflation rate between 2008 and 2009.
2. In a recent issue of the Survey of Current Business, find the data section
entitled “Selected NIPA Tables.” In Table 1.1.5, “Gross Domestic
Product,” find data on gross domestic product (a measure of total
output), exports, and imports. In Table 3.2, “Federal Government
Current Receipts and Expenditures,” find data on the government’s total
receipts (taxes) and expenditures. These tables from the Survey of
Current Business can be accessed from the home page of the Bureau of
Economic Analysis at www.bea.gov.
(a) Calculate the ratio of exports to GDP, the ratio of imports to GDP,
and the ratio of the trade imbalance to GDP in the latest reported
quarter. Compare the answers with the values reported for the
previous tow complete years.
(b) Calculate the ratio of Federal government receipts to GDP, the ratio
of Federal government expenditures to GDP, and the ratio of the
budget deficit to GDP, for the most recent quarter and for the
previous tow complete years.
Analytical Problems
1. Can average labor productivity fall even though total output is rising?
Can the unemployment rate rise even though total output is rising?

011-45076221 9811343411
2. Prices were much higher in the United States in 2009 than in 1890. Does
this fact mean that people were economically better off in 1890? Why or
why not?
3. State a theory for why people vote Republican or Democratic that

potentially could satisfy the criteria for a useful theory given in the test.
How would you go about testing your theory?
4. Which of the following statements are positive in nature and which are
normative?
(a) A tax cut will raise interest rates.
(b) A reduction in the payroll tax would primarily benefit poor and
middle-class workers.
(c) Payroll taxes are too high.
(d) A cut in the payroll tax would improve the President’[s popularity
ratings.
(e) Payroll taxes should not be cut unless capital gains taxes are cut
also.
5. In 2002, President George W. Bush imposed tariffs on certain types of

imported steel. He argued that foreign steel producers were dumping
their steel on the U.S. market at low prices. The foreign steel producers
were able to sell steel cheaply because they received subsidies from their
governments. The Bush administration argued that the influx of steel
was disrupting the U.S. economy, harming the domestic steel industry,
and causing unemployment among U.S. steel workers. What might a
classical economist say in response to these claims? Would a Keynesian
economist be more or less sympathetic to the imposition of tariffs? Why?

011-45076221 9811343411
The Measurement and Structure of the National Economy
(Abel – Ch. 2)
Review Questions
1. What are the three approaches to measuring economics activity? Why do
they give the same answer?
2. Why are goods and services counted in GDP at market value? Are there
any disadvantages or problems in using market values to measure
production?
3. What is the difference between intermediate and final goods and

services? In which of these categories do capital goods, such as factories
and machines, fall? Why is the distinction between intermediate and
final goods important for measuring GDP?
4. How does GDP differ from GNP? If a country employs many foreign
workers, which is likely to be higher: GDP or GNP?
5. List the four components of total spending. Why are imports subtracted
when GDP is calculated in the expenditure approach?
6. Define private saving. How is private saving used in the economy? What
is the relationship between private saving and national saving?
7. What is national wealth, and why is it important? How is national wealth

linked to national saving?
8. For the purposes of assessing an economy’s growth performance, which

is the more important statistic: real GDP or nominal GDP? Why?
9. Describe how the CPI and CPI inflation are calculated. What are some
reasons that CPI inflation may overstate the true increase in the cost of
living?
10. Explain the differences among the nominal interest rate, the real interest
rate, and the expected real interest rate. Which interest rate concept is
the most important for the decisions made by borrowers and lenders?
Why?
Numerical Problems
1. After a boat rescues everyone else from Gilligan’s Island, the Professor
and Gilligan remain behind, afraid of getting shipwrecked again with the
same bunch of people. The Professor grows coconuts and catches fish.

011-45076221 9811343411
Last year he harvested 1000 coconuts and caught 500 fish. He values
one fish as worth tow coconuts. The Professor gave 200 coconuts to
Gilligan in exchange for help in the harvest, and he gave Gilligan 100 fish
in exchange for collecting worms for use in fishing. The Professor stored
100 of his coconuts in his hut for consumption at some future time.
Gilligan consumed all his coconuts and fish.
In terms of fish, what is the GDP of Gilligan’s Island? What are
consumption and investment? What are the incomes of the Professor and
Gilligan?
2. National income and product data are generally revised. What effects
would the following revisions have on consumption, investment,
government purchases, net exports, and GDP?
(a) It is discovered that consumers bought $6 billion more furniture
than previously thought. This furniture was manufactured in
North Carolina.
(b) It is discovered that consumers bought $6 billion more furniture
Sweden.
(c) It is discovered that businesses bought $6 billion more furniture
Sweden.
(d) It is discovered that businesses bought $6 billion more furniture
Sweden.
3. ABC Computer Company has a $20,000,000 factory in Silicon Valley.

During the current year ABC builds $2,000,000 worth of computer
components. ABC’s costs are labor, $1,000,000; interest on debt,
$100,000; and taxes $200,000.
ABC sells all its output to XYZ Supercomputer. Using ABC’s components,
XYZ builds four supercomputers at a cost of $800,000 each ($500,000
worth of components, $200,000 in labor costs, and $100,000 in taxes
per computer). XYZ has a $30,000,000 factory.
XYZ sells three of the supercomputers for $1,000,000 each. At year’s
end, it had not sold the fourth. The unsold computer is carried on XYZ’s
books as an $800,000 increase in inventory.
(a) Calculate the contributions to GDP of these transactions, showing
that all three approaches give the same answer.
(b) Repeat part (a), but now assume that, in addition to its other costs,
ABC paid $500,000 for imported computer chips.

011-45076221 9811343411
4. For each of the following transactions, determine the contribution to the
current year’s GDP. Explain the effects on the product, income, and
expenditure accounts.
(a) On January 1, you purchase 10 gallons of gasoline at $2.80 per
gallon. The gas station purchased the gasoline the previous week
at a wholesale price (transportation included) of $2.60 per gallon.
(b) Colonel Hogwash purchases a Civil War-era mansion for $100,000.
The broker’s fee is 6%.
(c) A homemaker enters the work force, taking a job that will pay
$40,000 over the year. The homemaker must pay $16,000 over the
year for professional child care services.
(d) A Japanese company builds an auto plant in Tennessee for
$100,000,000, using only local labor and materials. (Hint : The
auto plant is a capital good produced by Americans and purchased
by the Japanese.)
(e) You are informed that you have won $3,000,000 in the New Jersey
State Lottery, to be paid to you, in total, immediately.
(f) The New Jersey state government pays you an additional $5000 fee
to appear in a TV commercial publicizing the state lottery.
(g) Hertz Rent-a-Car replaces its rental fleet by buying $100,000,000
worth of new cars from General Motors. It sells its old fleet to a
consortium of used-car dealers for $40,000,000. The consortium
resells the used cars to the public for a total of $60,000,000.
5. You are given the following information about an economy:

Gross private domestic investment = 40
Government purchases of goods and services = 30
Gross national product (GNP) = 200
Current account balance = –20
Taxes = 60
Government transfer payments to the domestic private sector = 25
Investment payments from the government to the domestic private sector
= 15 (Assume all interest payments by the government go to domestic
households.)
Factor income received from rest of world = 7
Factor payments made to rest of world = 9
Find the following, assuming that government investment is zero:
(a) Consumption (b) Net exports
(c) GDP (d) Net factor payments from abroad
(e) Private saving (f) Government saving
(g) National saving

011-45076221 9811343411
6. Consider an economy that produces only three types of fruit: apples,
oranges, and bananas. In the base year (a few years ago), the production
and price data were as follows:
Fruit Quantity Price
Apples 3,000 bags $2 per bag
Bananas 6,000 bunches $3 per bunch
Oranges 8,000 bags $4 per bag
In the current year the production and price data are as follows:
Fruit Quantity Price
Apples 4,000 bags $3 per bag
Bananas 32,000 $2 per bunch
Oranges 32,000 bags $5 per bag
(a) Find nominal GDP in the current year and in the base year. What
is the percentages increase since the base year?
(b) Find real GDP in the current year and in the base year. By what
percentage does real GDP increase from the base year to the
current year?
(c) Find the GDP deflator for the current year and the base year. By
what percentage does the price level change from the base year to
the current year?
(d) Would you say that the percentage increase in nominal GDP in this
economy since the base year is due more to increases in prices or
increases in the physical volume of output?
7. For the consumer price index values shown, calculate the rate of
inflation in each year from 1930 to 1933. What is unusual about this
period, relative to recent experience?
Year 1929 1930 1931 1932 1933
CPI 51.3 50.0 45.6 40.9 38.8
8. Hy Marks buys a one-year government bond or January 1, 2009, for

$500. He receives principal plus interest totaling $545 on January 1,
2010. Suppose that the CPI is 200 on January 1, 2009 and 214 on
January 1, 2010. This increase in prices is more that Hy had anticipated;
his guess was that the CPI would be at 210 by the beginning of 2010.
Find the nominal interest rate, the inflation rate, the real interest rate,
Hy’s expected inflation rate, and Hy’s expected real interest rate.
9. The GDP deflator in Econoland is 200 on January 1, 2008, The deflator

rises to 242 by January 1, 2010, and to 266.2 by January 1, 2011.

011-45076221 9811343411
(a) What is the annual rate of inflation over the two-year period
between January 1, 20008, and January 1, 2010? In other words,
what constant yearly rate of inflation would lead to the price rise
observed over those two years?
(b) What is the annual rate of inflation over the three-year period from
January 1, 2008, to January 1, 2011?
(c) In general, if P0 is the price level at the beginning of an n-year
period, and Pn is the price level at the end of that period, show that
the annual rate of inflation π over that period satisfies the
equation
1  πn  Pn /P0
The market and charges only $2 per phone call. All of the residents
immediately stop using Calls-R-Us and switch to Cheap Call. They
still make 2 million phone calls per year. The executives of Cheap
Call are proud of their market share. Moreover, they post
billboards stating, “O2ur country has increased its national saving
by $2 million per year by switching to Cheap Call.” Comment on
the accuracy of the statement on the billboards.
10. Economists have tried to measure the GDPs of virtually all the world’s
nations. This problem asks you to think about some practical issues that
arise in that effort.
(a) Before the fall of communism, the economies of the Soviet Union
and Eastern Europe were centrally planned. One aspect of central
planning is that most prices are set by the government. A
government-set price may be too low, in that people want to buy
more of the good at the fixed price than there are supplies
available; or the price may be too high, so that large stocks of the
good sit unsold on store shelves.
What problem does government control of prices create for

economists attempting to measure a country’s GDP? Suggest a
strategy for dealing with this problem.
(b) In very poor, agricultural countries, many people grow their own
food, make their own clothes, and provide services for one another
within a family or village group. Official GDP estimates for these
countries are often extremely low, perhaps just a few hundred
dollars per person. Some economists have argued that the official
GDP figures underestimate these nations’ actual GDPs. Why might
this be so? Again, can you suggest a strategy for dealing with this
measurement problem?

011-45076221 9811343411
11. Government saving is defined as T – (G + TR + INT), where G is
government purchases. But suppose that we split government purchases
into two parts: government consumption expenditures (GCE + TR + INT).
With this new definition of government saving, which treats government
investment similarly to private investment, how would the uses-of-saving
identity be modified?
To investigate how much difference this redefinition would make, look at
the NIPA section of a recent issue of the Survey of Current Business or
online at www.bea.gov, and find Table 5.1, “Gross Saving and
Investment”. The table refers to private saving as gross private saving, to
investment as gross private domestic investment, to the current account
balance as net foreign investment, to government investment as gross
government investment, and to the new version of government saving as
gross government investment, and to the new version of government
saving as gross government saving. Verify that both the old and new
definitions of the uses-of-savings identity are valid, except for statistical
discrepancies.

011-45076221 9811343411
Saving and Investment in the Open Economy
(Abel - Ch. 5)
Analytical Problems
1. Explain how each of the following transactions would enter the U.S.
balance of payments accounts. Discuss only the transactions described.
Do not be concerned with possible offsetting transactions.
(a) The U.S. government self F-16 fighter planes to a foreign
government.
(b) A London bank sells yen to, and buys dollars from, a Swiss bank.
(c) The Federal Reserve sells yen to, and buys dollars from, a Swiss
bank.
(d) A New York bank receives the interest on its loans to Brazil.
(e) A U.S. collector buys some ancient artifacts from a collection in
Egypt.
(f) A U.S. oil company buys insurance from a Canadian insurance
company to insure its oil rigs in the Gulf of Mexico.
(g) A U.S. company borrows from a British bank.
2. For each transaction described in Analytical Problem 1 that by itself

changes the sum of the U.S. current account balance, CA, and the U.S
capital and financial account balance, KFA, give an example of an
offsetting transaction that would leave CA + KFA unchanged.
3. A large country imposes capital controls that prohibit foreign borrowing

and lending by domestic residents. Analyze the effects on the country’s
current account balance, national saving, and investment, and on
domestic and world real interest rates. Assume the before the capital
controls were imposed, the large country was running a capital and
financial account surplus.
4. The text showed, for a small open economy, that an increase in the
government budget deficit raises the current account deficit only if it
affects desired national saving in the home country. Show that this
result is also true for a large open economy. Then assume that an
increase in the government budget deficit does affects will the increased
budget deficit have on the foreign country’s current account, investment
in both countries, and the world real interest rate?

011-45076221 9811343411
5. How would each of the following affect national saving, investment, the
current account balance, and the real interest rate in a large open
economy?
(a) An increase in the domestic willingness to save (which raises
described national saving at any given real interest rate).
(b) An increase in the willingness of foreigners to save.
(c) A temporary increase in foreign government purchases.
(d) An increase in foreign taxes (consider both the case in which
Ricardian equivalence holds and the case in which it doesn’t hold)
6. Analyze the effects on a large open economy of a temporary adverse

supply shock that hits only the foreign economy. Discuss the impact on
the home country’s national saving, investment, and current account
balance – and on the world real interest rate. How does your answer
differ if the adverse supply shock is worldwide?
7. The chief economic advisor of a small open economy makes the following
announcement. “We have good news and bad news: The good news is
that we have just had a temporary beneficial productivity shock that will
increase output; the bad news is that the increase in output and income
will lead domestic consumers to buy more imported goods, and our
current account balance will fall.” Analyze this statement, taking as given
that a beneficial productivity shock has indeed occurred.
8. The world is made up of only two large countries: Eastland and

Westland. Westland is running a large current account deficit. Currently,
the government of Eastland purchases $10 billion of goods and services,
and all of these goods and services are produced in Eastland. The finance
minister of Eastland proposes that the government purchase half of its
goods from Westland. Specifically, the government of Eastland will
continue to purchase $10 billion of goods, but %5 billion will be from
Eastland and $5 billion will be from Westland. The finance minister gives
the following rationale: “Both countries produce identical goods so it does
not really matter to us which country produced the goods we purchase.
Moreover, this change in purchasing policy will help reduce Westland’s
large current account deficit.” What are the effects of this change in
purchasing policy on the current account balance in each country and
on the world real interest rate?
*******

011-45076221 9811343411
UNIT – 2 & 3
Money and Inflation
Chapter – 4 (Mankiw)
Questions for Review

1. Describe the functions of money.
2. What is fiat money? What is commodity money?
3. Who controls the money supply and how?
4. Write the quantity equation and explain it.
5. What does the assumption of constant velocity imply?
6. Who pays the inflation tax?
7. If inflation rises from 6 to 8 percent, what happens to real and nominal

interest rates according to the Fisher effect?
8. List all the costs of inflation you can think of, and rank them according
to how important you think they are.
9. Explain the roles of monetary and fiscal policy in causing and ending
hyperinflations.
10. Define the terms real variable and nominal variable, and give an example
of each.
Problems and Applications

1. What are the three functions of money? Which of the functions do the
following items satisfy? Which do they not satisfy?
(a) A credit card
(b) A painting by Rembrandt
(c) A subway token
2. In the country of Wiknam, the velocity of money is constant. Real GDP

grows by 5 percent per year, the money stock grows by 14 percent per
year, and the nominal interest rate is 11 percent. What is the real
interest rate?

011-45076221 9811343411
3. A newspaper article once reported that the U.S. economy was
experiencing a low rate of inflation. It said that “low inflation has a
downside: 45 million recipients of Social Security and other benefits will
see their checks go up by just 2.8 percent next year.”
(a) Why does inflation affect the increase in Social Security and other
benefits?
(b) Is this effect a cost of inflation as the article suggests? Why or why
not?
4. Suppose you are advising a small country (such as Bermuda) on whether

to print its own money or to use the money of its larger neighbor (such as
the United States). What are the costs and benefits of a national money?
Does the relative political stability of the two countries have any role in
this decision?
5. Calvin Coolidge once said that “inflation is repudiation.” What might he

have meant by this? Do you agree? Why or why not? Does it matter
whether the inflation is expected or unexpected?
6. Calvin Coolidge once said that “inflation is repudiation.” What might he

have meant by this? Do you agree? Why or why not? Does it matter the
inflation is expected or unexpected?
7. Some economic historians have noted that during the period of the gold
standard, gold discoveries were most likely to occur after a long deflation.
(The discoveries of 1896 are an example.) Why might this be true?
8. Suppose that consumption depends on the level of real money balances

(on the grounds that real money balances are part of wealth). Show that
if real money balances depend on the nominal interest rate, then an
increase in the rate of money interest rate, then an increase in the rate of
money growth affects consumption, investment, and the growth affects
consumption, investment, and the real interest rate. Does the nominal
interest rate adjust more than one-for-one or less than one-for-one to
expected inflation?
This deviation from the classical dichotomy and the Fisher effect is called
the Mundell-Tobin effect. How might you decide whether the Mundell-
Tobin effect is important in practice?
9. Use the Internet to identify a country that has had high inflation over the
past year and another country that has had low inflation. (Hint: One
useful website to http://www.economist.com/markets/indicators/) For
these two countries, find the rate of money growth and the current level
of the nominal interest rate. Relate your findings to the theories
presented in this chapter.

011-45076221 9811343411
Financial Markets
Chapter – 4 (Blanchard)
Questions and Problems

Quick Check
1. Using the information in this chapter, label each of the following

statements true, false, or uncertain, Explain briefly.
(a) Income and financial wealth are both examples of stock variables.
(b) The demand for money does not depend on the interest rate
because only bonds earn interest.
(c) Financial innovations are the reason why velocity has increased
dramatically in the last 40 years.
(d) In the last 40 years, the ratio of money to nominal income has
moved in the same direction as the 8interest rate.
(e) The central bank can increase the supply of money by selling
bonds in the market for bonds.
(f) By construction, bond prices and interest rates always move in
opposite direction..
2. Suppose that a person’s yearly income is $60,000. Also, suppose that her
money demand function is given by : Md  $Y.35  i 
(a) What is her demand for money when the interest rate is 5%? 10%?
(b) Describe the effect of the interest rate on money demand. Explain.
(c) Suppose that the interest rate is 10%. In percentage terms, what
happens to her demand for money if her yearly income is reduced
by 50%?
(d) Suppose that the interest rate is 5%. In percentage terms, what
happens to her demand for money if her yearly income is reduced
by 50%?
(e) Summarize the effect of income on money demand. How does it
depend on the interest rate?
3. A bond promises to pay $100 in one year.

(a) What is the interest rate on the bond if its price today is $75? $85?
$95?

011-45076221 9811343411
(b) What is the relation between the price of the bond and the interest
rate?
(c) If the interest rate is 8%, what is the price of the bond today?
4. Suppose that money demand is given by : Md  $Y.25  i 

Where $Y is $100. Also, suppose that the supply of money is $20.
Assume equilibrium in financial markets.
(a) What is the interest rate?
(b) If the Federal Reserve Bank wants to increase i by 10 percentage
points (i.e., from, say, 2 to 12%), at what level should it set the
supply of money?
Dig Deeper
5. Suppose that a persons wealth is $50,000 and that her yearly income is
$60,000. Also suppose that her money demand function is given by
Md  $Y.35  i 
(a) Derive the demand for bonds. Suppose the interest rate increases
by 10 percentage points. What is the effect on the demand for
bonds?
(b) What are the effects of an increase in wealth on money and on
bond demand? Explain in words.
(c) What are the effects of an increase in income on money and on
bond demand? Explain in words.
(d) “When people earn more money, they obviously will hold more
bonds”. What is wrong with this sentence?
6. In Chapter 3, you learned that an increase in the interest rate makes

bonds more attractive, so it leads people to hold more of their wealth in
bonds, as opposed to money. However, you also learned that an increase
in the interest rate reduces the price of bonds. How can an increase in
the interest rate make bonds more attractive and reduce their price?
7. ATMs and credit cards

This problem examines the effect of the introduction of ATMs and credit
cards on money demand. For simplicity, let’s examine a person’s demand
for money over a period of four days.
Suppose that before ATMs and credit cards this person goes to the bank
once at the beginning of each four day period and withdraws from his
savings account all the money he needs for four days. He spends $4 per
day.

011-45076221 9811343411
(a) How much does he withdraw each time he goes to the bank?
Compute this person’s money holdings for days I through 4 (in the
morning, before he spends any of the money he withdraws.
(b) What is the amount of money he hold on average?
Suppose now that with the advent of ATMs he withdraws money
once every 2 days.
(c) Recompute your answer to part (a).
(d) Recompute your answer to part (b).
Finally, with the advent of credit cards, this person pays for all his
purchases using his card. He withdraws no money until the fourth days,
when he withdraws the whole amount necessary to pay for his credit
card purchases over the previous four days.
(e) Recompute your answer to part (a).
(f) Recompute your answer to part (b).
(g) Based on your answers to (b), (d) and (f), what has been the effect
of ATMs and credit cards on money demand?
8. The velocity of money

Let money demand be given by M d  $Y Li 
(a) Derive an expression for velocity as a function of i . How does it
depend on i?
(b) Look at Figure I in the Focus box “The Demand for Money and the
Interest Rate: The Evidence”. What has happened to the velocity of
money from 1960 to 2003?
(c) According to Figure 1, the interest rate was roughly the same in
2003 as it was in 1960. In light of this fact, what do you think
explains the increase in the velocity of money from 1960 to 2003?
9. The money multiplier

The money multiplier is described in Section 4-4.
Suppose the following assumptions hold:
(a) The public holds no currency.
(b) The ratio of reserves to deposits is 0.1.
(c) The demand for money is given by M d  $Y .8  4i 
Initially, the monetary base is $100 billion and nominal income is $5
trillion.
(a) What is the demand for central bank money?

011-45076221 9811343411
(b) Find the equilibrium interest rate by setting the demand for central
bank money equal to the supply of central bank money.
(c) What is the overall supply of money? Is it equal to the overall
demand for money at the interest rate you found in (b)?
(d) What is the impact on the interest rate if central bank money is
increased to $300 billion?
(e) If the overall money supply increases to $300 billion what will be
the impact on i?
10. Bank runs and the money multiplier

During the Great Depression, the U.S. economy experienced many bank
runs, to the point where people became unwilling to keep their money in
banks, preferring to keep it in cash.
How would you expect such a shift away from checkable deposits toward
currency to affect the size of the money multiplier? (To find out what
happened to the money multiplier during the Great Depression, go to
Chapter 22.)
Explore Further
11. Current monetary policy
Go to the website for the Federal Reserve Board of Governors (www.
Federalreserve.gov) and download the most recent monetary policy press
release of the Federal Open Market Committee (FOMC). Make sure you
get the most recent FOMC press release and not simply the nos recent
Fed press release. What is the current stance of monetary policy? Note
that policy will be described in terms of increasing or decreasing the
federal funds rate, as opposed to increasing or decreasing the money
supply. If the federal funds rate has changed recently, what does the
change imply about the bond holdings of the Federal Reserve? Has the
Fed been increasing or decr4easing its bond holdings? Finally, you may
wish to read the explanation of the FOMC for the current policy stance. It
may not make much sense now, but keep it in mind for Chapter 5.
*********

011-45076221 9811343411
Inflation its Causes, Effects, and Social Costs
Chapter – 5 (Mankiw)

1. Write the quantity equation and explain it.
2. What does the assumption of constant velocity imply?
3. Who pays the inflation tax?
4. If inflation rises from 6 to 8 percent, what happens to real and nominal

interest rates according to the Fisher effect?
5. List all the costs of inflation you can think of, and rank them according
to how important you think they are.
6. Explain the roles of monetary and fiscal policy in causing and ending
hyperinflations.
7. Define the terms “real variable” and “nominal variable,” and give an
example of each.
Problems And Applications

1. In the country of Wiknam, the velocity of money is constant. Real GDP
grows by 5 per year, the money stock grows by 14 per year, and the
nominal interest rate is 11 percent. What is the real interest rate?
2. A newspaper article once reported that the U.S. economy was

experiencing a low rate of inflation. It said that “low inflation has a
downside: 45 million recipients of Social Security and other benefits will
see their checks go up by just 2.8 percent next year?
(a) Why does inflation affect the increase in Social Security and other
benefits?
(b) Is this effect a cost of inflation, as the article suggest? Why or why
not?
3. Suppose a country has a money demand function M / P   kY , where k

d
is a constant parameter. The money supply grows by 12 percent per

year, and real income grows by 4 percent per year.
(a) What is the average inflation rate?

011-45076221 9811343411
(b) How would inflation be different if real income growth were higher?
Explain.
(c) How do you interpret the parameter k ?
What is its relationship to the velocity of money?
(d) Suppose, instead of a constant money demand function, the
velocity of money in this economy was growing steadily because of
financial innovation. How would that affect the inflation rate?
Explain.
4. During World War II, both Germany and England had plans for a paper
weapon they each printed the other’s currency, with the intention of
dropping large quantities by airplane. Why might this have been an
affective weapon?
5. Suppose that the money demand function takes the form

M / P d  Li, Y   Y / 5i 
(a) If output grows at rate g , at what rate will the demand for real
balances grow (assuming constant nominal interest rates)?
(b) What is the velocity of money in this economy?
(c) If inflation and nominal interest rates are constant, at what rate, if
any, will velocity grow?
(d) How will a permanents (once-and-for-all) increase in the level of
interest rates affect the level of velocity? How will it affect the
subsequent growth rate of velocity?
6. In each of the following scenarios, explain and categorize the cost of

inflation.
(a) Because inflation has risen, the L.L. Bean company decides to
issue a new catalog quarterly rather than annually.
(b) Grandma buys a annuity for $100,000 from an insurance
company, which promises to pay her $10,000 a year for the rest of
her life. After buying it, she is surprised that high inflation triples
the price level over the next few years.
(c) Maria lives in an economy with hyperinflation. Each day after
being paid, she runs to the store as quickly as possible so she can
spend her money before it loses value.
(d) Warren lives in an economy with an inflation rate of 10 percent.
Over the past year, he earned a return of $50,000 on his million
dollar portfolio of stocks and bonds. Because his tax rate is 20
percent, he paid $10,000 to the government.

011-45076221 9811343411
(e) Your father tells you that when he was your age, he worked for
only $3 an hour. He suggests that you are lucky to have a job that
pays $7 an hour.
7. When Calvin Coolidge was vice president and giving a speech about
government finances, he said that “inflation is repudiation.” What might
he have meant by this? Do you agree? Why or why not? Does it matter
whether the inflation is expected or unexpected?
8. Some economic historians have noted that during the period of the gold
standard, gold discoveries were most likely to occur after a long deflation.
Why might this be true?
**********

011-45076221 9811343411
High Inflation
Chapter – 23 (Blanchard)
Quick Check
1. Using the information in this chapter, label each of the following
statements true, false, or uncertain. Explain briefly.
(a) In the short run, governments can finance a deficit of any size
through money growth.
(b) The inflation tax is always equal to seignorage.
(c) Hyperinflations may distort prices, but have no effect on real
output.
(d) The solution to ending a hyperinflation is to institute a wage and
price freeze.
(e) As inflation is generally good for those who borrow money,
hyperinflations are the best times to take out large loans.
(f) Budget deficits usually shrink during hyperinflations.
2. Assume that money demand takes the following form:

M
P
 
 Y 1  r  π e 
Where Y = 1000 and x = 0.1.
(a) Assume that, in the short run, π e is constant and equal to 25%.
Calculate the amount of seignorage if the rate of money growth,
M/M , equals:
(i) 25%
(ii) 50%
(iii) 75%
(b) In the medium run, π e  π  ΔM/M . Compute the amount of
seignorage associated with the three rates of money growth in part
(a). Explain why the answers differ from those in (a).
3. How would each of the following change the Tanzi-Olivera effect?

(a) Requiring monthly instead of yearly tax payments by households.
(b) Assessing greater penalties for under withholding of taxes from
monthly paychecks.
(c) Decreasing the income tax, and increasing the sales tax.

011-45076221 9811343411
Dig Deeper
4. You are the economic adviser to a country experiencing hyperinflation.
Discuss the following statements made by politicians debating the proper
course for stabilization:
“This crisis will not end until workers begin to pay their fair share of
taxes.”
“The central bank has demonstrated that it cannot responsibly wield its
power to create money, so we have no choice but to adopt a currency
board.”
“Price controls are necessary to end this madness.”
“Stablization will only be successful if there is a large recession and a
substantial increase in unemployment.”
“Let’s not blame the central bank. The problem is fiscal policy, not
monetary policy.”
5. What is the rate of money growth that maximizes seignorage in the
economy described in problem 2(b)?
Explore Further
6. High inflation around the world
Inflation rates are quite low in most advance economies. However, you
should not think that high inflation is only a historical topic. Today, a
number of countries are experiencing double-digit inflation rates (some
even triple-digit inflation rates).
(a) Go to the website of the IMF (www.imf.org) and find the current
issue of the World Economic outlook. In the statistical appendix,
look at Table 11, which lists inflation rates. Find countries that
have inflation rates of 10% or higher. Do any countries have
inflation rates of 100% or higher?
(b) Find Venezuela in Table 11. How long has Venezuela had an
inflation rate of more than 10%? Table 11 also lists projected
inflation rates for the current year and the next year. Does
inflation show any signs of slowing in Venezuela?
(c) Venezuela is an oil producer, so its economy fluctuates with oil
prices. Government tax revenues, in particular, depend heavily on
the prosperity of the oil industry. With oil prices rising, Venezuela
has increased government spending dramatically in recent years.
Suppose oil prices fall in the future, but Venezuela does not reduce
government spending. How would a fall in oil prices affect the
budget deficit in Venezuela? Given the effect on the budget deficit,
and following the logic of this chapter, how would a fall in oil prices
make a hyperinflation possible in Venezuela?

011-45076221 9811343411
UNIT – 4
Closed Economy in Short-run
Chapter 3 (Mankiw)

1. What determines the amount of output an economy produces?
2. Explain how a competitive, profit-maximizing firm decides how much of

each factor of production to demand.
3. What is the role of constant returns to scale in the distribution of

income?
4. Write a Cobb-Douglas production function for which capital earns one-

fourth of total income.
5. What determines consumption and investment?
6. Explain the difference between government purchases and transfer

payments. Give two examples of each.
7. What makes the demand for the economy’s output of goods and services
equal the supply?
8. Explain what happens to consumption, investment, and the interest rate

when the government increases taxes.

1. Use the neoclassical theory of distribution to predict the impact on the
real wage and the real rental price of capital of each of the following
events:
(a) A wave of immigration increases the labor force.
(b) An earthquake destroys some of the capital stock.
(c) A technological advance improves the production function.
(d) High inflation doubles the prices of all factors and outputs in the
economy.
2. Suppose the production function in medieval Europe is Y  K0.5L0.5 , where
K is the amount of land and L is the amount of labor. The economy
begins with 100 units of land and 100 units of labor. Use a calculator
and equations in the chapter to find a numerical answer to each of the
following questions.

011-45076221 9811343411
(a) How much output does the economy produce?
(b) What share of output does labor receive?
(c) What share of output does labor receive?
(d) If a plague kills half the population, what is the new level of
output?
(e) What is the new wage and rental price of land?
(f) What share of output does labor receive now?
3. If a 10 percent increase in both capital and labor causes output to

increase by less than 10 percent, the production function is said to
exhibit decreasing returns to scale. If it causes output to increase by
more than 10 percent, the production function is said to exhibit
increasing returns to scale. Why might a production function exhibit
decreasing or increasing returns to scale?
4. Suppose that an economy’s production function is Cobb-Douglas with

parameter α  0.3 .
(a) What fractions of income do capital and labor receive?
(b) Suppose that immigration increases the labor force by 10 percent.
What happens to total output (in percent)? The rental price of
capital? The real wage?
(c) Suppose that a gift of capital from abroad raises the capital stock
by 10 percent. What happens total output (in percent)? The rental
price of capital? The real wage?
(d) Suppose that a technological advance raises the value of the
parameter A by 10 percent. What happens to total output (in
percent)? The rental price of capital? The real wage?
5. Figure 3-5 shows that in U.S. data, labor’s share of total income is
approximately a constant over time. Table 3-1 shows that the trend in
the real wage closely tracks the trend in labor productivity. How are
these facts related? Could the first fact be true without the second also
being true? Use the mathematical expression for labor’s share to justify
your answer.
6. According to the neoclassical theory of distribution, the real wage earned

by any worker equals that worker’s marginal productivity. Let’s use this
insight to examine the income of two groups of workers: farmer and
barbers.
(a) Over the past century, the productivity of farmers has risen
substantially because of technological progress. According to the
neoclassical theory, what should have happened to their real
wage?

011-45076221 9811343411
(b) In what units is the real wage discussed in part (a) measured?
(c) Over the same period, the productivity of barbers has remained
constant. What should have happened to their real wage?
(d) In what units is the real wage in part (c) measured?
(e) Suppose workers can move freely between being farmers and being
barbers. What does this mobility imply for the wages of farmers
and barbers?
(f) What do your previous answers imply for the price of haircuts
relative to the price of food?
(g) Who benefits from technological progress in farming-farmers or
barbers?
7. Consider a Cobb-Douglas production function with three inputs. K is

capital (the number of machines) L is labor (the number of workers), and
H is human capital (the number of college degrees among the workers).
The production function is
Y  K1/3L1/3H1/3
(a) Derive an expression for the marginal product of human capital.
How does an increase in the amount of human capital. How does
an increase in the3 amount of human capital affect he marginal
product of human capital?
(b) Derive an expression for the marginal product of human capital.
How does an increase in the amount of human capital affect the
marginal product of human capital?
(c) What is the income share paid to labor? What is the income share
paid to human capital? In the national income accounts of this
economy, what share of total income do you think workers would
appear to receive?
(d) An unskilled worker earns the marginal product of labor, whereas
a skilled worker earns the marginal product of labor plus the
marginal product of human capital. Using your answers to parts
(a) and (b), find the ratio of the skilled wage to the unskilled wage.
How does an increase in the amount of human capital affect this
ratio? Explain.
(e) Some people advocate government funding of college scholarships
as a way of creating a more egalitarian society. Others argue that
scholarships help only those who are able to go to college. Do your
answers to the preceding questions shed light on this debate?
8. The government raises taxes by $100 billion. If the marginal propensity

to consume is 0.6, what happens to the following? Do they rise or fall?
By what amounts?

011-45076221 9811343411
(a) Public saving
(b) Private saving
(c) National saving
(d) Investment
9. Suppose that an increase in consumer \confidence raises consumers’

expectation about their future income and thus increases the amount
they want to consume today. This might be interpreted as an upward
shift in the consumption function. How does this shift affect investment
and the interest rate?
10. Consider an economy described by the following equations:

Y=C+I+G
Y = 5,000
G = 1,000
T = 1,000
C = 250 + 0.75 (Y – T)
I = 1,000 – 50r
(a) In this economy, compute private saving public saving, and
national saving.
(b) Find the equilibrium interest rate.
(c) Now suppose that G rises to 1,250. Compute private saving, public
saving, and national saving.
(d) Find the new equilibrium interest rate.
11. Suppose that the government increases taxes and government purchase
by equal amounts. What happens to the interest rate and investment in
response to this balanced-budget change? Explain how your answer
depends on the marginal propensity to consume.
12. When the government subsidizes investment, such as with an

investment tax credit, the subsidy often applies to only some types of
investment. This question asks you to consider the effect of such a
change. Suppose there are two types of investment in the economy:
business investment and residential investment. The interest rate
adjusts to equilibrate national saving and total investment, which is the
sum of business investment and residential investment. Now suppose
that the government institutes an investment tax credit only for business
investment.
(a) How does this policy affect the demand curve for business
investment? The demand curve for residential investment?

011-45076221 9811343411
(b) Draw the economy’s supply and demand for loanable funds. How
does this policy affect the supply and demand for loanable funds?
What happens to the equilibrium interest rate?
(c) Compare the old and the new equilibria. How does this policy affect
the total quantity of investment? The quantity of business
investment? The quantity of business investment? The quantity of
residential investment?
13. Suppose that consumption depends on the interest rate. How, if at all,
does this alter the conclusions reached in the chapter about the impact
of an increase in government purchases on investment, consumption,
national saving, and the interest rate?
14. Macroeconomic data do not show a strong correlation between

investment and interest rates. Let’s examine why this might be so. Use
our model in which the interest rate adjusts to equilibrate the supply of
loanable funds (which is upward sloping) and the demand for loanable
funds (which is downward sloping).
(a) Suppose the demand for loanable funds is stable but the supply
fluctuates from year to year. What might cause these fluctuations
in supply? In this case, what correlation between investment and
interest rates would you find?
(b) Suppose the supply of loanable funds is stable but the demand
fluctuates from year to year. What might cause these fluctuations
in demand? In this case, what correlation between investment and
interest rates would you find now?
(c) Suppose that both supply and demand in this market fluctuate
over time. If you were to construct a scatterplot of investment and
the interest rate, what would you find?
(d) Which of the above three cases seems most empirically realistic to
you?

011-45076221 9811343411
Introductions to Economic Fluctuations
Chapter 10 (Mankiw)

1. When real GDP declines during a recession, what typically happens to
consumption, investment, and the unemployment rate?
2. Give an example of a price that is sticky in the short run but flexible in
the long run.
3. Why does the aggregate demand curve slope downward?
4. Explain the impact of an increase in the money supply in the short run
and in the long run.
5. Why is it easier for the Fed to deal with demand shocks than with supply
shocks?

1. An economy begins in long-run eq2uilibrium, and then a change in
government regulations allows bank to start paying interest on checking
accounts. Recall that the money stock is the sum of currency and
demand deposits, including checking accounts, so this regulatory change
makes holding money more attractive.
(a) How does this change affect the demand for money?
(b) What happens to the velocity of money?
(c) If the Fed keeps the money supply constant, what will happen to
output and prices in the short run and in the long run?
(d) If the goal of the Fed is to stabilize the price level, should the Fed
keep the money supply constant in response to this regulatory
change? If not, what should it do? Why?
(e) If the goal of the Fed is to stabilize output, how would your answer
to part (d) change?
2. Suppose the Fed reduces the money supply by 5 percent. Assume the
velocity of money is constant.
(a) What happens to the aggregate demand curve?
(b) What happens to the level of output and the price level in the short
run and in the long run?

011-45076221 9811343411
(c) In light of your answer to part (b), what happens to unemployment
in the short run and in the long run according to Okun’s law?
(d) What happens to the real interest rate in the short run and in the
long run?
3. Let’s examine how the goals of the Fed influence its response to shocks.
Suppose that in scenario A the Fed cares only about keeping the price
level stable and in scenario B the Fed cares only about keeping output
and employment at their natural levels. Explain how in each scenario the
Fed would respond to the following.
(a) An exogenous decrease in the velocity of money.
(b) An exogenous increase in the price of oil.
4. The official arbiter of when recessions begin and end is the National
Bureau of Economic Research, a non-profit economics research group.
Go to the NBER’s Web site (www.nber.org) and find the latest turning
point in the business cycle. When did it occur? Was this a switch from
expansion to constraction or the other way around? List all the
recessions (constractions) that have occurred during your lifetime and
the dates when they began and ended.
*********

011-45076221 9811343411
Income and Spending
Chapter – 3 (Dornbusch)
Problems
1. Here we investigate a particular example of the model studied in Sections

3-2 and 3-3 with no government. Suppose the consumption function is
given by C = 100 + 0.8Y, while investment is given by I = 50.
(a) What is the equilibrium level of income in this case?
(b) What is the level of saving in equilibrium?
(c) If, for some reason, output were at the level of 800, what would the
level of involuntary inventory accumulation be?
(d) If I were to rise to 100 (we discuss what determines I in later
chapters), what would the effect be on equilibrium income?
(e) What is the value of the multiplier,  , here?
(f) Draw a diagram indicating the equilibria in both 1a and 1d.
2. Suppose consumption behavior were to change in problem 1 so that

C = 100 + 0.9Y, while I remained at 50.
(a) Would you expect the equilibrium level of income to be higher or
lower than in 1a? Calculate the new equilibrium level, Y  , to verify
this.
(b) Now suppose investment increases to I = 100, just as in 1d. What
is the new equilibrium income?
(c) Does this change in investment spending have more or less of an
effect on Y than in problem1? Why?
(d) Draw a diagram indicating the change in equilibrium income in
this case.
3. We showed in the test that the equilibrium condition Y = AD is equivalent

to the S = I, or saving = investment, condition. Starting from S = I and
the saving function, derive the equilibrium level of income, as in equation
(10).
4. (a) Using the relationship between the marginal propensity to

consume, c, and the marginal propensity to save, s, write equation
(14) for the multiplier in terms of s rather than c.
(b) Does the formula you derived in 4(a) apply also when the
government enters the picture and the multiplier is given in
equation (24)? Explain.

011-45076221 9811343411
5. This problem relates to the so-called paradox of thrift. Suppose that I = I0
and that C = C + cY.
(a) Draw a diagram where income is measured on the horizontal axis
and investment and saving on the vertical axis.
(b) What is the saving function, that is, the function that shows how
saving is related to income?
(c) Draw the investment function which is flat. Explain why the
intersection of the saving and investment function gives as the
equilibrium level of output.
(d) Suppose individuals want to save more at every level of income.
Show, using a figure like Figure 3-4, how the saving function is
shifted.
(e) What effect does the increased desire to save have on the new
equilibrium level of saving? Explain the paradox.
6. Now let us look at a model that is an example of the one presented in

Sections 3-4 and 3-5; that is, it includes government purchase, taxes,
and transfers. It has the same features as the one in problem 1 and 2
except that it also has a government. Thus, suppose consumption is
given by C = 100 + 0.8YD and that I = 50, while fiscal policy is
summarized by G = 200, TR = 62.5, and t = 0.25.
(a) What is the equilibrium level of income in this more complete
model?
(b) What is the value of the new multiplier, α G ? Why is this less than
the multiplier in problem 1(e)?
7. Using the same model as in problem 5, determine the following:

(a) What is the value of the budget surplus, BS, when I = 50?
(b) What is BS when I increases to 100?
(c) What accounts for the change in BS between 7b and 7a?
(d) Assuming that the full-employment level of income, Y*, is 1,200,
what is the full-employment budget surplus BS* when I = 50? 100?
(Be careful.)
(e) What is BS* if I = 50 and G = 250, with Y* still equal to 1,200?
(f) Explain why we use BS* rather than simply BS to measure the
direction of fiscal policy.
8. Suppose we expand our model to take account of the fact that transfer
payments, TR, do depend on the level of income, Y. When income is high,
transfer payments such as unemployment benefits will fall. Conversely,
when income is low, unemployment is high and so are unemployment

011-45076221 9811343411
benefits. We can incorporate this into our model by writing transfers as
TR  TR  bY, b  0 . Remember that equilibrium income is derived as the
solution to Y0  C  I  G  cYD  I  G , where YD  Y  TR  TA is disposable
income.
(a) Derive the expression for Y0 in this case, just as equation (22) was
derived in the text.
(b) What is the new multiplier?
(c) Why is the new multiplier less than the standard one, α G ?
(d) How does the change in the multiplier relate to the concept of
automatic stabilizers?
9. Now we look at the role taxes play in determining equilibrium income.

Suppose we have an economy of the type in Section 3-4 and 3-5,
described by the following functions:
C  50  0.8YD
I  70
G  200
TR  100
t  0.20
(a) Calculate the equilibrium level of income and the multiplier in this
model.
(b) Calculate also the budget surplus, BS.
(c) Suppose that t increase to 0.25. What is the new equilibrium
income? The new multiplier?
(d) Calculate the change in the budget surplus. Would you expect the
change in the surplus to be more or less if C = 0.9 rather than 0.8?
(e) Can you explain why the multiplier is 1 when t = 1?
10. Suppose the economy is operating at equilibrium, with Y0  1000 . If the

government undertakes a fiscal change so that the tax rate, t, increases
by 0.05 and government spending increases by 50, will the budget
surplus go up or down? Why?
11. Suppose Congress decides to reduce transfer payments (such as welfare)

but to increase government purchases of goods and services by an equal
amount. That is, it undertakes a change in fiscal policy such that
ΔG  ΔTR .
(a) Would you expect equilibrium income to rise or fall as a result of
this change? Why? Check your answer with the following example:

011-45076221 9811343411
Suppose that initially, c = 0.8, t = 0.25 and Y0  600 . Now let
ΔG  10 and ΔTR  10 .
(b) Find the change in equilibrium income, ΔY0 .
(c) What is the change in the budget surplus, ΔBS ? Why has BS
changed?
12. The Balanced Budget Multiplier. The balanced budget multiplier states
that an increase in government spending combined with an increase in
taxes such that the budget surplus is unchanged will raise output by
exactly the increase in government spending. (Equivalently, the
multiplier for a balanced budget change in government spending is one.)
We now ask you to demonstrate that result. To start, note that since
BS  TA  TR  G . And TR does not change, it has to be that
ΔBS  ΔTA  ΔG  0 , so that
ΔTA  ΔG (P1)
Note also that the change in output, ΔY , has to be equal to the change
in aggregate demand, ΔAD , and that the change in aggregate demand
results from changes in government spending and in consumption :
ΔY  ΔAD  ΔG  ΔC
 ΔG  cΔΔY (P2)
 ΔG  cΔY  ΔTA 
Using equation (P1) and the last line of equation (P2), you should be able
to get the balanced budget multiplier result.
(Note: If you can do calculus, you may want to try to derive the result
using the calculus. To do so you will have to impose the constraint that
the change in government spending is equal to the change in tax
receipts.)
13. Suppose the aggregate demand function is as in the accompanying

figure. Notice that at Y0 the slope of the aggregate demand curve is
greater than 1. (This would happen if c > 1). Complete this picture as is
done in Figure 3-3 to include the arrows indicating adjustment when
Y  Y0 and show that IU is for Y  Y0 and Y  Y0 . What is happening in
this example, and how does it differ fundamentally from Figure 3-3?
14. This problem anticipates our discussion of the open economy in Chapter
6. It is hard, and only the ambitious student should try it. You are asked
to derive some of the results that will be shown there. We start with the
assumption that foreign demand for out goods is given and equal to X.
Our demand for foreign goods, or imports, denoted Q, is a linear function
of income.

011-45076221 9811343411
Exports = X Imports = Q  Q  mY
Where m is the marginal propensity to import.
(a) The trade balance, or net exports, NX, is defined as the excess of
exports over imports. Write an algebraic expression for the trade
balance and show in a diagram net exports as a function of the
level of income. (Put Y on the horizontal axis.)
(b) Show the effect of a change in income on the trade balance, using
your diagram. Show also the effect of a change in exports on the
trade balance, given income.
(c) The equilibrium condition in the goods market is that aggregate
demand for our goods be equal to supply. Aggregate demand for
our goods includes exports but excludes imports. Thus we have
Y  C  I  NX
Where we have added net exports (exports less imports) to
investment and consumption. Using the expression for net exports
developed in 14a and the consumption function C = cY, derive the
equilibrium level of income, Y0.
(d) On the basis of your expression for the equilibrium level of income
in 14c, what is the effect of a change in exports, X, on equilibrium
income? Interpret your result and discuss the multiplier in an
open economy.
(e) Using your results in 14a and 14d, show the effect of an increase
in exports on the trade balance.

011-45076221 9811343411
Money, Interest and Income
Problem
1. The following equations describe an economy. (Think of C, I, G, etc, as
being measured in billions and i as a percentage; a 5 percent interest
rate implies i = 5).
C  0.81  t Y
t  0.25
I  900  50i
G  800
L  0.25Y  62.5i
M/P  500
(a) What is the equation that describes the IS curve?
(b) What is the general definition of the IS curve?
(c) What is the equation that describes the LM curve?
(d) What is the general definition of the LM curve?
(e) What are the equilibrium levels of income and the interest rate?
(f) Describe in words the conditions that are satisfied at the
intersection of the IS and LM curves, and explain why this is an
equilibrium.
2. Continue with the same equations.

(a) What is the value of α G , which corresponds to the simple multiplier
(with taxes) of Chapter 3?
(b) By how much does an increase in government spending of ΔG
increase the level of income in this model, which includes the
assets markets?
(c) By how much does a change in government spending of ΔG affect
the equilibrium interest rate?
(d) Explain the difference between your answers to 2a and 2b.
3. (a) Explain in words how and why the multiplier α G and the interest
sensitivity of aggregate demand affect the slope of the IS curve.

011-45076221 9811343411
(b) Explain why the slope of the IS curve is a factor in determining the
working of monetary policy.
4. Explain in words how and why the income and interest sensitivities of
the demand for real balances affect the slope of the LM curve.
5. (a) Why does a horizontal LM curve imply that fiscal policy has the
same effects on the economy as we derived in Chapter 3?
(b) What is happening in this case in terms of Figure 4-2?
(c) Under what circumstances might the LM curve be horizontal?
6. It is possible that the interest rate might affect consumption spending.

An increase in the interest rate could, in principle, lead to increases in
saving and therefore a reduction in consumption, given the level of
income. Suppose that consumption were in fact reduced by an increase
in the interest rate. How would the IS curve be affected?
7. Suppose that the money supply, instead of being constant, increased

(slightly) with the interest rate.
(a) How would this change affect the construction of the LM curve?
(b) Could you see any reason why the Fed might follow a policy of
increasing the money supply along with the interest rate?
8. (a) How does an increase in the tax rate affect the IS curve?
(b) How does the increase affect the equilibrium level of income?
(c) How does the increase affect the equilibrium interest rate?
9. Draw a graph of how i and Y respond over time (i.e. use time as the
horizontal axis) to an increase in the money supply. You may assume
that the money market adjusts much more rapidly than the goods
market.
10. (a) Show that a given change in the money stock has a larger effect on
output the less interest sensitive the demand for money. (you can
answer using either graphs or the formal analysis of Section 4-5).
(b) How does the response of the interest rate to a change in the
money stock depend on the interest sensitivity of money demand?
11. In 1991 the Treasury bill rate decreased from 6.3 percent in January to
4.1 percent in December. The economy fell deeper into recession during
this period (i.e., Y was declining). Can you explain this pattern of
declining output and declining interest rates using the IS-LM Model?
*****

011-45076221 9811343411
Monetary and Fiscal Policy
Problems
1. In the text we describe the effect of an open market purchase by the Fed.
(a) Define an open market sale by the Fed.
(b) Show the impact of an open market sale on the interest rate and
output. Show both the immediate and the longer-term impacts.
2. The economy is at full employment. Now the government wants to

change the composition of demand toward investment and away from
consumption without, however, allowing aggregate demand to go beyond
full employment. What is the required policy mix? Use the IS-LM diagram
to show your policy proposal.
3. Discuss the role of the parameter α G , h, b and k in the transmission

mechanism linking an increase in government spending to the resulting
change in equilibrium income. In developing the analysis use the
following table:
(1) (2) (3)
Increase in G raises The increase in income The increase in

aggregate demand and raises money demand interest rates reduces
output and hence interest investment spending
rates. and hence dampens
output expansion
4. Suppose the government cuts income taxes. Show in the IS-LM model
the impact of the tax cut under two assumptions: one, the government
keeps interest rates constant through an accommodating monetary
policy; two, the money stock remains unchanged. Explain the difference
in results.
5. Discuss the circumstances under which the monetary and fiscal policy
multipliers are each in turn, equal to zero. Explain in words why this can
happen and how likely you think this is.
6. Consider two alternative programs for contraction. One is the removal of

an investment subsidy; the other is a rise in income tax rates. Use the
IS-LM model and the investment schedule, as shown in Figure 5-6, to
discuss the impact of these alternative policies on income, interest rates,
and investment.

011-45076221 9811343411
7. Suppose the parameters k and α G are 0.5 and 2, respectively. Assume
there is an increase of $1 billion in government spending. By how much
must the real money stock be increased to hold interest rates constant?
8. In Figure 5-7 the economy can move to full employment by an expansion

in either money or the full-employment deficit. Which policy leads to E1
and which to E 2 ? How would you expect the choice to be made? Who
would most strongly favor moving to E1 ? To E 2 ? What policy would
correspond to “balanced growth”?
9. “We can have the GNP path we want equally well with a tight fiscal policy
and an easier monetary policy, or the reverse, within fairly broad limits.
The real basis for choice lies in many subsidiary targets, besides real
GNP and inflation, that are differentially affected by fiscal and monetary
policies.” What are some of the subsidiary targets referred to in the
quote? How would they be affected by alternative policy combinations?
10. Calculate the average real interest rate in the United States in 19991,
and in Germany, using Tables 5-5 and 5-6. What impact do you expect
the difference to have on investment rates in the two countries?
11. As of the middle of 1992, many observers believed that the short-term
interest rate in the United States would rise as the economy recovered
from the recession. The Treasury bill rate in the middle of 1992 was
below 4 percent as a result of expansionary monetary policy. How has
the interest rate changed since then? Use a diagram like Figure 5-3 to
explain these recent changes.
*****

011-45076221 9811343411
Previous Year Questions - 2016
B.A. (Hons.) Economics/ Sem-II
(Introductory Macroeconomics)
Duration: 3 Hours Maximum Marks: 75

Instructions:
All questions are to be attempted. Part (a) of each question is compulsory.
1. Part (a) is Compulsory. Do any 2 out of Parts (b), (c) and (d).
(a) Determine the contribution of each of the following transaction to

the current year’s GDP. Explain your answer.
(i) Mr. X purchase a 10 year odd apartment for Rs. 50 lakhs.
The broker’s fee is 5%.
(ii) A homemaker takes up a job that will pay Rs. 1,40,000 over
a year. She also pays Rs. 24,000 over the year for
professional house keeping services.
(iii) Your neighbor has won Rs. 1 lakh in the state lottery, to be
paid to him immediately.
(iv) A Korean Company builds a factory in Haryana for Rs. 10
crores using only local labour and materials.
(v) The Government buys defense equipment worth Rs. 2 crores.
(5)
(b) The following information pertains to an economy

Gross Domestic Private Investment = 60
Govt. purchases of goods and services = 50
Gross National Product = 300
Current Account Balance =  30
Taxes = 100
Government transfer payments to the Domestic private sector = 50
Interest payments from the Government to the domestic private
sector =20
Factor incomes received from rest of the world = 10
Factor payments made to rest of the world = 15
Assuming Government Investment = 0,

011-45076221 9811343411
Calculate
(i) Private Consumption Expenditure
(ii) Private savings and Government savings
(iii) Establish the “Uses of Private Savings” Identity.
(c) (i) Ram grows apples and oranges. Last year he harvested 1800
apples and 900 oranges. He values 1 orange worth 3 apples.
In exchange for helping him, he gave Mohan 600 apples and
300 oranges, all of which were consumed by Mohan. Ram,
set aside 200 oranges to help with next year’s harvest. What
is total Consumption in terms of oranges?
(ii) What are inventories? How are they treated as – final or
intermediate good – in National Income Accounting? (3+2)
(d) (i) A person from country ‘A’ travels to country ‘B’ and buys a
$100 worth household electronic machine from a company.
The company then deposits the $100 cheque it receives in
its account with its bank in country A. How would these
transactions show up in the ‘Balance of Payments’ accounts
of country A?
(ii) Nominal GDP in a country was $6890 billion in 2012 &
$7650 billion in 2013. The GDP deflator was 102.4 in 2012
& 105.6 in 2013.
(a) What is the inflation rate from 2012 to 2013 ?
(b) What is the growth rate of real GDP from 2012 to 2013 ?
(2+3)
2. Part (a) is compulsory. Do any 3 out of Part (b), (c), (d) and (e).
(a) The following information pertains to a classical macroeconomic

model.
Real output = 2000
Money Stock = 800
Income velocity of money = 25
(i) What are the aggregate demand and aggregate supply

schedules? Roughly sketch them.
(ii) If the money stock increase to 1000, how will the schedules
shift? (4)
(b) (i) Comment on the following statements. Justify your answer.
(A) An increase in nominal money growth rate will always
increase seignorage.

011-45076221 9811343411
(B) The inflation tax is always equal to seignorag.
(ii) In a classical macroeconomic model, what will be the impact
of a 20% increase in the supply of money, holding everything
else constant, on the price level, money wages, real output,
interest rate, employment and nominal output? (4+3)
(c) (i) Graphically illustrate and briefly explain the impact of an

increase in the reserve ratio, θ, on the market for Central
Bank money.
(ii) Assume that the demand for real money balances is:
M
P
 
 Y 0.6  r  π e 
Income, Y  1000 real interest rate, r  0.05 5%
Expected inflation rate
π e is constant at 0.05 5%
Calculate seignorage if the rate of growth of nominal money
is 7%. (4+3)
(d) Given Reserves = 500 Deposits = 4000 Currency = 2500

Calculate
(i) The size of the monetary base.
(ii) The money multiplier
(iii) Given the above values, fill in the Assets and Liabilities in
the Central Bank’s balance sheet and the Bank’s balance
sheet
(iv) Suppose the Central Bank wants to reduce the money
supply by Rs. 65 Crores, what type of Open Market
Operation should it pursue? What should be the value of
the Central Bank’s purchase or sale of bonds so that it is
successful? (7)
(e) (i) Suppose the ratio of currency to checkable deposit is 0.25

and the reserve ratio (R/D) is 0.25, what is the value of the
money multiplier?
(ii) Differentiate between ‘Orthodox’ and ‘Heterodox’ stabilization
programmes adopted during hyperinflation.
(iii) Given that, a bond pays, Rs. 1000 in a year and the yield on
it is 15%, calculate the price of this bond. (3+3+1)

011-45076221 9811343411
3. Part (a) is Compulsory. Do any 3 out of Parts (b), (c), (d) and (e).
(a) Comment on the following statements in the contest of IS – LM

framework
(i) An increase in the Government spending leads to an
increase in income but by an amount less than the
horizontal shift in the IS curve.
(ii) An expansionary monetary policy is always effective in
expanding output in the economy. (5)
(b) (i) Assume the following IS-LM model

Expenditure Sector
Private Consumption Expenditure C   100  3 YD

5
Taxes t   1 Y
6
Private Investment Expenditure I   210 10 i
Government Purchases (G) = 200
Net Exports =  10
Money Market
1
Demand for money M d  Y  5i
4
National Money M  300
Price Level P  2
Where
YD = Disposable Income of the Private Sector
Y = Income
i  interest rate
(A) Derive the equilibrium value of C (Private
Consumption Expenditure) and Md (Demand for
money)
(B) How much Investment will be crowded out if the
Government increases its purchases by 100?
(ii) In a simple model of the expenditure sector with a tax rate t,
does a fall in autonomous Investment affect the Budget
Surplus? Explain (8+2)

011-45076221 9811343411
(c) (i) A fall in the income tax rate will increase consumer
spending; therefore, the demand for money will go up and
the LM curve will shift to the right. Explain using diagrams
whether you agree or disagree.
(ii) In a simple model of the expenditure sector, by how much
should the Government reduce its spending so that the
Budget Deficit falls by 1000? Assume that the income tax
rate is 33 1 3 % and that the marginal propensity to consume
is 0.6.
(iii) Explain how ‘Income tax system’ works as an ‘automatic
stabilizer’. (4+4+2)
(d) (i) In the Classical Model, there is a positive relationship
between real wages and output. Comment.
(ii) Assume an economy described by the following equations.
Expenditure Sector
AD  C  I  G  NX
4
AD  300  Y  20 i
5
Money Market
1
Md  Y  50 i
3
M / P  200
Where
AD = Aggregate demand
C = Private consumption expenditure
I = Private investment expenditure
G = Govt. Expenditure
NX = Net Exports
M d  Demand for money
M/P  Real Money Supply.
Y  Income
i = Interest rate
(A) Calculate the equilibrium levels of Y (income) and i

(interest rate).

011-45076221 9811343411
(B) What should be the money supply increase by the
Central Bank, if its goal is to keep interest rate
constant after Government purchases increased by
100? (4+6)
(e) (i) In the Classical Model, an autonomous decline in the

Investment leads to a fall in the overall demand in the
economy. Explain, with the help of a diagram, whether you
agree or disagree.
(ii) An expansionary monetary Policy is more effective, greater
the interest sensitivity of Investment spending. Explain with
the help of a diagram. Also, provide an intuitive explanation.
(iii) Assume a model of the expenditure sector with no
Government or foreign sector. If the savings function is
defined as S   400  0.2 Y, (Y  income) and the
autonomous Investment increases by 100, by how much will
consumption increase?
(3+5+2)
********

011-45076221 9811343411
Previous Year Questions - 2015
B.A. (Hons.) Economics/ Sem-II
1. (a) State True or False. Give reasons for your answer:

(i) Domestic financial assets held by the domestic residents are
part of national wealth of the domestic country.
(ii) Indian capital and labour used abroad to produce output are
included in India’s Gross National Product. 2+2=4
(b) (i) The country of Myrule produced the following quantity of

apples, bananas and potatoes, with the price of each listed
in dollar:
Year 1999 (Base Year) 2000

Quantity Price Quantity Price
Bananas 3000 2 2000 3
Potatoes 6000 3 12000 2
Apples 8000 4 6000 6
(A) What is the percentage change in Real GDP (Gross

Domestic Product) between two years?
(B) What is the increase in the overall level of prices as
measured by the GDP deflator in these two years?
(C) Based on the GDP deflator, what is the inflation rate
from 1999 to 2000 ? 2+2+1=5
(ii) How is real GDP an important measure for assessing the
economy’s growth performance ?
(c) (i) Explain the concept of nominal interest rate, real interest
rate and expected real interest rate.
Which interest rate is more important for the decisions made
by the lenders and borrowers? Give reasons for your
answer. 5
(ii) The company ‘ X ’ sells mixed fruit shakes for Rs. 54,000,
using apples, bananas and grapes that it buys from another
firm for Rs. 20,000. It pays Rs 1,000 is taxes, and Rs. 3,000
to its workers as wages. What is its value added?

011-45076221 9811343411
(d) (i) Define National Income. 2
(ii) Calculate GDP and National Savings from the following data:
Compensation of Employers = 7937
Income of self-employed = 1006
Rental income = 110
Corporate profits = 1260
Indirect business taxes = 994
Consumption of fixed capital = 1747
Payment of factor income to rest of the world = 567
Consumption = 9765
Government spending = 900 5
(e) (i) “Increase in National Savings leads to increase in National

Wealth.” Explain. 2
(ii) What do you mean by Balance of Payments Accounts? What
is the fundamental balance of payments identity? 3
(iii) A payment of Rs. 500 is made by an Indian citizen for dinner
at a Thai restaurant in Thailand by his Visa credit card. How
is this transaction accounted for in the balance of payment
account of India? 2
2. (a) (i) “An increase rate of interest leads to an increase in the

price of bonds.” True or False. Give Reasons.
(ii) In the country of William, the velocity of money is constant.
If real GDP grows by 6% per year, the money stock grows by
16% per year, and the nominal interest rate is 13%, then
what is the real interest rate? 2+2=4
(b) (i) The Central Bank of Singapore issued currency worth 2

million dollars in circulation. Out of this, citizens hold 1
million dollars in hand and deposit the rest with the banks.
(a) What is the money supply in Singapore, if required reserve
ratio is 20%?
(b) By how much amount will money supply change if citizens
withdraw 5,00,000 dollars from the banks for shopping
during festival season? 2+2
(ii) What are the costs of unexpected inflation ? 3

011-45076221 9811343411
(c) (i) Suppose income is given at 300 units and money supply is
fixed at 200 units, Initially individuals wish to hold
money balances equal to one third of their income. If
individuals increase money demand to half of their income,
how does this change in money demand affect the
equilibrium value of aggregate price level? Explain the
process using the Cambridge version of Quantity Theory of
Money. 4
(ii) Explain the Orthodox Policies to stabilize Hyperinflation. 3
(d) What are the determinants of demand for Money? How is money
market equilibrium determined? How does equilibrium rate of
interest change with a decrease in money supply? 7
(e) (i) Using the Fisher Approach to Quantity Theory of Money,

explain the relationship between quantity of money and
price level. 4
(ii) Explain High Powered Money. 3
3. (a) For each of the following statements, explain whether you agree or
disagree:
(i) A tax cut will increase the equilibrium level of GDP
irrespective of government budget being in deficit or
surplus.
(ii) The reduction in government transfers lowers the
equilibrium level of output. 2+2=4
(b) Analyse the impact of an increase in the marginal income tax rate
on the output, employment and price level in the classical model.
7
(c) (i) If the economy is in the disequilibrium zone of excess supply
in the goods market and an excess demand in the money
market then, how the adjustment process leads to the
equilibrium in the IS-LM Model? Show using diagram. 3
(ii) How does the slope of the LM curve play an important role in
determining the effectiveness of Monetary Policy? 4

011-45076221 9811343411
(d) If
Consumption = 200  0.6 Yd
Government Spending = 150
Investment = 150  8 i,
Taxes = 200
Money Demand: L = 0.2 Y  2 i
Real Money Supply M P  = 160

Yd  Disposable Income, i =interest rate and Y  income)
(i) Find the equilibrium level of income and the rate of interest.
(ii) How does the equilibrium level of income change with an
increase in government expenditure to 210 ?
(iii) By how much amount should money supply change to keep
the level of income constant? 3+2+2+7
(e) (i) Using IS-LM framework, show the impact of the following
policies on income interest rate and investment:
(A) Removal of investment subsidy
(B) Rise in tax rate. 2.5+2.5
(ii) Explain the concept of liquidity trap. 2
**********

011-45076221 9811343411
011-45076221 9811343411
Previous Year Questions 2014
B.A. (Hons.)/ Sem – II
Attempt all three questions. Each question is divided among 5 parts (a),
(b), (c), (d) and (e). Part (a) is compulsory and attempt any three part from
(b), (c), (d) and (e).
1. (a) (Compulsory) Choose the correct answer and give brief reason(s)
for your choice :
(i) In an open economy: 2
(A) national saving are always equal to domestic
investment
(B) national saving equals domestic investment plus the
current account balance
(C) national saving equals domestic investment plus
statistical discrepancy.
(ii) The real interest rate is : 2
(A) interest rate given by a commercial bank
(B) nominal interest rate minus inflation rate
(C) nominal interest rate plus inflation rate
(D) none of the above
(b) What is inflation rate? If GDP deflator rises from 100 in year one to
107 in year two and 115 in year three, what will be the inflation
rate between year one and two and between year two and three.
If the nominal interest rate is 9% per annum during all these
years, what will be the real rate of interest between year 1 and 2
and between year 2 and 3. 7
(c) What do you mean by Balance of Payment Accounts? What is the

fundamental balance of payments identity? Explain with examples.
7
(d) What do the unemployment rate and the inflation rate measure?
Why do economists care about unemployment and inflation? 7
(e) If there were three goods 1, 2 and 3 and p stands for price, and q
for output, then the prices and quantities in the base year ( year 0)
and current year (year 1) are given as :

011-45076221 9811343411
q1 p1 q2 p2 q3 p3
Year 0 q10  4 p10  1 q 20  5 p 20  1 q 30  2 p30  4
Year 1 q11  6 p11  4 q 21  15 p 21  3 q 31  6 p31  2
Find the nominal expenditure and the real expenditure. Also find
the inflation rate of the economy and the weighted average of price
increase. 7
2. (a) (Compulsory) Choose the correct answer and given the brief
reason(s) for your choice:
(i) quantity Theory of Money implies that : 2
(A) The rate of growth in the quantity of money determines
the inflation rate
(B) Money supply is controlled by the Central Bank
(C) Money function as a store of value
(D) MY = PV
(ii) Hyperinflations typically begin when: 2
(A) Government finance large budget deficits by external
borrowings
(B) Government finance large budget deficits by internal
borrowings
(C) Government finance large budget deficits by printing
money
(D) All of the above
(b) Explain the Central Bank influences the monetary base and the
inter-bank interest rate by open market operations. 7
(c) How is the rate of interest determined by the demand and supply
of money? What happens to the interest rate if :
(i) Nominal income increase and
(ii) Money supply increases. 7
(d) What is nominal interest rate? If inflation rises from 4 to 7 per cent
or the real interest rate changes from 6 to 8 percent, then what will
happen to the nominal interest rate according to Fisher Effect?
What is the social cost of expected inflation? 7

011-45076221 9811343411
(e) How does Hyperinflation affect the economy? How do the
Hyperinflations end; do they die a natural death or a stabilization
program is required? What are the elements and costs of such
program? 7
3. (a) (Compulsory) Explain in brief whether the following statements are

True or False
(i) For a given interest rate, an increase in taxes shifts the 1S
curve to the right. 2
(ii) The greater the propensity to consume, the higher the
multiplier. 2
(b) Explain the determination of equilibrium level of output,

employment and the real wage in the classical system. 7
(c) In Keynesian model discuss the effects of changes in fiscal

variables – increase in govt. purchases, reduction in the income
tax rate and an increase in transfer payments, on the equilibrium
level of income. 7
(d) Discuss with the help of IS-LM model the effects of fiscal
contraction by increasing taxes while keeping government
spending unchanged, on output, on its composition, and on the
interest rate. 7
(e) Does the slope of LM curve has any implication for the
effectiveness of monetary policy in terms of changes in income?
What happens in two extreme cases of horizontal and vertical LM
curves? 7
*****

011-45076221 9811343411
PRACTICE TEST -1
INTRODUCTORY MACRO
Maximum Marks : 75 Time : 3 Hours

Instruction :
All questions are compulsory
1. (a) Define private saving. How is private saving used in the economy?
What is the relationship between private saving and national
saving? 6
(b) You are given the following information about an economy:

Taxes = 60
Government transfer payments to the domestic private sector = 25
Interest payments from the government to the domestic private
sector = 15 (Assume all interest payments by the government go to
domestic households.)
(a) Consumption
(b) Net exports
(c) GDP
(d) Net factor payments from abroad
(e) Private saving
(f) Government saving
(g) National saving 7
(c) “Macro economist measure income as sum of aggregate domestic

income, indirect tax and depreciation and income measured in this
way always equals output. Elaborate. 7

011-45076221 9811343411
(d) How does GDP differ from GNP? If a country employs many foreign
workers, which is likely to be higher: GDP or GNP? 5
Or
(a) An economy produces three goods: Cars, computers and oranges.

Quantities and price per unit for 2003 and 2004 are as follows:
2003 2004
Quantity Price Quantity Price
Cars 10 $2,000 12 $3,000
Computers 4 $1,000 6 $500
Oranges 1000 $1 1000 $1
(i) What is nominal GDP in 2003 and 2004? By what
percentage does nominal GDP change from 2003 to 2004?
(ii) Using the prices for 2003 as the set of common prices, what
is real GDP in 2003 and in 2004? By what percentage does
real GDP change from 2003 to 2004?
(iii) Using the prices for 2004 as the set of common prices, what
is real GDP in 2003 and in 2004? By what percentage does
real GDP change from 2003 to 2004? 6
(b) The nation of Economica had a current account deficit of $2 billion

and a nonreserve financial account surplus of $1 billion in 2008.
(i) What was the balance of payments of Economica in that
year? What happened to the country’s net foreign assets?
(ii) Assume that foreign central banks neither buy nor sell
Economica assets. How did the Economican central bank’s
foreign reserves change in 2008? How would these official
purchases enter foreign balance of payments accounts?
(iii) How would your answer to (b) change if you learned that
foreign central banks had purchased $1.2 billion of
Economican assets in 2008? How would these official
purchases enter foreign balance of payments accounts? 6
(c) After a boat rescues everyone else from Gilligan’s Island, the
Professor and Gilligan remain behind, afraid of getting shipwrecked
again with the same bunch of people. The Professor grows
coconuts and catches fish. Last year he harvested 1000 coconuts
and caught 500 fish. He values one fish as worth tow coconuts.
The Professor gave 200 coconuts to Gilligan in exchange for help in
the harvest, and he gave Gilligan 100 fish in exchange for
collecting worms for use in fishing. The Professor stored 100 of his
coconuts in his hut for consumption at some future time. Gilligan
consumed all his coconuts and fish.

011-45076221 9811343411
In terms of fish, what is the GDP of Gilligan’s Island? What are
consumption and investment? What are the incomes of the
Professor and Gilligan? 7
(d) What is national wealth, and why is it important? How is national

wealth linked to national saving? 6
2. (a) Assume that money demand takes the following form:

M
P

 Y 1  r  π e 
Where Y = 1000 and x = 0.1.
(i) Assume that, in the short run, π e is constant and equal to
25%. Calculate the amount of seignorage if the rate of
money growth, M/M , equals:
(A) 25%
(B) 50%
(C) 75% 5
(b) Explain the roles of monetary and fiscal policy in causing and
ending hyperinflations. 7
(c) Derive money multiplier. How does it depend on c(currency-money

ratio) and θ (reserve-deposit ratio) 7
(d) How would each of the following change the Tanzi-Olivera effect?
(i) Requiring monthly instead of yearly tax payments by
households.
(ii) Assessing greater penalties for under withholding of taxes
from monthly paychecks.
(iii) Decreasing the income tax, and increasing the sales tax. 6
Or
(a) What is hyper-inflation. How it is caused? Suggest measures to

control it. 6
(b) What are social cost of inflation. Explain. 6
(c) Suppose that a person’s wealth is $50000 and that her yearly
income is $60000. Also suppose that her money demand function
is given by
Md  $Y.35  i 

011-45076221 9811343411
(i) Derive the demand for bonds. Suppose the interest rate
increases by 10 percentage points. What is the effect on the
demand for bonds?
(ii) What are the effects of an increase in wealth on money and
on bond demand? Explain in words.
(iii) What are the effects of an increase in income on money and
on bond demand? Explain in words. 6
(d) Explain relation between deficit, seigniorage and inflation. Why it

is difficult for government to maintain constant money growth? 7
3. (a) C = 50 + 0.8(Y – T)
T = 100
I = 150 – 5i
G = 100
L = 0.2Y – 10i
M = 200
P =2
Calculate
(i) Equilibrium income & interest rate.
(ii) If government expenditure increases to 150, find new
equilibrium income & crowing out effect.
(iii) If full employment income is Rs. 1200, calculate change in
nominal money supply required to achieve fill employment.
6
(b) Consider a modified IS-LM system where:
C  C  cY - T 
I  I  br  eY 
GG
 M/P  kY  hr
Assume that all the sensitivity coefficients (c, b, e, k and h) are

greater than 0.
Solve for the equilibrium levels of output, interest rate and
investment [assume that [(c + e) < 1] 6

011-45076221 9811343411
(c) Explain how the interest rate works in the classical system to
stabilize aggregate demand in the face of autonomous changes in
components of aggregate demand such as investment or
government spending. 6
(d) Suppose that the public’s taste changes in such a way that leisure
comes to be more desirable relative to commodities. How would
you expect such a change to affect output, employment, and the
real wage in the classical model? 7
Or
(a) In a closed economy, let us define policy effectiveness as an

increase in output due to policy interventions. Use IS-LM diagrams
to answer the following:
(i) is fiscal policy effective when the interest elasticity of
investment is tending to infinity?
(ii) is fiscal policy effective when the interest elasticity of money
demand is tending to infinity?
(iii) is a price fall effective if the economy is in the liquidity trap?
6
(b) Suppose that the money supply, instead of being constant,

increased (slightly) with the interest rate.
(i) How would this change affect the construction of the LM
curve?
(ii) Could you see any reason why the Fed might follow a policy
of increasing the money supply along with the interest rate?
6
(c) (i) Explain in words how and why the multiplier α G and the
interest sensitivity of aggregate demand affect the slope of
the IS curve.
(ii) Explain why the slope of the IS curve is a factor in
determining the working of monetary policy. 6
(d) Within the classical model, analyze the effects of an increase in the
marginal income tax rate. Explain how output, employment, and
the price level are affected. 7
*****

011-45076221 9811343411
PRACTICE TEST-2
INTRODUCTORY MACRO
Maximum Marks : 75 Time : 3 Hours

Instruction : Attempt all three questions. Each question is divided among
5 parts (a), (b), (c), (d) and (e). Part (a) is compulsory and attempt any
three part from (b), (c), (d) and (e).
All questions are compulsory
1. (a) You are given the following information about an economy:

Taxes = 60
Government transfer payments to the domestic private
sector = 25
Interest payments from the government to the domestic private
sector = 15 (Assume all interest payments by the government go to
domestic households.)
(i) Consumption
(ii) Net exports
(iii) GDP
(iv) Net factor payments from abroad
(v) Private saving
(vi) Government saving
(vii) National saving 7
(b) What is inflation rate? If GDP deflator rises from 100 in year one to
107 in year two and 115 in year three, what will be the inflation
rate between year one and two and between year two and three.

011-45076221 9811343411
If the nominal interest rate is 9% per annum during all these
years, what will be the real rate of interest between year 1 and 2
and between year 2 and 3. 7
(c) What do you mean by Balance of Payment Accounts? What is the

fundamental balance of payments identity? Explain with examples.
7
(d) Define private saving. How is private saving used in the economy?
What is the relationship between private saving and national
saving? 4
(e) What is national wealth, and why is it important? How is national
wealth linked to national saving? 7
2. (a) Assume that money demand takes the following form:

M
P
 
 Y 1  r  π e 
Where Y = 1000 and x = 0.1.
(i) Assume that, in the short run, π e is constant and equal to
25%. Calculate the amount of seignorage if the rate of
money growth, M/M , equals:
(A) 25%
(B) 50%
(C) 75% 7
(b) How would each of the following change the Tanzi-Olivera effect?
(i) Requiring monthly instead of yearly tax payments by
households.
(ii) Assessing greater penalties for under withholding of taxes
from monthly paychecks.
(iii) Decreasing the income tax, and increasing the sales tax. 7
(c) Derive money multiplier. How does it depend on c(currency-money
ratio) and θ (reserve-deposit ratio) 7
(d) What is nominal interest rate? If inflation rises from 4 to 7 per cent
or the real interest rate changes from 6 to 8 percent, then what will
happen to the nominal interest rate according to Fisher Effect?
What is the social cost of expected inflation? 7
(e) How does Hyperinflation affect the economy? How do the
Hyperinflations end; do they die a natural death or a stabilization
program is required? What are the elements and costs of such
program? 7

011-45076221 9811343411
3. (a) C = 50 + 0.8(Y – T)
T = 100
I = 150 – 5i
G = 100
L = 0.2Y – 10i
M = 200
P =2
Calculate
(ii) If government expenditure increases to 150, find new
equilibrium income & crowing out effect.
(iii) If full employment income is Rs. 1200, calculate change in
nominal money supply required to achieve fill employment.
7
(b) Explain how the interest rate works in the classical system to
stabilize aggregate demand in the face of autonomous changes in
components of aggregate demand such as investment or
government spending. 7
(c) Suppose that the public’s taste changes in such a way that leisure
comes to be more desirable relative to commodities. How would
you expect such a change to affect output, employment, and the
real wage in the classical model? 7
(d) (i) Explain in words how and why the multiplier α G and the
interest sensitivity of aggregate demand affect the slope of
the IS curve.
(ii) Explain why the slope of the IS curve is a factor in
determining the working of monetary policy. 7
(e) Does the slope of LM curve has any implication for the
effectiveness of monetary policy in terms of changes in income?
What happens in two extreme cases of horizontal and vertical LM
curves? 7
*********

011-45076221 9811343411
IS-LM (Numericals)
1. An economy is characterized by the following equations
C = 4 + 0.75Yd
I = 110, G = 120, R = 8, T = 0.2Y
Subsequently, the economy is opened with X = 55 and M = 5 + 0.1Y
(i) Calculate the difference in income in closed economy and open
economy.
(ii) What is budget surplus or deficit in the open economy?
(iii) What should be level of government spending and the rate of tax if
the government wants to achieve full employment level of income of
Rs. 600 and have a balanced budget i.e. G + R = T.
2. C = 150 + 0.75Yd
I = 100, R = 40, X = 35, M = 15 + 0.1Y
G = 115, T = 20 + 0.2Y
Find out:
(i) Equilibrium level of income
(ii) Consumption at equilibrium level of income
(iii) Net exports at equilibrium income balance of trade
(iv) By how much would the equilibrium income change if investment
increases by Rs. 50?
(v) The increase in govt. spending required to ensure that the
economy reaches full employment level of income of Rs. 1200?
3. C = 10 + 0.8Yd
T = 50, I = 135, G = 60, X = 35, M = 0.05Y
Find out ___________
(i) Equilibrium income
(ii) Balance of trade
(iii) The increase in income if both govt. spending and tax were to
increase by Rs. 10 each
(iv) Net exports if export increases by 6.25
(v) The increase in govt. spending read to achieve full employment of
Rs. 825

011-45076221 9811343411
4. Suppose :
Consumption, C = 50 + 0.6Yd (disposable income)
Investment, I = 35
Govt. Expenditure, G = 25
Taxes, T = 20
Exports, X = 30
Imports, M = 8 + 0.1Y
(figures in Rs. Crores)
(i) Compute the equilibrium level of income.

(ii) If the government wants to achieve full employment level of income
which is Rs. 256 crores, by how much does the government need
to:
– Increase G, or
– Increase G and T by the same amount?
Which of these two measures is likely to be preferred by a government
concerned about controlling the budget deficit?
The next four questions (5-8) are based on the following:
Suppose, in equilibrium, aggregate income (in units of money per year) in an
economy Y=C+I, where investment expenditure (in units of money per
year)I=1000 and aggregate consumption expenditure (in units of money per
year) C satisfies the following conditions:
(a) C is a function of current disposable income in the economy (Yd)
(b) If Yd =0,then C=500
(c) Marginal propensity to save out of Yd is constant in the economy
and equal to 30%
Suppose the government collects direct tax revenues equal to 15% of Y
and makes direct transfer payments equal to 750 units of money per
year.
5. What is the value of the investment multiplier in the economy?

(a) Between 1.9 and 2.1
(b) Between 2.1 and 2.3
(c) Between 2.3 and 2.5
(d) More then 2.5

011-45076221 9811343411
6. What is the equilibrium value of Y in the economy?
(a) Between 3250 and 3750
(b) Between 3750 and 4250
(c) Between 4250 and 4750
(d) Between then 4750 and 5250
7. If instead of 750 units of money the government makes annual transfer

payments equal to 10% of Y, then the value of the investment multiplier
will
(a) decrease by less than unity
(b) decrease by more than unity
(c) increase by less than unity
(d) increase by more than unity
8. If instead of 750 units of money the government makes annual transfer

payments equal to 10% of Y, then the equilibrium value of Y will
(a) decrease by less than 1000
(b) decrease by more than 1000
(c) increase by less than 1000
(d) increase by more than 1000
The next Two questions (9-10) are based on the following information:
Consider an open economy simple Keynesian model with autonomous
investment (I). People save a constant proportion (s) of their disposable income
and consume the rest Government taxes the total income at a constant rate  
and spends an exogenous amount G  on various administrative activities. The
level of export  X  is autonomous, import M  on the other hand is a linear
function of total income with a constant import propensity m. Let
1 2 1
I  3200; G  4000; X  800; s  ;   ; and m  .
2 5 10
9. The equilibrium level of income is given by;

(a) 8,000 (b) 16,000 (c) 10,000 (d) None of these
10. At this equilibrium level of income

(a) there is trade surplus
(b) there is trade deficit

011-45076221 9811343411
(c) trade is balanced
(d) one cannot comment on the trade account without further
information
11. The following equations describe an economy. (Think of C, I, G, etc, as

being measured in billions and i as a percentage; a 5 percent interest
rate implies
i = 5).
C  0.81  t Y
t  0.25
I  900  50i
G  800
L  0.25Y  62.5i
M/P  500
(a) What is the equation that describes the IS curve?

(b) What is the general definition of the IS curve?
(c) What is the equation that describes the LM curve?
(d) What is the general definition of the LM curve?
(e) What are the equilibrium levels of income and the interest rate?
(f) Describe in words the conditions that are satisfied at the
intersection of the IS and LM curves, and explain why this is an
equilibrium.
12. (a) C = 50 + 0.8(Y – T)

T = 100
I = 150 – 5i
G = 100
L = 0.2Y – 10i
M = 200
P =2
Calculate
(ii) If government expenditure increases to 150, find new equilibrium
income & crowing out effect.

011-45076221 9811343411
(iii) If full employment income is Rs. 1200, calculate change in nominal
money supply required to achieve fill employment.
13. Consider the following IS-LM model:

C  200  .25YD
I  150  .25Y 1000i
G = 250
T = 200
M/P d  2Y  8,000i
M/P  1,600
(a) Derive the IS relation.
(b) Derive the LM relation.
(c) Solve for equilibrium real output.
(d) Solve for the equilibrium interest rate.
(e) Solve for the equilibrium values of C and I and verify the value you
obtained for Y by adding up C, I and G.
(f) Now suppose that the money supply increase to M/P = 1840. Solve
for Y, i, C and I, and describe in words the effects of an
expansionary monetary policy.
(g) Set M/P equal to its initial value of 1600. Now suppose that
government spending increases to G = 400. Summarize the effects
of an expansionary fiscal policy on Y, I and C.
14. Consumption C = 100 + 0.9Yd

Investment I = 600 – 30i
Government expenditure G = 300
Tax T = 1/3Y
Full employment Level of Income = 2500
Demand for Real Balances Md = 0.4Y – 50i
Nominal Money Supply M = 1040
Price level P=2
Note: Do not change the fraction 1/3 in T = 1/3 into decimal.
(i) Derive the IS and the LM equations and compute the equilibrium
levels of income and rate of interest.
(ii) Compute the change required in the level of government
expenditure to achieve the full employment level of income.

011-45076221 9811343411
(iii) Explain the change in the position and slope of the IS and LM
curves if the MPC changes to 0.6.

Demand for real balance Md = 0.2y – 2i
Nominal Money Supply Ms = 300
Price level P=2
(i) Compute the equilibrium levels of income (Y) and the rate of
interest (i)
(ii) Suppose the government purchases are raised from 100 to 150
and the nominal money supply is raised from 300 to 350. What is
the magnitude of shift in IS and LM curves? What are the new
equilibrium levels of income and the rate of interest?
(iii) For the initial values of monetary and fiscal values, derive the
equation of the aggregate demand curve.

Tax T = 0.2Y
Transfer payments TR = 80
Real demand for Money L = 0.2Y – 8i
M
Real Money Supply  200
P
(i) Write down the equation for the IS and LM Curves. Calculate the
equilibrium levels of income and the rate of interest. What would
be the budget surplus corresponding to this level of income?
(ii) How much is the increase in money supply required to increase
equilibrium income by 100?

Tax T = 50
Real demand for Money Md = 0.2Y – 4i
Nominal Money Supply Ms=300
Price level P=3

011-45076221 9811343411
(i) Compute the monetary and fiscal policy multipliers.
(ii) If the full employment level of income is 950. What is the (a)
increase in the nominal supply of money required to achieve full
employment; and
(b) Increase in government expenditure required to achieve full
employment?
(iii) What will be the effect of (a) & (b) on the rate of interest?
18. Consumption C = 85 + 0.75Y

Tax T = 40 + 0.25Y
Transfer Payments TR = 2500
Demand for real Balance Md = 0.2Y – 20i
Nominal Money supply M = 1800
Price level P=3
(i) Compute the equilibrium levels of income and the rate of interest.
(ii) Find the value of the fiscal multiplier.
(iii) By how much would equilibrium income change if government
expenditure increases by 60?
(iv) By how much must real money supply be increased in (iii) above so
that the increased government expenditure has its full multiplier
effect.
19. Consumption C = 50 + 0.8(Y–T)
Tax T = 100
Government Spending G = 100
Real demand for money L = 0.2Y – 10i
Real money supply M/P = 100
Export X = 20
Imports M = 10 + 0.1Y
(i) Write down the IS and LM equations.

(ii) Compute the equilibrium values of interest rate and income.
(iii) Calculate the trade balance.

011-45076221 9811343411
20. C = 70 + 0.75Yd
I = 35, G = 28, lump-sum tax (Ta) = 14,
income tax (T) = 0.2Y, X = 72, M = 16 + 0.05Y
(i) Find equilibrium income.

(ii) Consumption at equilibrium income.
(iii) If equilibrium level of income falls short of full employment level of
income by 100, then can full employment be reached by increasing
Government spending by 16 and transfer payment (R) by 12.
************

011-45076221 9811343411

Sem-II Book INTRODUCTORY MACROECONOMICS

Uploaded by

Document Information

Original Description:

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Sem-II Book INTRODUCTORY MACROECONOMICS

Uploaded by

Copyright:

Available Formats

UNIT - 1

INTRODUCTION TO MACROECONOMICS AND

3. Define inflation and deflation. Compare the behavior of consumer prices

6. List the principal professional activities of macroeconomists. What role

7. What steps are involved in developing and testing an economic theory or

8. Might tow economists agree about the effects of a particular economic

Bliss Point Studies 1 Ravindra N. Jha

Bliss Point Studies 2 Ravindra N. Jha

3. State a theory for why people vote Republican or Democratic that

5. In 2002, President George W. Bush imposed tariffs on certain types of

Bliss Point Studies 3 Ravindra N. Jha

3. What is the difference between intermediate and final goods and

7. What is national wealth, and why is it important? How is national wealth

8. For the purposes of assessing an economy’s growth performance, which

Bliss Point Studies 4 Ravindra N. Jha

3. ABC Computer Company has a $20,000,000 factory in Silicon Valley.

Bliss Point Studies 5 Ravindra N. Jha

5. You are given the following information about an economy:

Bliss Point Studies 6 Ravindra N. Jha

8. Hy Marks buys a one-year government bond or January 1, 2009, for

9. The GDP deflator in Econoland is 200 on January 1, 2008, The deflator

Bliss Point Studies 7 Ravindra N. Jha

What problem does government control of prices create for

Bliss Point Studies 8 Ravindra N. Jha

Bliss Point Studies 9 Ravindra N. Jha

2. For each transaction described in Analytical Problem 1 that by itself

3. A large country imposes capital controls that prohibit foreign borrowing

Bliss Point Studies 10 Ravindra N. Jha

6. Analyze the effects on a large open economy of a temporary adverse

8. The world is made up of only two large countries: Eastland and

Bliss Point Studies 11 Ravindra N. Jha

Questions for Review

2. What is fiat money? What is commodity money?

3. Who controls the money supply and how?

4. Write the quantity equation and explain it.

5. What does the assumption of constant velocity imply?

6. Who pays the inflation tax?

7. If inflation rises from 6 to 8 percent, what happens to real and nominal

Problems and Applications

2. In the country of Wiknam, the velocity of money is constant. Real GDP

Bliss Point Studies 12 Ravindra N. Jha

4. Suppose you are advising a small country (such as Bermuda) on whether

5. Calvin Coolidge once said that “inflation is repudiation.” What might he

6. Calvin Coolidge once said that “inflation is repudiation.” What might he

8. Suppose that consumption depends on the level of real money balances

Bliss Point Studies 13 Ravindra N. Jha

Questions and Problems

1. Using the information in this chapter, label each of the following

3. A bond promises to pay $100 in one year.

Bliss Point Studies 14 Ravindra N. Jha

4. Suppose that money demand is given by : Md  $Y.25  i 

6. In Chapter 3, you learned that an increase in the interest rate makes

7. ATMs and credit cards

Bliss Point Studies 15 Ravindra N. Jha

8. The velocity of money

9. The money multiplier

Bliss Point Studies 16 Ravindra N. Jha

10. Bank runs and the money multiplier

Bliss Point Studies 17 Ravindra N. Jha

Questions for Review

2. What does the assumption of constant velocity imply?

3. Who pays the inflation tax?

4. If inflation rises from 6 to 8 percent, what happens to real and nominal