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ASSIGNMENT SOLUTIONS GUIDE (2021-22)

BECC-133: PRINCIPLES OF MACROECONOMICS – I
Disclaimer/Special Note: These are just the sample of the Answers/Solutions to some of the Questions
given in the Assignments. These Sample Answers/Solutions are prepared by Private
Teacher/Tutors/Authors for the help and guidance of the student to get an idea of how he/she can
answer the Questions given the Assignments. We do not claim 100% accuracy of these sample
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answers may be seen as the Guide/Help for the reference to prepare the answers of the Questions
given in the assignment. As these solutions and answers are prepared by the private teacher/tutor so

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the chances of error or mistake cannot be denied. Any Omission or Error is highly regretted though
every care has been taken while preparing these Sample Answers/Solutions. Please consult your own

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Teacher/Tutor before you prepare a Particular Answer and for up-to-date and exact information, data
and solution. Student should must read and refer the official study material provided by the

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university.

98 80 E Assignment I
Answer the following Descriptive Category Questions in about 500 words each. Each question
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carries 20 marks. Word limit does not apply in the case of numerical questions.
Q1. Explain how the circular flows of income and output in a three sector economy take place.
Draw appropriate diagram to substantiate your answer. Point out the leakages from the circular
flows.
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Ans. Circular Flow of Income Definition: Circular flow of income is an economic model that
describes how the money exchanged in the process of production, distribution and consumption of
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goods and services flows in a circular manner from producers to consumers and back to the
producers.
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Diagram of the Circular Flow of Income: The flow of money in society can be referred to in the
diagram below:
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The circular flow of income is an integral concept in economics as it describes the foundation of the
transactions that build an economy. The basic model of the circular flow of income considers only
two sectors, the firms and the households, which is why it is called the two-sector economy model.
Let understand the meaning of these terms as well as the whole concept in simple steps.

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 Firms are the producers of goods and services. Firms require various factors of production or
societal resources to produce goods and services.
 The factors of production are land, labor, building, stock, stationery, etc.
 Households provide the resources or factors of production. For example, a household
provides land and labor to carry out business operations in exchange for the money paid in
the form of rent, wages, etc.
 So, the money flows from the firms to the household in the form of rent, wages, etc.
 The households utilize the money from wages and rent to purchase certain goods and
services to full their needs and wants.
 When the households pay for these goods and services, the money flows back to the firms,
completing the circular movement of money.

Q2. (a) Describe the functions of money.

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Ans. Money is any object that is generally accepted as payment for goods and services and repayment
of debts in a given socioeconomic context or country. Money comes in three forms: commodity

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money, fiat money, and fiduciary money.
Many items have been historically used as commodity money, including naturally scarce precious
metals, conch shells, barley beads, and other things that were considered to have value. The value of

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commodity money comes from the commodity out of which it is made. The commodity itself
constitutes the money, and the money is the commodity.
Fiat money is money whose value is not derived from any intrinsic value or guarantee that it can be
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converted into a valuable commodity (such as gold). Instead, it has value only by government order
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(fiat). Usually, the government declares the fiat currency to be legal tender, making it unlawful to not
accept the fiat currency as a means of repayment for all debts. Paper money is an example of fiat
money.
Fiduciary money includes demand deposits (such as checking accounts) of banks. Fiduciary money is
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accepted on the basis of the trust its issuer (the bank) commands.
Most modern monetary systems are based on fiat money. However, for most of history, almost all
money was commodity money, such as gold and silver coins.
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Functions of Money: Money has three primary functions. It is a medium of exchange, a unit of
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account, and a store of value:

 Medium of Exchange: When money is used to intermediate the exchange of goods and
services, it is performing a function as a medium of exchange.
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 Unit of Account: It is a standard numerical unit of measurement of market value of goods,

services, and other transactions. It is a standard of relative worth and deferred payment, and
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as such is a necessary prerequisite for the formulation of commercial agreements that involve
debt. To function as a unit of account, money must be divisible into smaller units without loss
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of value, fungible (one unit or piece must be perceived as equivalent to any other), and a
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specific weight or size to be verifiably countable.

 Store of Value: To act as a store of value, money must be reliably saved, stored, and
retrieved. It must be predictably usable as a medium of exchange when it is retrieved.
Additionally, the value of money must remain stable over time.
Economists sometimes note additional functions of money, such as that of a standard of deferred
payment and that of a measure of value. A ‚standard of deferred payment‛ is an acceptable way to
settle a debt–a unit in which debts are denominated. The status of money as legal tender means that
money can be used for the discharge of debts. Money can also act a as a standard measure and
common denomination of trade. It is thus a basis for quoting and bargaining prices. Its most
important usage is as a method for comparing the values of dissimilar objects.
The Functions of Money: The monetary economy is a significant improvement over the barter
system, in which goods were exchanged directly for other goods.

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Barter is a system of exchange in which goods or services are directly exchanged for other goods or
services without using a medium of exchange, such as money. The reciprocal exchange is immediate
and not delayed in time. It is usually bilateral, though it can be multilateral, and usually exists parallel
to monetary systems in most developed countries, though to a very limited extent. The barter system
has a number of limitations which make transactions very inefficient, including:
 Double coincidence of wants: The needs of a seller of a commodity must match the needs of
a buyer. If they do not, the transaction will not occur.
 Absence of common measure of value: In a monetary economy, money plays the role of a
measure of value of all goods, making it possible to measure the values of goods against each
other. This is not possible in a barter economy.
 Indivisibility of certain goods: If a person wants to buy a certain amount of another’s goods,
but only has payment of one indivisible good which is worth more than what the person
wants to obtain, a barter transaction cannot occur.

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 Difficulty of deferred payments: It is impossible to make payments in installments and
difficult to make payments at a later point in time.
 Difficulty storing wealth: If society relies exclusively on perishable goods, storing wealth for

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the future may be impractical.
Despite the long list of limitations, the barter system has some advantages. It can replace money as

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the method of exchange in times of monetary crisis, such as when a the currency is either unstable
(e.g. hyperinflation or deflationary spiral) or simply unavailable for conducting commerce. It can also

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be useful when there is little information about the credit worthiness of trade partners or when there
is a lack of trust.
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The money system is a significant improvement over the barter system. It provides a way to quantify
the value of goods and communicate it to others. Money has several defining characteristics. It is:
 Durable.
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
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Divisible.
Portable.
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 Liquid.

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A unit of account.
 Legal tender.
 Resistant to counterfeiting.
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Money serves four primary purposes. It is:

 A medium of exchange: an object that is generally accepted as a form of payment.
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 A unit of account: a means of keeping track of how much something is worth.

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 A store of value: it can be held and exchanged later for goods and services at an approximate
value.
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 A standard of deferred payments (this is not considered a defining purpose of money by all
economists).
The use of money as a medium of exchange has removed the major difficulty of double coincidence of
wants in the barter system. It separates the act of sale and purchase of goods and services and helps
both parties in obtaining maximum satisfaction and profits independently.

(b) What according to Keynes are the factors that lead to demand for money?
Ans. Demand for money: The demand for money refers to how much assets individuals wish to hold
in the form of money (as opposed to illiquid physical assets.) It is sometimes referred to as liquidity

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preference. The demand for money is related to income, interest rates and whether people prefer to
hold cash(money) or illiquid assets like money.

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This shows that the demand for money is inversely related to the interest rate.
 At high-interest rates, people prefer to hold bonds (which give a high-interest payment).
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When interest rates fall, holding bonds gives a lower return so people prefer to hold cash.
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Types of demand for money
 Transaction demand – money needed to buy goods – this is related to income.
 Precautionary demand – money needed for financial emergencies.

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Asset motive/speculative demand – when people wish to hold money rather than buy
assets/bonds/risky investment.
Transaction demand for money: Transaction demand for money – the money we need to purchase
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goods and services in day to day life.

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In the classical quantity theory of money. The demand for money is a function of prices and income
(assuming the velocity of circulation is stable.) If income rises, demand for money will rise.
In an inventory model, the demand for holding money depends on the frequency of getting paid, and
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the cost of depositing money in a bank. When employees are paid, they will hold some money to buy
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goods. If they are paid once a month, they may deposit half to benefit from interest payments, and
then withdraw after two months. However, electronic transfers and debit cards have made this less
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relevant.
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Precautionary demand for money

 Precautionary demand for money – the money we may need for unexpected purchases or
emergencies.
Asset motive
 The asset motive states that people demand money as a way to hold wealth. This may occur
during periods of deflation or periods where investors expect bonds to fall in value.
Speculative demand: Keynes explained the asset motive through what he termed ‘speculative
demand’. In this theory, he argued that demand for money is a choice between holding cash and
buying bonds.

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If interest rates are low, then people will tend to expect rising interest rates, and therefore a fall in the

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price of bonds. In this case, demand for holding wealth in the form of money will be higher.
If interest rates are high, and people expect interest rates to fall, then there is likely to be greater
demand for buying bonds and less demand for holding money. If interest rates fall, then the price of
bonds will rise.
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Portfolio motive: The portfolio motive is another way of considering the asset motive. This theory
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was developed by James Tobin. He placed emphasis on the trade off between asset growth and risk
aversion. For example, if an individual is nervous about future economic trends, he will hold money
rather than purchase more risky bonds and shares. If the individual is optimistic, he will take risks
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and purchase fewer bonds and shares.
The demand for money can vary due to many factors other than income and interest rates. These
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include
 Technological changes – e.g. debit cards, make holding cash less important. Easy access to
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current accounts can enable people to hold less cash.

 Availability of credit. If credit is more available, precautionary demand for money will fall as
individuals feel they can borrow – if they meet short-term difficulties.
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 Irrational behaviour of asset prices. Markets can enter boom and busts driven by
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psychological factors such as over-exuberance. In these bubble periods, demand for assets
will rise and demand for holding money will fall.
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 Empirical evidence in A Monetary History of the United States (1963) Friedman and Schwartz
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suggested a relationship between demand for money and income and interest rates.
However, this relationship seems to break-down post-1975
 It depends on how you define money. Narrow definitions such as M0 and M1 are quite
different from broader definitions. Also, there is near-money which includes short-term gilts
with the maturity of fewer than six months.
 The demand for money can refer to narrow definitions of the money supply (M0, M1) or
broad measures of the money supply like M3 or M4.
Money demand in a liquidity trap: In a liquidity trap, the demand for money is perfectly elastic.
Increasing the money supply doesn’t reduce interest rates and the impact of increasing the money
supply is ineffective in boosting demand.

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Assignment II
Answer the following Middle Category Questions in about 250 words each. Each question carries
10 marks. Word limit does not apply in the case of numerical questions.
Q3. Why did the classical economists fail to explain the Great Depression? What is the Keynesian
explanation for the same?
Ans. The Great Depression discredited classical economics by casting a doubt on how the market was
able to regulate the economy.
Explanation: After 1929 a doubt was cast over the classical economic theory according to which
government should not intervene in the economy. The 1929 crisis brought deflation, banks going
bankrupt and massive unemployment with businesses shutting down in masses.
In 1936 John Maynard Keynes published the "General Theory", in this book he advocated a certain
amount of state intervention to stimulate consumption. Transfering money from the wealthy to the
poor was one of the main means to achieve that goal.

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After WWII the Keynesian remedies were applied in the economy as the 1929 crisis had discredited
classical liberalism. It was henceforth thought that market economy would bring instabilty and that

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government could stabilize the economy.
Keynesian economics is a macroeconomic economic theory of total spending in the economy and its
effects on output, employment, and inflation. Keynesian economics was developed by the

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British economist John Maynard Keynes during the 1930s in an attempt to understand the Great
Depression. Keynesian economics is considered a "demand-side" theory that focuses on changes in
the economy over the short run. Keynes’s theory was the first to sharply separate the study of
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economic behavior and markets based on individual incentives from the study of broad national
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economic aggregate variables and constructs.
Based on his theory, Keynes advocated for increased government expenditures and lower taxes to
stimulate demand and pull the global economy out of the depression. Subsequently, Keynesian
economics was used to refer to the concept that optimal economic performance could be achieved—
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and economic slumps prevented—by influencing aggregate demand through activist stabilization
and economic intervention policies by the government.
Understanding Keynesian Economics
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Keynesian economics represented a new way of looking at spending, output, and inflation.
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Previously, what Keynes dubbed classical economic thinking held that cyclical swings in employment
and economic output create profit opportunities that individuals and entrepreneurs would have an
incentive to pursue, and in so doing correct the imbalances in the economy. According to Keynes’s
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construction of this so-called classical theory, if aggregate demand in the economy fell, the resulting
weakness in production and jobs would precipitate a decline in prices and wages. A lower level of
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inflation and wages would induce employers to make capital investments and employ more people,
stimulating employment and restoring economic growth. Keynes believed that the depth and
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persistence of the Great Depression, however, severely tested this hypothesis.

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In his book, The General Theory of Employment, Interest, and Money and other works, Keynes argued
against his construction of classical theory, that during recessions business pessimism and certain
characteristics of market economies would exacerbate economic weakness and cause aggregate
demand to plunge further.
For example, Keynesian economics disputes the notion held by some economists that lower wages
can restore full employment because labor demand curves slope downward like any other normal
demand curve. Instead he argued that employers will not add employees to produce goods that
cannot be sold because demand for their products is weak. Similarly, poor business conditions may
cause companies to reduce capital investment, rather than take advantage of lower prices to invest in
new plants and equipment. This would also have the effect of reducing overall expenditures and
employment.

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Q4. Give a brief account of the various instruments of monetary policy.

Ans. The monetary policy refers to a regulatory policy whereby the central bank maintains its control
over the supply of money to achieve the general economic goals. Main instruments of the monetary
policy are: Cash Reserve Ratio, Statutory Liquidity Ratio, Bank Rate, Repo Rate, Reverse Repo Rate,
and Open Market Operations. Monetary policy refers to the credit control measures adopted by the
central bank of a country. In case of Indian economy, RBI is the sole monetary authority which
decides the supply of money in the economy.
The Chakravarty committee has emphasized that price stability, growth, equity, social justice,
promoting and nurturing the new monetary and financial institutions have been important objectives
of the monetary policy in India.
Instruments of Monetary Policy: The instruments of monetary policy are of two types:
1. Quantitative, general or indirect (CRR, SLR, Open Market Operations, Bank Rate, Repo Rate,

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Reverse Repo Rate)
2. Qualitative, selective or direct (change in the margin money, direct action, moral suasion)

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These both methods affect the level of aggregate demand through the supply of money, cost of money
and availability of credit. Of the two types of instruments, the first category includes bank rate
variations, open market operations and changing reserve requirements (cash reserve ratio, statutory

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reserve ratio).
Policy instruments are meant to regulate the overall level of credit in the economy through
commercial banks. The selective credit controls aim at controlling specific types of credit. They
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include changing margin requirements and regulation of consumer credit.
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We discuss them as under:
(a) Bank Rate Policy: The bank rate is the minimum lending rate of the central bank at which it
rediscounts first class bills of exchange and government securities held by the commercial
banks. When the central bank finds that inflation has been increasing continuously, it raises
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the bank rate so borrowing from the central bank becomes costly and commercial banks
borrow less money from it (RBI).
The commercial banks, in reaction, raise their lending rates to the business community and
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borrowers who further borrow less from the commercial banks. There is contraction of credit
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and prices are checked from rising further. On the contrary, when prices are depressed, the
central bank lowers the bank rate.
It is cheap to borrow from the central bank on the part of commercial banks. The latter also
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lower their lending rates. Businessmen are encouraged to borrow more. Investment is
encouraged and followed by rise in Output, employment, income and demand and the
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downward movement of prices is checked.

(b) Open Market Operations: Open market operations refer to sale and purchase of securities in
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the money market by the central bank of the country. When prices start rising and there is
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need to control them, the central bank sells securities. The reserves of commercial banks are
reduced and they are not in a position to lend more to the business community or general
public.
Further investment is discouraged and the rise in prices is checked. Contrariwise, when
recessionary forces start in the economy, the central bank buys securities. The reserves of
commercial banks are raised so they lend more to business community and general public. It
further raises Investment, output, employment, income and demand in the economy hence
the fall in price is checked.
(c) Changes in Reserve Ratios: Under this method, CRR and SLR are two main deposit ratios,
which reduce or increases the idle cash balance of the commercial banks. Every bank is
required by law to keep a certain percentage of its total deposits in the form of a reserve fund
in its vaults and also a certain percentage with the central bank.

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When prices are rising, the central bank raises the reserve ratio. Banks are required to keep
more with the central bank. Their reserves are reduced and they lend less. The volume of
investment, output and employment are adversely affected. In the opposite case, when the
reserve ratio is lowered, the reserves of commercial banks are raised. They lend more and the
economic activity is favourably affected.
Selective Credit Controls: Selective credit controls are used to influence specific types of credit for
particular purposes. They usually take the form of changing margin requirements to control
speculative activities within the economy. When there is brisk speculative activity in the economy or
in particular sectors in certain commodities and prices start rising, the central bank raises the margin
requirement on them.
(a) Change in Margin Money: The result is that the borrowers are given less money in loans
against specified securities. For instance, raising the margin requirement to 70% means that
the pledger of securities of the value of Rs 10,000 will be given 30% of their value, i.e. Rs 3,000

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as loan. In case of recession in a particular sector, the central bank encourages borrowing by
lowering margin requirements.

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(b) Moral Suasion: Under this method RBI urges to commercial banks to help in controlling the
supply of money in the economy.
Objectives of the Monetary Policy of India

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 Price Stability: Price Stability implies promoting economic development with
considerable emphasis on price stability. The centre of focus is to facilitate the
environment which is favourable to the architecture that enables the developmental
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projects to run swiftly while also maintaining reasonable price stability.
 Controlled Expansion Of Bank Credit: One of the important functions of RBI is the
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controlled expansion of bank credit and money supply with special attention to seasonal
requirement for credit without affecting the output.
 Promotion of Fixed Investment: The aim here is to increase the productivity of
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investment by restraining non essential fixed investment.
 Restriction of Inventories: Overfilling of stocks and products becoming outdated due to
excess of stock often results is sickness of the unit. To avoid this problem the central
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monetary authority carries out this essential function of restricting the inventories. The
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main objective of this policy is to avoid over-stocking and idle money in the organization
 Promotion of Exports and Food Procurement Operations: Monetary policy pays special
attention in order to boost exports and facilitate the trade. It is an independent objective
of monetary policy.
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 Desired Distribution of Credit: Monetary authority has control over the decisions
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regarding the allocation of credit to priority sector and small borrowers. This policy
decides over the specified percentage of credit that is to be allocated to priority sector and
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small borrowers.
 Equitable Distribution of Credit: The policy of Reserve Bank aims equitable distribution
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to all sectors of the economy and all social and economic class of people
 To Promote Efficiency: It is another essential aspect where the central banks pay a lot of
attention. It tries to increase the efficiency in the financial system and tries to incorporate
structural changes such as deregulating interest rates, ease operational constraints in the
credit delivery system, to introduce new money market instruments etc.
 Reducing the Rigidity: RBI tries to bring about the flexibilities in the operations which
provide a considerable autonomy. It encourages more competitive environment and
diversification. It maintains its control over financial system whenever and wherever
necessary to maintain the discipline and prudence in operations of the financial system.
Conclusion: So it can be conclude that the implementation of the monetary policy plays a very
prominent role in the development of a country. It’s a kind of double edge sword, if money is not
available in the market as the requirement of the economy, the investors will suffer (investment will

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decline in the economy) and on the other hand if the money is supplied more than its requirement
then the poor section of the country will suffer because the prices of essential commodities will start
rising.
Q5. What according to Keynes are the components of aggregate demand? Describe how
equilibrium output is determined in the simple Keynesian model.
Ans. Key points
 Aggregate demand is the sum of four components: consumption, investment, government
spending, and net exports.
 Consumption can change for a number of reasons, including movements in income, taxes,
expectations about future income, and changes in wealth levels.
 Investment can change in response to its expected profitability, which in turn is shaped by
expectations about future economic growth, the creation of new technologies, the price of key
inputs, and tax incentives for investment. Investment can also change when interest rates rise

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or fall.
 Government spending and taxes are determined by political considerations.
 Exports and imports change according to relative growth rates and prices between two

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economies.
 Disposable income is income after taxes.

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 An inflationary gap exists when equilibrium is at a level of output above potential GDP.
 A recessionary gap exists when equilibrium is at a level of output below potential GDP.

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Assignment III
Answer the following Short Category Questions in about 100 words each. Each question carries 6
marks.
Q6. Explain the concept of liquidity trap.

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Ans. A liquidity trap is a contradictory economic situation in which interest rates are very low
and savings rates are high, rendering monetary policy ineffective. First described by economist John
Maynard Keynes, during a liquidity trap, consumers choose to avoid bonds and keep their funds in
cash savings because of the prevailing belief that interest rates could soon rise (which would push
bond prices down). Because bonds have an inverse relationship to interest rates, many consumers do
not want to hold an asset with a price that is expected to decline. At the same time, central bank
efforts to spur economic activity are hampered as they are unable to lower interest rates further to
incentivize investors and consumers.
Understanding Liquidity Traps: In a liquidity trap, should a country's reserve bank, like the Federal
Reserve in the USA, try to stimulate the economy by increasing the money supply, there would be no
effect on interest rates, as people do not need to be encouraged to hold additional cash.
As part of the liquidity trap, consumers continue to hold funds in standard deposit accounts, such as
savings and checking accounts, instead of in other investment options, even when the central banking

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system attempts to stimulate the economy through the injection of additional funds. High consumer
savings levels, often spurred by the belief of a negative economic event on the horizon, causes

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monetary policy to be generally ineffective. The belief in a future negative event is key, because as
consumers hoard cash and sell bonds, this will drive bond prices down and yields up. Despite rising
yields, consumers are not interested in buying bonds as bond prices are falling. They prefer instead to

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hold cash at a lower yield.
A notable issue of a liquidity trap involves financial institutions having problems finding qualified
borrowers. This is compounded by the fact that, with interest rates approaching zero, there is little
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room for additional incentive to attract well-qualified candidates. This lack of borrowers often shows
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up in other areas as well, where consumers typically borrow money, such as for the purchase of cars
or homes.

Q7. With an example, explain the concept of double counting.

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Ans. Double counting in accounting is an error whereby a transaction is counted more than once. For
example, the costs of intermediate goods used by a business to produce a finished good are included
in the computation of a nation’s gross domestic product. Since the final price of a good already
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includes the value of all the intermediate goods used to produce it, including the price of intermediate
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goods when calculating gross domestic product would involve double counting. Double counting
seriously overstates gross domestic product. Take the example of the production of a product like
Wacky Willy Stuffed Amigos. Stuffed Amigos have three primary material inputs or intermediate
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goods, fabric, thread and stuffing. The fabric is 100 per cent cotton, produced by Omni Textiles.
The thread is a cotton-polyester blend, produced by Mega Thread. And the stuffing is a gelatinous
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substance produced using soybean extract, graphite, and recycled newspapers by a firm called Ooze.
In addition to these intermediate goods, The Wacky Willy Company also uses the four basic factors of
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production labor, capital, land, and entrepreneurship.

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The expense of these resources in the production of stuffed amigos is not particularly important at the
present. What is important is the market transactions for the intermediate goods. If the government
added all market transactions, it would be overstating the value associated with the production of this
stuffed amigo. If the government does this for all production, it would seriously over estimates the
actual value of production during the year. It happens in income method also because national
income estimate total economic activity, including GDP, gross national product, net national income,
and adjusted national income. All are especially concerned with counting the total amount of goods
and services produced within some boundary. The boundary is usually defined by geography or
citizenship, and may also restrict the goods and services that are counted.
Double counting can be avoided. In order to avoid double or multiple counting, only final goods and
services should be included in GDP. However, this should not be regarded as meaning that the
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farmer or the miller or the baker has not contributes anything to GDP. In fact, their contributions are
already included in the value of the final product. Their individual contributions to GDP can be
worked out by the, value added method which is the same as the value-of final product.

Q8. For a three sector economy the following are given:

𝐶 = 30 + 0.75𝑌, I = 30, G = 40
Where C = consumption, I = investment, and G = government expenditure.
Find out the equilibrium output level. Find out the value of investment multiplier.
Ans.

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Q9. What is meant by net exports? What are the determinants of net exports?
Ans. Net exports are a measure of a nation's total trade. The formula for net exports is a simple one:
The value of a nation's total export goods and services minus the value of all the goods and services it
imports equal its net exports.
A nation that has positive net exports enjoys a trade surplus, while negative net exports mean the
nation has a trade deficit. A nation's net exports are thus a component of its overall balance of trade.
Understanding Net Exports

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A country that enjoys net exports brings in more revenues from goods sold overseas than it spends on
total imports. Exports consist of all the goods and other services a country sends to the rest of the
world, including merchandise, freight, transportation, tourism, communication, and financial
services. Companies export products and services for a variety of reasons. Exports can increase sales
and profits if the goods create new markets or expand existing ones, and they may even present an
opportunity to capture significant global market share. Companies that export spread business risk
by diversifying into multiple markets. Exporting into foreign markets can also reduce per-unit costs
by expanding operations to meet increased demand. Finally, companies that export into foreign
markets gain new knowledge and experience that may allow the discovery of new technologies,
marketing practices, and insights into foreign competitors.
If a nation's currency is weak in relation to other currencies, the goods available for export become
more competitive in international markets as their prices are relatively less expensive,
which encourages positive net exports. If a country has a strong currency, its exports are more

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expensive and consumers will pass them up for cheaper local products, which can lead to negative
net exports

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Net exports equal exports minus imports. Many of the same forces affect both exports and imports,
albeit in different ways.
Income: As incomes in other nations rise, the people of those nations will be able to buy more goods

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and services— including foreign goods and services. Any one country’s exports thus will increase as
incomes rise in other countries and will fall as incomes drop in other countries.
A nation’s own level of income affects its imports the same way it affects consumption. As consumers
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have more income, they will buy more goods and services. Because some of those goods and services
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are produced in other nations, imports will rise. An increase in real GDP thus boosts imports; a
reduction in real GDP reduces imports. Figure shows the relationship between real GDP and the real
level of import spending in the United States from 1960 through 2007. Notice that the observations lie
close to a straight line one could draw through them and resemble a consumption function.
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Figure Real GDP and Imports, 1960–2007

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The chart shows annual values of U.S. real imports and real GDP from 1960 through 2007. The
observations lie quite lose to a straight line.
Relative Prices: A change in the price level within a nation simultaneously affects exports and
imports. A higher price level in the United States, for example, makes U.S. exports more expensive for
foreigners and thus tends to reduce exports. At the same time, a higher price level in the United States
makes foreign goods and services relatively more attractive to U.S. buyers and thus increases imports.
A higher price level therefore reduces net exports. A lower price level encourages exports and
reduces imports, increasing net exports. As we saw in the chapter that introduced the aggregate
demand and supply model, the negative relationship between net exports and the price level is called
the international trade effect and is one reason for the negative slope of the aggregate demand curve.
The Exchange Rate: The purchase of U.S. goods and services by foreign buyers generally requires the
purchase of dollars, because U.S. suppliers want to be paid in their own currency. Similarly,
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purchases of foreign goods and services by U.S. buyers generally require the purchase of foreign
currencies, because foreign suppliers want to be paid in their own currencies. An increase in the
exchange rate means foreigners must pay more for dollars, and must thus pay more for U.S. goods
and services. It therefore reduces U.S. exports. At the same time, a higher exchange rate means that a
dollar buys more foreign currency. That makes foreign goods and services cheaper for U.S. buyers, so
imports are likely to rise. An increase in the exchange rate should thus tend to reduce net exports. A
reduction in the exchange rate should increase net exports.
Trade Policies: A country’s exports depend on its own trade policies as well as the trade policies of
other countries. A country may be able to increase its exports by providing some form of government
assistance (such as special tax considerations for companies that export goods and services,
government promotional efforts, assistance with research, or subsidies). A country’s exports are also
affected by the degree to which other countries restrict or encourage imports. The United States, for
example, has sought changes in Japanese policies toward products such as U.S.-grown rice. Japan

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banned rice imports in the past, arguing it needed to protect its own producers. That has been a costly
strategy; consumers in Japan typically pay as much as 10 times the price consumers in the United

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States pay for rice. Japan has given in to pressure from the United States and other nations to end its
ban on foreign rice as part of the GATT accord. That will increase U.S. exports and lower rice prices in
Japan.

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Similarly, a country’s imports are affected by its trade policies and by the policies of its trading
partners. A country can limit its imports of some goods and services by imposing tariffs or quotas on
them—it may even ban the importation of some items. If foreign governments subsidize the
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manufacture of a particular good, then domestic imports of the good might increase. For example, if
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the governments of countries trading with the United States were to subsidize the production of steel,
then U.S. companies would find it cheaper to purchase steel from abroad than at home, increasing
U.S. imports of steel.
Preferences and Technology: Consumer preferences are one determinant of the consumption of any
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good or service; a shift in preferences for a foreign-produced good will affect the level of imports of
that good. The preference among the French for movies and music produced in the United States has
boosted French imports of these services. Indeed, the shift in French preferences has been so strong
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that the government of France, claiming a threat to its cultural heritage, has restricted the showing of
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films produced in the United States. French radio stations are fined if more than 40% of the music
they play is from ‚foreign‛ (in most cases, U.S.) rock groups.
Changes in technology can affect the kinds of capital firms import. Technological changes have
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changed production worldwide toward the application of computers to manufacturing processes, for
example. This has led to increased demand for high-tech capital equipment, a sector in which the
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United States has a comparative advantage and tends to dominate world production. This has
boosted net exports in the United States.
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Q10. What type of fiscal policy should the government adopt during recession? Justify your
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answer.
Ans. Fiscal policy is the use of government spending and tax policy to influence the path of the
economy over time. Graphically, we see that fiscal policy, whether through changes in spending or
taxes, shifts the aggregate demand outward in the case of expansionary fiscal policy and inward in
the case of contractionary fiscal policy. We know from the chapter on economic growth that over time
the quantity and quality of our resources grow as the population and thus the labor force get larger,
as businesses invest in new capital, and as technology improves. The result of this is regular shifts to
the right of the aggregate supply curves, as (Figure) illustrates.
The original equilibrium occurs at E0, the intersection of aggregate demand curve AD0 and aggregate
supply curve SRAS0, at an output level of 200 and a price level of 90. One year later, aggregate
supply has shifted to the right to SRAS1 in the process of long-term economic growth, and aggregate

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demand has also shifted to the right to AD1, keeping the economy operating at the new level of
potential GDP. The new equilibrium (E1) is an output level of 206 and a price level of 92. One more
year later, aggregate supply has again shifted to the right, now to SRAS 2, and aggregate demand
shifts right as well to AD2. Now the equilibrium is E2, with an output level of 212 and a price level of
94. In short, the figure shows an economy that is growing steadily year to year, producing at its
potential GDP each year, with only small inflationary increases in the price level.
A Healthy, Growing Economy
In this well-functioning economy, each year aggregate supply and aggregate demand shift to the right
so that the economy proceeds from equilibrium E0 to E1 to E2. Each year, the economy produces at
potential GDP with only a small inflationary increase in the price level. However, if aggregate
demand does not smoothly shift to the right and match increases in aggregate supply, growth with
deflation can develop.

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Aggregate demand and aggregate supply do not always move neatly together. Think about what
causes shifts in aggregate demand over time. As aggregate supply increases, incomes tend to go up.
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This tends to increase consumer and investment spending, shifting the aggregate demand curve to
the right, but in any given period it may not shift the same amount as aggregate supply. What
happens to government spending and taxes? Government spends to pay for the ordinary business of
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government- items such as national defense, social security, and healthcare, as (Figure) shows. Tax
revenues, in part, pay for these expenditures. The result may be an increase in aggregate demand
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more than or less than the increase in aggregate supply.

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Aggregate demand may fail to increase along with aggregate supply, or aggregate demand may even
shift left, for a number of possible reasons: households become hesitant about consuming; firms
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decide against investing as much; or perhaps the demand from other countries for exports
diminishes.
For example, investment by private firms in physical capital in the U.S. economy boomed during the
late 1990s, rising from 14.1% of GDP in 1993 to 17.2% in 2000, before falling back to 15.2% by 2002.
Conversely, if shifts in aggregate demand run ahead of increases in aggregate supply, inflationary
increases in the price level will result. Business cycles of recession and recovery are the consequence
of shifts in aggregate supply and aggregate demand. As these occur, the government may choose to
use fiscal policy to address the difference.
Monetary Policy and Bank Regulation shows us that a central bank can use its powers over the
banking system to engage in countercyclical—or ‚against the business cycle‛—actions. If recession
threatens, the central bank uses an expansionary monetary policy to increase the money supply,
increase the quantity of loans, reduce interest rates, and shift aggregate demand to the right. If

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inflation threatens, the central bank uses contractionary monetary policy to reduce the money supply,
reduce the quantity of loans, raise interest rates, and shift aggregate demand to the left. Fiscal policy
is another macroeconomic policy tool for adjusting aggregate demand by using either government
spending or taxation policy.
Expansionary Fiscal Policy: Expansionary fiscal policy increases the level of aggregate demand,
through either increases in government spending or reductions in tax rates. Expansionary policy can
do this by (1) increasing consumption by raising disposable income through cuts in personal income
taxes or payroll taxes; (2) increasing investment spending by raising after-tax profits through cuts in
business taxes; and (3) increasing government purchases through increased federal government
spending on final goods and services and raising federal grants to state and local governments to
increase their expenditures on final goods and services. Contractionary fiscal policy does the reverse:
it decreases the level of aggregate demand by decreasing consumption, decreasing investment, and
decreasing government spending, either through cuts in government spending or increases in taxes.

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The aggregate demand/aggregate supply model is useful in judging whether expansionary or
contractionary fiscal policy is appropriate.

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Consider first the situation in (Figure), which is similar to the U.S. economy during the 2008-2009
recession. The intersection of aggregate demand (AD0) and aggregate supply (SRAS0) is occurring
below the level of potential GDP as the LRAS curve indicates. At the equilibrium (E 0), a recession

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occurs and unemployment rises. In this case, expansionary fiscal policy using tax cuts or increases in
government spending can shift aggregate demand to AD 1, closer to the full-employment level of
output. In addition, the price level would rise back to the level P1 associated with potential GDP.
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The original equilibrium (E0) represents a recession, occurring at a quantity of output (Y 0) below
potential GDP. However, a shift of aggregate demand from AD 0 to AD1, enacted through an
expansionary fiscal policy, can move the economy to a new equilibrium output of E 1 at the level of
potential GDP which the LRAS curve shows. Since the economy was originally producing below
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potential GDP, any inflationary increase in the price level from P0 to P1 that results should be
relatively small.
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Should the government use tax cuts or spending increases, or a mix of the two, to carry out
expansionary fiscal policy? During the 2008-2009 Great Recession (which started, actually, in late
2007), the U.S. economy suffered a 3.1% cumulative loss of GDP. That may not sound like much, but
it’s more than one year’s average growth rate of GDP. Over that time frame, the unemployment rate
doubled from 5% to 10%. The consensus view is that this was possibly the worst economic downturn
in U.S. history since the 1930’s Great Depression. The choice between whether to use tax or spending

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tools often has a political tinge. As a general statement, conservatives and Republicans prefer to see
expansionary fiscal policy carried out by tax cuts, while liberals and Democrats prefer that the
government implement expansionary fiscal policy through spending increases. In a bipartisan effort
to address the extreme situation, the Obama administration and Congress passed an $830 billion
expansionary policy in early 2009 involving both tax cuts and increases in government spending. At
the same time, however, the federal stimulus was partially offset when state and local governments,
whose budgets were hard hit by the recession, began cutting their spending.

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