NAME : ABDUL RAUF

CLASS: BSBA VI

SUBJECT: MACRO ECONOMICS

PROJECT TITLE: SOLUTION OF PAST

PAPERS(2011- 2018)
 ANSWERS
Q1

Define fiscal policy and its role?

ANS:
FISCAL POLICY:

'Fiscal policy is the means by which a government adjusts its spending levels and tax rates to monitor and
influence a nation's economy.'

EXPLANATION

The term fiscal policy refers to those measures or line of action taken by the government and its functionaries
in relation to raise revenues by imposing taxes or borrowings from internal and external sources and spending
them on different heads of expenditure. Arranging foreign aid and managing outstanding debt is also a part of
fiscal policy .The usual goals of both fiscal and monetary policy are to achieve or maintain full employment, to
achieve or maintain a high rate of economic growth, and to stabilize prices and wages.

ROLES OF FISCAL POLICY:

Fiscal policy can promote macroeconomic stability by sustaining aggregate demand and private sector
incomes during an economic downturn and by moderating economic activity during periods of strong growth.
Following are the roles of fiscal policy.

Short-Term Stabilization

One of the big functions of fiscal policy is to stabilize the economy on a year-by-year or period-by-period basis.
If the economy is sluggish or in crisis, the government might roll out some combination of spending and tax
relief to help get things moving again. That's called a loose or expansionary approach. On the other hand, if the
economy is overheated and threatening to cause runaway inflation or a dangerous "bubble" in the markets,
the government might cut spending and raise taxes as a means of pulling in the reins. That's referred to as a
tight, or deflationary policy.

Longer-Term Development

The next important role of fiscal policy is creating a stable framework for long-term growth. If the economy
never becomes too hot or too cold, companies can make long-term plans in the secure knowledge that they
won't be blindsided by a disastrous economic meltdown.

Allocating and Distributing Resources

One of the key things fiscal policy tries to do is allocate and distribute those resources in a way that creates the
greatest benefit for the economy, and the country, as a whole. A large portion of the government's resources
go to defense and national security, for example, which protect every citizen.

Some funds might be expended in subsidies, grants or loan guarantees that encourage the growth of
businesses, or entire industries or sectors of the economy. Others might go to social programs that help keep
low-income citizens solvent and productive, boosting the economy from the bottom rather than the top.

Maximizing Employment

A fourth goal of fiscal policy is full employment, which is closely linked to the other goals. A stable and growing
economy generates jobs as a side effect – and high levels of employment mean there are plenty of people with
paychecks to spend. That stimulates local economies, which helps companies grow, which in turn creates more
employment. This is a good thing for the community and the country as a whole, but it can create an issue for
individual employers. In times of full employment, you might find it difficult to recruit and retain enough staff,
and wages can rise as a result.

B)
 Discuss the concept of discretionary fiscal policy?

ANS:

DISCRETIONARY FISCAL POLICY:

‘Discretionary fiscal policy is a change in government spending or taxes. Its purpose

is to expand or shrink the economy as needed.’

CONCEPT OF DISCRETIONARY FISCAL POLICY

Discretionary fiscal policy is enforced for the purpose of delibrate change in the government expenditure and
taxes to influence the level of national output and prices. Discretionary fiscal policy increases spending on
infrastructure for eg builds roads,schools,communication systems etc. It also added advantage of increasing
capital goods in economy which can shift AS in the future. To cure recession, government prefers to enforce
discretionary fiscal policy. In this regard, government increases its expenditureor cuts down taxes or adopt a
combination of the both.

Q2)

Define consumption, saving and income?

ANS:

CONSUMPTION:

Consumption, in economics, the use of goods and services by households. Consumption is distinct from
consumption expenditure, which is the purchase of goods and services for use by households. Consumption
differs from consumption expenditure primarily because durable goods, such as automobiles, generate an
expenditure mainly in the period when they are purchased, but they generate “consumption services” (for
example, an automobile provides transportation services) until they are replaced or scrapped.

SAVING

Saving, process of setting aside a portion of current income for future use, or the flow of resources
accumulated in this way over a given period of time. Saving may take the form of increases in bank deposits,
purchases of securities, or increased cash holdings. The extent to which individuals save is affected by their
preferences for future over present consumption, their expectations of future income, and to some extent by
the rate of interest.

INCOME

Income is money (or some equivalent value) that an individual or business receives, usually in exchange for
providing a good or service or through investing capital. Income is used to fund day-to-day expenditures.
Investments, pensions, and Social Security are primary sources of income for retirees. For individuals, income
is most often received in the form of wages or salary. Business income can refer to a company's remaining
revenues after paying all expenses and taxes. In this case, income is referred to as "earnings.”

B)

Discuss the concept of marginal propensity to consume?

ANS:

MARGINAL PROPENSITY TO CONSUME(MPC)

 Marginal propensity to consume is a very useful tool to know how much of the increased income is consumed
and how much is saved to invest. Marginal propensity to consume is the ratio or proportion of a rise in income
that goes on consumption. In other words,it is the ratio of change in consumption to the change in income.
Symbolically represented as:

MPC: ΔC/ΔY

Example

Let’s work out MPC in the following three cases: Mark recently received a raise of $500 per month which
caused an increase in his spending by $300.

Mark’s MPC is the ratio of change in consumption (∆C) to change in income (∆Y):

MPC= $300/$500

MPC =0.6

Q3

a) Define tax and its types?

ANS:

TAXES:

‘Taxes are involuntary fees levied on individuals or corporations and enforced by a government
entity—whether local, regional or national—in order to finance government activities.’

UNDERSTANDING TAXES:

To help fund public works and services—and to build and maintain the infrastructures used in a country—the
government usually taxes its individual and corporate residents. The tax collected is used for the betterment of
the economy and all living in it.In the U.S. and many other countries in the world, taxes are applied to some
form of money received by a taxpayer. The money could be income earned from salary, capital gains from
investment appreciation, dividends received as additional income, payment made for goods and services, etc.

Direct Taxes:

When the burden of money is on the person who is obligated to pay tax , this type of tax is known as
direct tax or the amount of Tax which is levied on the income or wealth of person who pays it. It is called direct
tax because government collects tax directly from the person on whom the tax is levied. For example : Tax
levied on income is called income now this tax will be directly deducted from that person`s income and he
cannot shift this (tax) burden to another person. Wealth tax and Land revenue taxes are also included in direct
taxes.

Indirect Taxes:

Unlike , direct taxes the person is not directly paying the taxes. In indirect taxes one person shifts the
burden to other person. For example : In case of sales tax , firstly some amount of tax is paid by the
businessman but then the businessman shifts the tax burden to his customers. The businessman raises the
prices of its commodity and when the buyers buys that particular commodity at higher prices , all the tax
burden is beard by the final buyer of that commodity not by the businessman.

Progressive taxes
 This is a type of taxation where as you have more income that is subject to tax, you pay higher
average rates. This mostly relates to income taxes. The term “progressive” comes from the fact that as taxable
income increases, the tax rate gets progressively higher.

The federal income tax brackets are an example of progressive taxation. The federal government uses
marginal tax rates, which tax income within a certain range at one rate and income in a higher range at a
higher rate.A progessive income tax may also be referred to as a graduated income tax.

Regressive taxes

The opposite of a progessive tax is a regressive tax. This is a method of taxation where as you have
more that is subject to tax, your average tax rate is lower. One example of a regressive tax is the Social Security
tax, a type of payroll tax (more on that later).

Proportional and flat tax

A proportional tax is one where the amount you pay is proportional to how much you have. You

will also hear people refer to this as a flat tax. For example, imagine you live in a state with a flat income tax of
5%. Each taxpayer will pay 5% of his or her taxable income. Since everyone is paying a proportional amount of
their income, this is a proportional tax.

Federal income tax

The federal income tax is the tax applied on the annual earnings of individuals, corporations, trusts,
and other legal entities. Federal income taxes are applied to all forms of earnings that make up a taxpayer's
taxable income, such as employment earnings or capital gains.

Sales Tax

A sales tax is a consumption tax imposed by the government on the sale of goods and services. A
conventional sales tax is levied at the point of sale, collected by the retailer, and passed on to the government.
A business is liable for sales taxes in a given jurisdiction if it has a nexus there, which can be a brick-and-mortar
location, an employee, an affiliate, or some other presence, depending on the laws in that jurisdiction.

Local Tax

A local tax is an assessment by a state, county, or municipality to fund public services ranging from
education to garbage collection and sewer maintenance. Local taxes fund government services including police
and fire services, education and health services, libraries, road maintenance, and other programs and projects
which benefit the community at large.

Value-added tax

A value-added tax (VAT) is a consumption tax placed on a product whenever value is added at each
stage of the supply chain, from production to the point of sale. The amount of VAT that the user pays is on the
cost of the product, less any of the costs of materials used in the product that have already been taxed.

Property tax

Property tax is any tax on real estate or certain other forms of property. The proceeds from property
taxes represent one of the principal sources of income for local and state governments. Local governments
impose property taxes on buildings, land, and certain categories of personal property bought or owned within
their jurisdictions. Land, with or without buildings, is usually taxed on an annual basis. The value of a given
property fluctuates over time, depending on the value of surrounding properties or improvements to the
property.

B)

Discuss impact of taxation on aggregate demand?

ANS:

Income taxes affect the consumption component of aggregate demand. An increase in income taxes reduces
disposable personal income and thus reduces consumption (but by less than the change in disposable personal
income). That shifts the aggregate demand curve leftward by an amount equal to the initial change in
consumption that the change in income taxes produces times the multiplier. A change in tax rates will change
the value of the multiplier. A reduction in income taxes increases disposable personal income, increases
consumption (but by less than the change in disposable personal income), and increases aggregate demand.

Suppose, for example, that income taxes are reduced by $200 billion. Only some of the increase in disposable
personal income will be used for consumption and the rest will be saved. Suppose the initial increase in
consumption is $180 billion. Then the shift in the aggregate demand curve will be a multiple of $180 billion; if
the multiplier is 2, aggregate demand will shift to the right by $360 billion. Thus, as compared to the $200-
billion increase in government purchases that we saw in Figure 12.9 “An Increase in Government Purchases,”
the shift in the aggregate demand curve due to an income tax cut is somewhat less, as is the effect on real GDP
and the price level.

Q4 a)

Define GDP,GNP and NNP?

ANS:

GROSS DOMESTIC PRODUCT:

‘Gross domestic product (GDP) is the total value of everything produced within a country's borders.’

EXPLANATION:

GDP is that total market-value, at current prices, of final goods and services which are produced within a
country during a specific period usually a year. What is produced or earned outside the country by a country’s
workers, being the part of that country where they work, is not included in GDP of that country to which they
belong. Hence ,the remittances are excluded from GDP; they are included in GDP where they work. GDP
provides an economic snapshot of a country, used to estimate the size of an economy and growth rate.

GDP can be calculated in three ways, using expenditures, production, or incomes. It can be adjusted for
inflation and population to provide deeper insights.Though it has limitations, GDP is a key tool to guide
policymakers, investors, and businesses in strategic decision

GDP is defined by the following formula:

GDP = Consumption + Investment + Government Spending + Net Exports

or more succinctly as
GDP = C + I + G + NX

EXAMPLE:

In this case the if the Household Consumption is $304.

Government Spending is $156.

gross private investment is $124.

net exports shown to be $18.

Therefore:

GDP = $304 + $156 + $124 + $18

GDP = $602

GROSS NATIONAL PRODUCT:

‘Gross National Product (GNP) is the total value of all finished goods and services produced by a country’s
citizens in a given financial year, irrespective of their location.’

EXPLANATION:

GNP also measures the output generated by a country’s businesses located domestically or abroad. It can be
defined as a piece of economic statistics that comprises Gross Domestic Product (GDP), and income earned by
the residents from investments made overseas.

Simply put, GNP is a superset of the GDP. While GDP confines its analysis of the economy to the geographical
borders of the country, GNP extends it to also take account of the net overseas economic activities
performed by its residents.

Basically, GNP signifies how a country’s people contribute to its economy. It considers citizenship, regardless
of the location of the ownership. GNP does not include foreign residents’ income earned within the country.
GNP also does not count any income earned in India by foreign residents or businesses, and excludes products
manufactured in the country by foreign companies.

In calculation, GNP adds government expenditure, personal consumption expenditure, private domestic
investments, net exports, and income earned by nationals overseas, and eliminates the income of foreign
residents within the domestic economy. Moreover, GNP omits the value of intermediary goods to avoid
double counting, as these entries get included in the value of final products and services.

The basic distinction between GDP and GNP is the difference in estimating the production output by foreigners
in a country and by nationals outside of a country.

How is GNP calculated?

The formula for GNP = GDP + Net factor income from abroad

or

GNP = C + I + G + X + Z

EXAMPLES OF GNP:
Where C is Consumption, I is investment, G is government, X is net exports, and Z is net income earned by
domestic residents from overseas investments minus net income earned by foreign residents from domestic
investments.

Assume that Country ABC spends a total of $100 million on consumption, $75 million on investments, and
$200 million on government expenditure. Additionally, the country spends $50 million on imports and sells
$25 million of exports.

Country ABC also has multiple citizens and businesses in foreign countries who generate another $150 million
in income. The foreign businesses that operate within the country earn $50 million, which is sent back to their
home countries.

Using the formula above, we can calculate the GNP for Country ABC:

GNP = C + I + G + X + Z

Where:

Consumption = $100 million

Investments = $75 million

Government expenditure = $200 million

X [Net Exports (Value of exports - value of imports)] = -$25 million

Z [Net Income (Net income inflows from abroad - net income outflows)] = $100 million

GNP = 100m + 75m + 200m + -25m + 100m = $450 million

Therefore, we can conclude that Country ABC’s GNP is $450 million.

NET NATIONAL PRODUCT(NNP):

‘Net national product (NNP) is gross national product (GNP), the total value of finished goods and services
produced by a country's citizens overseas and domestically, minus depreciation.’

EXPLANATION:

NNP is often examined on an annual basis as a way to measure a nation's success in continuing minimum
production standards. It can be a useful method to keep track of an economy as it takes into account all its
citizens, regardless of where they make their money, and acknowledges the fact that capital must be spent to
keep production standards high.

The NNP is expressed in the currency of the nation it represents. That means that in the United States the NNP
is expressed in dollars (USD), while for European Union (EU) member nations the NNP is expressed in euros
(EUR).

The NNP can be extrapolated from the GNP by subtracting the depreciation of any assets. The depreciation
figure is determined by assessing the loss of the value of assets attributed to normal use and aging.

The relationship between a nation's GNP and NNP is similar to the relationship between its gross domestic
product (GDP) and net domestic product (NDP)

Formula for NNP:

Net National Product (NNP) = Gross National Product (GNP) – Depreciation

EXAMPLE:

Let's assume Country XYZ's companies, citizens and entities produce $1 trillion worth of goods and $3 trillion
worth of services this year. The assets used to produce those goods and services depreciated by $500 billion.
Using the formula above, Country XYZ's NNP is:

NNP = $1 trillion + $3 trillion - $0.5 trillion = $3.5 trillion

B)

What are the methods of measuring National Income?

Ans:

1. Product Method:

In this method, national income is measured as a flow of goods and services. We calculate money value of all
final goods and services produced in an economy during a year. Final goods here refer to those goods which
are directly consumed and not used in further production process.

Goods which are further used in production process are called intermediate goods. In the value of final goods,
value of intermediate goods is already included therefore we do not count value of intermediate goods in
national income otherwise there will be double counting of value of goods.

The money value is calculated at market prices so sum-total is the GDP at market prices. GDP at market price
can be converted into by methods discussed earlier.

2. Income Method:

Under this method, national income is measured as a flow of factor incomes. There are generally four factors
of production labour, capital, land and entrepreneurship. Labour gets wages and salaries, capital gets interest,
land gets rent and entrepreneurship gets profit as their remuneration.

Besides, there are some self-employed persons who employ their own labour and capital such as doctors,
advocates, CAs, etc. Their income is called mixed income. The sum-total of all these factor incomes is called
NDP at factor costs.

3. Expenditure Method:

In this method, national income is measured as a flow of expenditure. GDP is sum-total of private consumption
expenditure. Government consumption expenditure, gross capital formation (Government and private) and
net exports (Export-Import).

Q5

Define deficit financing?

ANS:
DEFICIT FINANCING:

'Deficit financing means generating funds to finance the deficit which results from excess of expenditure over
revenue.'

EXPLANATION:

Deficit financing, practice in which a government spends more money than it receives as revenue, the
difference being made up by borrowing or minting new funds. Although budget deficits may occur for
numerous reasons, the term usually refers to a conscious attempt to stimulate the economy by lowering tax
rates or increasing government expenditures. The influence of government deficits upon a national economy
may be very great. It is widely believed that a budget balanced over the span of a business cycle should replace
the old ideal of an annually balanced budget. Some economists have abandoned the balanced budget concept
entirely, considering it inadequate as a criterion of public policy.

Deficit financing, however, may also result from government inefficiency, reflecting widespread tax evasion or
wasteful spending rather than the operation of a planned countercyclical policy.

Where capital markets are undeveloped, deficit financing may place the government in debt to foreign
creditors. In addition, in many less-developed countries, budget surpluses may be desirable in themselves as a
way of encouraging private saving.

B)

Deficit financing source of inflation?

ANS:

Deficits can be a source of inflation if they are accommodated by monetary policy-that is, if the Federal
Reserve responds to higher deficits by increasing the growth of money. The Federal Reserve has two ways of
responding to higher deficits:

1) The central bank directly purchases the securities issued by the government to finance the deficits.

2) The private sector purchases these same securities; then, the central bank attempts to limit any potential
interest rate increases.

Under either scenario, deficits lead to greater money base growth, which can create inflationary pressure

For developing countries like Pakistan, higher economic growth is a priority. A higher economic growth
requires finances. With the private sector being shy of making huge expenditure, the responsibility of drawing
financial resources rests on the government

Often both the tax and non-tax revenues fail to mobilize enough resources just through taxes. The deficit is
often funded through borrowings or printing new currency notes.

Q6)

Write short note:

Ans:

THE MULTIPLIER
Multiplier is a numerical coefficient which shows how large an increase in income will take place from a certain
increase in investment. It is the ratio of change in income to the change in investment.

Multiplier=change in income/ Change in investment

The essence of the theory of multiplier is that a given increase in investment consequently leads to manifold
increase in income, output and employment. According to the theory for example,if an investment of Rs 10
million is undertaken, then the income will not rise by Rs 10 million only but a multiple of it,i.e the income will
increase by 50 million so the multiplier will be equal to 5 (50/10). Multiplier is 6 if the national income rises by
Rs 60 million. The multiplier is, therefore,the ratio of increment in income responding to increase in income.

It in the theory of multiplier,the most vital factor is the multiplier coefficient K,which indicates the power by
which an initial investment leads to increase in income.

Multiplier is closely related to the consumption function or marginal propensity to consume (MPC) and
marginal propensity to save (MPS). The size of the multiplier depends upon the size of MPC. Higher the MPC,
higher the size of the multiplier. The size of the multiplier varies directly with MPC and inversely with the MPS.
Since the MPC is always greater than zero and less than 1, the multiplier is always between 1 and infinity.

NOMINAL VS REAL GDP:

The aggregate market value of the economic output produced in a year within the boundaries of the country
is known as Nominal GDP. Real GDP refers to the value of economic output produced in a given period,
adjusted according to the changes in the general price level. Nominal GDP is GDP without the effect of
inflation. Real GDP is inflation adjusted GDP. Nominal GDP expresses in Current year prices. Real GDP
expressed in base year prices or constant prices. Nominal GDP use for comparison of various quarters of the
given year can be made. Real GDP use for comparison of two or more financial year can be done easily. In
Nominal GDP economic growth cannot be analyzed easily. Real GDP is good indicator of economic growth.

MARGINAL PROPENSITY TO SAVE(MPS)

Marginal propensity to save is the proportion of an increase in income that gets saved instead of spent on
consumption.Suppose you receive a $500 bonus with your paycheck. You suddenly have $500 more in income
than you did before. If you decide to spend $400 of this marginal increase on a new business suit and save the
remaining $100, your marginal propensity to save is 0.2 ($100 change in saving divided by $500 change in
income). MPS varies by income level. MPS is typically higher at higher incomes.with an increase in salary
comes the ability to cover household expenses more easily, allowing for more leeway to save.If economists
know what consumers' MPS is, they can determine how increases in government spending or investment
spending will influence saving. MPS is used to calculate the expenditures multiplier using the formula: 1/MPS.
The expenditures multiplier tells us how changes in consumers’ marginal propensity to save influences the rest
of the economy. The smaller the MPS, the larger the multiplier and the more economic impact a change in
government spending or investment will have. In Keynesian economic theory, the marginal propensity to save
(MPS) refers to the proportion of an aggregate raise in income that a consumer saves rather than spends on
the consumption of goods and services. Put differently, the marginal propensity to save is the proportion of
each added dollar of income that is saved rather than spent.

JUNE 24 ,2013
 Q1 (a)

Why does an aggregate demand curve slope downward?

The aggregate demand curve (AD) is the total demand in the economy for goods at different price levels. AD =
C+I+G+X–M

If there is a fall in the price level, there is a movement along the AD curve because with goods cheaper –
effectively, consumers have more spending power.

Why is AD curve downwardly sloping?

1. Increased spending power. At a lower price level, consumers are likely to have higher disposable
income and therefore spend more. (Note this assumes that wages are constant and not falling with
prices)

2. Increase in demand for exports. If there is a lower price level in the UK, UK goods will become
relatively more competitive, leading to higher exports. Exports are a component of AD, and therefore AD will
be higher.

3. Lower interest rates. At a lower price level, interest rates usually fall, and this causes higher aggregate
demand.

Difference with microeconomics

The rise in demand is not due to the usual microanalysis. In microeconomics when we examine one particular
good, a lower price of a good leads to more demand because it is cheaper. If the price of potatoes falls, you
may buy more potatoes instead of pasta because potatoes are now relatively cheaper. This is an example of a
fall in the price of a particular good.

With aggregate demand (AD) we are looking at the aggregate price level for the whole economy.

Why lower prices may not increase AD

In macroeconomics, a period of (deflation) (falling prices) can cause a different dynamic which leads to lower
spending.

A period of deflation (falling prices) can often cause lower aggregate demand – especially if falling prices is
accompanied with falling wages (or at least stagnant wages)

If prices are falling, consumers may delay purchases because they expect prices to be cheaper in the future

If prices (and wages) are falling, then consumers may see an increase in the real value of debt. Deflation
increases the effective debt burden, leaving less for spending.

Falling prices may increase real interest rates – if nominal interest rates can’t fall any further.

However, falling prices could be compatible with rising aggregate demand

If falling prices are due to technological improvements and enabling higher real wages. In this case, we could
get lower prices, but AD continues to increase.

If falling prices are caused by a recession and spare capacity, then we are much more likely to get lower AD. In
a recession, wage growth will be weak and consumers nervous to spend. Falling prices will be not sufficient to
encourage spending because confidence is low.

Q1. (b)

What can cause aggregate demand and supply to increase and decrease?

ANS:

Aggregate Demand Curve

If you were to represent aggregate demand graphically, the aggregate amount of goods and services
demanded is represented on the horizontal X-axis, and the overall price level of the entire basket of goods and
services is represented on the vertical Y-axis.

The aggregate demand curve, like most typical demand curves, slopes downward from left to right. Demand
increases or decreases along the curve as prices for goods and services either increase or decrease. Also, the
curve can shift due to changes in the money supply or increases and decreases in tax rates.

Calculating Aggregate Demand

The equation for aggregate demand adds the amount of consumer spending, private investment, government
spending, and the net of exports and imports. The formula is shown as follows:

Aggregate Demand= C+I+G+Nx

where:
C=Consumer spending on goods and services

I=Private investment and corporate spending on

non-final capital goods (factories, equipment, etc.)

G=Government spending on public goods and social

services (infrastructure, Medicare, etc.)

Nx=Net exports (exports minus imports)

Factors That Can Affect Aggregate Demand

The following are some of the key economic factors that can affect the aggregate demand in an economy.

Changes in Interest Rates consumers and businesses. Lower interest rates will lower the borrowing costs for
big-ticket items such as appliances, vehicles, and homes. Also, companies will be able to borrow at lower rates,
which tends to lead to capital spending increases.

Conversely, higher interest rates increase the cost of borrowing for consumers and companies. As a result,
spending tends to decline or grow at a slower pace, depending on the extent of the increase in rates.

Income and Wealth

As household wealth increases, aggregate demand usually increases as well. Conversely, a decline in wealth
usually leads to lower aggregate demand. Increases in personal savings will also lead to less demand for goods,
which tends to occur during recessions. When consumers are feeling good about the economy, they tend to
spend more leading to a decline in savings.

Changes in Inflation Expectations

Consumers who feel that inflation will increase, or prices will rise, tend to make purchases now, which leads
to rising aggregate demand. But if consumers believe prices will fall in the future, aggregate demand tends to
fall as well.

Currency Exchange Rate Changes

If the value of the U.S. dollar falls (or rises), foreign goods will become more (or less expensive). Meanwhile,
goods manufactured in the U.S. will become cheaper (or more expensive) for foreign markets. Aggregate
demand will, therefore, increase (or decrease).

Changes in Aggregate Supply

A shift in aggregate supply can be attributed to many variables, including changes in the size and quality of
labor, technological innovations, an increase in wages, an increase in production costs, changes in producer
taxes, and subsidies and changes in inflation. Some of these factors lead to positive changes in aggregate
supply while others cause aggregate supply to decline. For example, increased labor efficiency, perhaps
through outsourcing or automation, raises supply output by decreasing the labor cost per unit of supply. By
contrast, wage increases place downward pressure on aggregate supply by increasing production costs.

Aggregate Supply Over the Short and Long Run

In the short run, aggregate supply responds to higher demand (and prices) by increasing the use of current
inputs in the production process. In the short run, the level of capital is fixed, and a company cannot, for
example, erect a new factory or introduce a new technology to increase production efficiency. Instead, the
company ramps up supply by getting more out of its existing factors of production, such as assigning workers
more hours or increasing the use of existing technology.

In the long run, however, aggregate supply is not affected by the price level and is driven only by
improvements in productivity and efficiency. Such improvements include increases in the level of skill and
education among workers, technological advancements, and increases in capital. Certain economic viewpoints,
such as the Keynesian theory, assert that long-run aggregate supply is still price elastic up to a certain point.
Once this point is reached, supply becomes insensitive to changes in price.

Example of Aggregate Supply

XYZ Corporation produces 100,000 widgets per quarter at a total expense of $1 million, but the cost of a
critical component that accounts for 10% of that expense doubles in price because of a shortage of materials
or other external factors. In that event, XYZ Corporation could produce only 90,909 widgets if it is still spending
$1 million on production. This reduction would represent a decrease in aggregate supply. In this example, the
lower aggregate supply could lead to demand exceeding output. That, coupled with the increase in production
costs, is likely to lead to a rise in price.

Q2. (a)

Define business cycle and its phases with the help of diagram?

ANS:

The Business Cycle

The term “business cycle” (or economic cycle or boom-bust cycle) refers to economy-wide fluctuations in
production, trade, and general economic activity. From a conceptual perspective, the business cycle is the
upward and downward movements of levels of GDP (gross domestic product) and refers to the period of
expansions and contractions in the level of economic activities (business fluctuations) around a long-term
growth trend.

Business Cycle Phases

Business cycles are identified as having four distinct phases: expansion, peak, contraction, and trough.

Expansion: Expansion, considered the "normal" — or at least, the most desirable — state of the economy, is an
up period. During an expansion, businesses and companies are steadily growing their production and profits,
unemployment remains low, and the stock market is performing well. Consumers are buying and investing,
and with this increasing demand for goods and services, prices begin to rise too.

When the GDP growth rate is in the 2% to 3% range, inflation is at the 2% target, unemployment is between
3.5% and 4.5%, and the stock market is a bull market, then the economy is considered to be in a healthy period
of expansion.

Peak: Once these numbers start to increase outside of their traditional bands, though, then the economy is
considered to be growing out of control. Companies may be expanding recklessly. Investors are overconfident,
buying up assets and significantly increasing their prices, which are not supported by their underlying value.
Everything is starting to cost too much.
The peak marks the climax of all this feverish activity. It occurs when the expansion has reached its end and
indicates that production and prices have reached their limit. This is the turning point: With no room for
growth left, there's nowhere to go but down. A contraction is forthcoming.

Contraction: A contraction spans the length of time from the peak to the trough. It's the period when
economic activity is on the way down. During a contraction, unemployment numbers typically spike, stocks
enter a bear market, and GDP growth is below 2%, indicating that businesses have cut back their activities.

When the GDP has declined for two consecutive quarters, the economy is often considered to be in a
recession.

Trough: As the peak is the cycle's high point, the trough is its low point. It occurs when the recession, or
contraction phase, bottoms out and starts to rebound into an expansion phase — and the business cycle starts
all over again. The rebound is not always quick, nor is it a straight line, along the way towards full economic
recovery.

Q2. (b)

Define inflationary and recessionary gap and full employment situation in the short run equilibrium. How do
they influence the phases of business cycle?

What Is an Inflationary Gap?

An inflationary gap is a macroeconomic concept that measures the difference between the current level of real
gross domestic product (GDP) and the GDP that would exist if an economy was operating at full employment.

Understanding an Inflationary Gap

An inflationary gap exists when the demand for goods and services exceeds production due to factors such as
higher levels of overall employment, increased trade activities, or elevated government expenditure.

Against this backdrop, the real GDP can exceed the potential GDP, resulting in an inflationary gap. The
inflationary gap is named as such because the relative rise in real GDP causes an economy to increase its
consumption, leading prices to climb in the long run.

The inflationary gap represents the point in the business cycle when the economy is expanding. Due to the
higher number of funds available within the economy, consumers are more inclined to purchase goods and
services. As demand for goods and services increases but production has not yet compensated for the shift,
prices rise to restore market equilibrium.

When the potential GDP is higher than the real GDP, the gap is instead referred to as a deflationary gap. The
other type of output gap is the recessionary gap, which describes an economy operating below its full-
employment equilibrium.

What Is a Recessionary Gap?

A recessionary gap, or contractionary gap, is a macroeconomic term used when a country's real gross domestic
product (GDP) is lower than its GDP at full employment.

Understanding a Recessionary Gap

Essentially, a recessionary gap refers to the difference between actual and potential production in an
economy, with the actual being lower than the potential, which puts downward pressure on prices in the long
run. Often, these gaps are evident during an economic downturn and are associated with higher
unemployment numbers.

Significant reductions in economic activity for several months will indicate a recession. During periods of
recession, companies will often pull back on spending, creating a gap from the contraction in the business
cycle.

Economists define a recessionary gap as a lower, real-income level, as measured by real GDP, than the real-
income level at a point of full employment. Real GDP values all goods and services for a specific time-frame,
adjusted for inflation. In the period leading up to a recession, there is often a significant reduction in consumer
expenditure or investment due to a decrease in the take-home pay of workers.

Unemployment increases during business cycle recessions and decreases during business cycle expansions
(recoveries). Inflation decreases during recessions and increases during expansions (recoveries).

unemployment rate?

4 Types of Unemployment and Their Causes

There are four main types of unemployment in an economy—frictional,

structural, cyclical, and seasonal—and each has a different cause.

• Frictional unemployment. Frictional unemployment is caused by

temporary transitions in workers’ lives, such as when a worker moves to
a new city and has to find a new job. Frictional unemployment also
includes people just entering the labor force, such as freshly graduated
college students. It is the most common cause of unemployment, and it
is always in effect in an economy.

• Structural unemployment. Structural unemployment is caused by a

mismatch in the demographics of workers and the types of jobs
available, either when there are jobs available that workers don’t have
the skills for, or when there are workers available but no jobs to fill.
Structural unemployment is most obvious in industries undergoing
technological advancements. For example, in the farming industry, much
of the work is becoming mechanized, which means that fewer farmers
are needed, and many are let go. When these farmers go to cities to find
work, they may find no other similar jobs in which to apply their skills.

• Cyclical unemployment. Cyclical unemployment is caused by

declining demand: when there is not enough demand in an economy for
goods and services, businesses cannot offer jobs. According to
Keynesian economics, cyclical unemployment is a natural result of the
business cycle in times of recession: if all consumers become fearful at
once,
 consumers will attempt to increase their savings at the same time, which
means there will be a decrease in spending, and businesses will not be
able to employ all employable workers.

• Seasonal unemployment. Seasonal unemployment is caused by

different industries or parts of the labor market being available during
different

seasons. For instance, unemployment goes up in the winter months,

because many agricultural jobs end once crops are harvested in the fall,
and those workers are left to find new jobs.
The rate is calculated by taking the number of people in the labor force, that is,
the number employed and the number unemployed, divided by the total adult
population and multiplying by 100 to get the percentage.

Unemployment rate= ×100

Q4. (a) What is measured in GDP?

Measuring GDP

GDP measures the monetary value of final goods and services—that is, those
that are bought by the final user—produced in a country in a given period of
time (say a quarter or a year). It counts all of the output generated within the
borders of a country. GDP is composed of goods and services produced for sale
in the market and also includes some nonmarket production, such as defense or
education services provided by the Theoretically, GDP can be viewed in three
different ways:

● The production approach sums the “value-added” at each stage of

production, where value-added is defined as total sales less the value of
intermediate inputs into the production process. For example, flour would be an
intermediate input and bread the final product; or an architect’s services would
be an intermediate input and the building the final product.

● The expenditure approach adds up the value of purchases made by final

users—for example, the consumption of food, televisions, and medical
services
by households; the investments in machinery by companies; and the purchases
of goods and services by the government and foreigners.

● The income approach sums the incomes generated by production—for

example, the compensation employees receive and the operating surplus
of companies (roughly sales less costs).

GDP in a country is usually calculated by the national statistical agency, which

compiles the information from a large number of sources. In making the
calculations, however, most countries follow established international standards.
The international standard for measuring GDP is contained in the System of
National Accounts, 1993, compiled by the International Monetary Fund, the
European Commission, the Organization for Economic Cooperation and
Development, the United Nations, and the World Bank. government.

Q4. (b) Why is the real GDP a better measure of variation in aggregate
production over time than nominal GDP?
real GDP provides a more accurate portrait of economic growth than nominal
GDP because it uses constant prices, making comparisons between years more
meaningful by allowing for comparisons of the actual volume of goods and
services without considering inflation.

It is thus a more accurate tool when considering the changes over time in an
economy’s output level—economists use real GDP to monitor a country’s
economic growth. Real GDP is a better tool to judge long-term national
economic performance because it only considers the actual change in a
country’s economic output.

The best way to express the difference between the two terms is to consider the
difference between positive growth to nominal GDP and real GDP: positive
nominal GDP growth can be attributed to inflation; a positive real GDP growth
rate, however, can only result from an increase in output.

Q5. (a) What is consumer price index and how it is calculated?

What is Consumer Price Index (CPI)?

The Consumer Price Index (CPI) is a measure that examines the weighted
average of prices of a basket of consumer goods and services, such as
transportation, food, and medical care. It is calculated by taking price changes
for each item in the predetermined basket of goods and averaging them.
Changes in the CPI are used to assess price changes associated with the cost of
living. The CPI is one of the most frequently used statistics for identifying
periods of inflation or deflation.

Understanding Consumer Price Index (CPI)

The CPI measures the average change in prices over time that consumers pay
for a basket of goods and services, commonly known as inflation. Essentially it
attempts to quantify the aggregate price level in an economy and thus measure
the purchasing power of a country's unit of currency. The weighted average of
the prices of goods and services that approximates an individual's consumption
patterns is used to calculate CPI. A trimmed mean may be used as part of this.

While it does measure the variation in price for retail goods and other items paid
by consumers, it does not include things like savings and investments, and can
often exclude spending by foreign visitors.

Calculating CPI

The BLS records about 80,000 items each month by calling or visiting retail
stores, service establishments (such as cable providers, airlines, car and truck
rental agencies), rental units and doctors’ offices across the country in order to
get the best outlook for the CPI.

The formula used to calculate the Consumer Price Index for a single item is as
follows:

CPI= x100

the base year is determined by the BLS. CPI data for the years 2017 and 2018
were based on surveys collected in 2014 and 2015.

Q5. (b) What is the relationship between inflation rate and consumer price
index?
Inflation and interest rates are often linked and frequently referenced in
macroeconomics. Inflation refers to the rate at which prices for goods and
services rise. In the U.S., the interest rate (which is the amount charged by a
lender to a borrower) is based on the federal funds rate that is determined by the
Federal Reserve. The Federal Reserve System is the central bank of the U.S.; it
is sometimes just referred to as the Fed.

The Fed attempts to influence the rate of inflation by setting and adjusting the
target for the federal funds rate. This tool enables the Fed to expand or contract
the money supply as needed, which influences target employment rates, stable
prices, and stable economic growth.

Under a system of fractional reserve banking, interest rates and inflation tend to
be inversely correlated. This relationship forms one of the central tenets of
contemporary monetary policy: Central banks manipulate short-term interest
rates to affect the rate of inflation in the economy.

The below chart demonstrates the inverse correlation between interest rates and
inflation. In the chart, CPI refers to the Consumer Price Index, a measurement
that tracks changes in prices. Changes in the CPI are used to identify periods of
inflation and deflation.

In general, as interest rates are reduced, more people are able to borrow more
money. The result is that consumers have more money to spend. This causes the
economy to grow and inflation to increase.

The opposite holds true for rising interest rates. As interest rates are increased,
consumers tend to save because returns from savings are higher. With less
disposable income being spent, the economy slows and inflation decreases.

To better understand how the relationship between inflation and interest rates
works, it's important to understand the banking system, the quantity theory
of money, and the role interest rates play.

Q6. (a) Explain fiscal policy and its components?

What is Fiscal Policy?

Fiscal policy refers to the use of government spending and tax policies to
influence economic conditions, especially macroeconomic conditions, including
aggregate demand for goods and services, employment, inflation, and economic
growth.

The four main components of fiscal policy are

• expenditure, budget reform
• revenue (particularly tax revenue) mobilization,
• deficit containment/ financing and
• determining fiscal transfers from higher to lower levels of government.
• Expenditure, budget reform:
A government's budget describes all of its sources of income and where it
spends that income, and budget reform is the process of making changes to how
the government collects and spends money.

• Revenue (particularly tax revenue) mobilization:

Tax revenue mobilization is a central concern of economic policymaking in
many countries. Experience has shown that while some countries exhibit
marked increases in their tax-to-GDP ratios, others show little or no increase
over extended periods. Greater domestic resource mobilization is critical for
many countries

• Deficit containment/ financing:

Deficit financing, practice in which a government spends more money than
it receives as revenue, the difference being made up by borrowing or minting
new funds......The influence of government deficits upon a national economy
may be very great.

• Determining fiscal transfers from higher to lower levels of

government
Fiscal decentralization is defined as the devolution of fiscal powers from
national to subnational governments. The principle behind the federalization
is improving efficiency in the provision and production of public goods,
thereby enhancing and stimulating the process of growth and development
throughout the state

Q6. (b) When the government apply contractionary and expansionary

fiscal policy?
Contractionary fiscal policy is when the government either cuts spending or
raises taxes. It gets its name from the way it contracts the economy. It reduces
the amount of money available for businesses and consumers to spend.

Purpose
The purpose of contractionary fiscal policy is to slow growth to a healthy
economic level. That's between 2% to 3% a year.1 An economy that grows
more than 3% creates four negative consequences.

• It creates inflation. That's when prices rise too fast in clothing, food, and
other necessities. Higher prices quickly gobble up savings and destroy
the standard of living.

• It drives up prices in investments. That's called an asset bubble. It's

happened in stocks, gold, and oil. An example of its devastating effects
is the 2006 housing bubble. By 2005, the cost of housing became
unaffordable for most families. Banks lowered their terms to entice
subprime borrowers, creating a crisis in 2008.

• It's unsustainable. Growth at 4% or more leads to a recession. That

especially occurs with asset bubbles. Unfortunately, a recession is part
of the business cycle.

• It lowers unemployment to below the natural rate of unemployment.

Employers struggle to find enough workers to meet market demand.
That slows growth from the production side.
When governments cut spending or increase taxes, it takes money out of
consumers' hands. That also happens when the government cuts subsidies,
transfer payments including welfare programs, contracts for public works, or the
number of government employees.

Shrinking the money supply decreases demand. It gives consumers less

purchasing power. That reduces business profit, forcing companies to cut
employment.

Expansionary Fiscal Policy :

The Purpose

The purpose of expansionary fiscal policy is to boost growth to a healthy

economic level, which is needed during the contractionary phase of the business
cycle. The government wants to reduce unemployment, increase consumer
demand, and avoid a recession.1 If a recession has already occurred, then it
seeks to end the recession and prevent a depression.
How it Works

By using subsidies, transfer payments (including welfare programs), and

income tax cuts, expansionary fiscal policy puts more money into consumers'
hands to give them more purchasing power.

It also reduces unemployment by contracting public works or hiring new

government workers, both of which increase demand and spurs consumer
spending, which drives almost 70% of the economy. The other three
components of gross domestic product are government spending, net exports,
and business investment.

Corporate tax cuts put more money into businesses' hands, which the
government hopes will be put toward new investments and increasing
employment. In that way, tax cuts create jobs, but if the company already has
enough cash, it may use the cut to buy back stocks or purchase new companies.
The theory of supply-side economics recommends lowering corporate taxes
instead of income taxes, and advocates for lower capital gains taxes to increase
business investment. But the Laffer Curve states that this type of trickle-down
economics only works if tax rates are already 50% or higher.

Q7. Discuss the following:

• Supply Side Shocks:

What Is a Supply Shock?

A supply shock is an unexpected event that suddenly changes the supply of a

product or commodity, resulting in an unforeseen change in price. Supply
shocks can be negative, resulting in a decreased supply, or positive, yielding an
increased supply; however, they're often negative. Assuming aggregate demand
is unchanged, a negative (or adverse) supply shock causes a product's price to
spike upward, while a positive supply shock decreases the price.

Understanding Supply Shock

A positive supply shock increases output causing prices to decrease due to a

shift in the supply curve to the right, while a negative supply shock decreases
production causing prices to rise. Supply shocks can be created by any
unexpected event that constrains output or disrupts the supply chain, including
natural disasters and geopolitical developments such as acts of war or terrorism.
A commodity that is widely perceived as the most vulnerable to negative
supply
shocks is crude oil because most of the world's supply comes from the volatile
Middle East region.

Example of Supply Shock

The struggles of a single firm can cause a supply shock if the company is a
large producer of high demand products such as copper. According to CNBC,
this was the case when Glencore announced in September 2015 its plans to
close two major copper mines in the Democratic Republic of Congo and
Zambia, removing 400,000 tones of copper from the global output. The decision
came in response to a prolonged slump in copper prices. Therefore, this
particular supply shock was positive for competing firms.

According to The Economist, a slowdown in Chinese demand for copper

caused copper prices to drop. For the previous decade, demand had grown at an
annual rate of more than 10% until it fell to 3% to 4% in 2015. This drop in
price highlights how a concentrated change in demand can influence prices. A
change in demand must be abrupt and perceived as temporary to qualify as a
shock, as is the case on the supply side.

• Wage price spiral

What Is the Wage-price Spiral?

The wage-price spiral is a macroeconomic theory used to explain the cause-and-

effect relationship between rising wages and rising prices, or inflation. The
wage-price spiral suggests that rising wages increase disposable income raising
the demand for goods and causing prices to rise. Rising prices increase demand
for higher wages, which leads to higher production costs and further upward
pressure on prices creating a conceptual spiral.

The Wage-price Spiral and Inflation

The wage-price spiral is an economic term that describes the phenomenon of

price increases as a result of higher wages. When workers receive a wage hike,
they demand more goods and services and this, in turn, causes prices to rise.
The wage increase effectively increases general business expenses that are
passed on to the consumer in the form of higher prices. It is essentially a
perpetual loop or cycle of consistent price increases. The wage-price spiral
reflects the causes and consequences of inflation, and it is, therefore,
characteristic of Keynesian economic theory. It is also known as the "cost-push"
origin of inflation. Another cause of inflation is known as "demand-pull"
inflation, which monetary theorists believe originates with the money supply.

How a Wage-price Spiral Begins

A wage-price spiral is caused by the effect of supply and demand on aggregate

prices. People who earn more than the cost of living select an allocation mix
between savings and consumer spending. As wages increase, so too does a
consumer's propensity to both save and consume.

If the minimum wage of an economy increased, for example, it would cause

consumers within the economy to purchase more product, which would increase
demand. The rise in aggregate demand and the increased wage burden causes
businesses to increase the prices of products and services. Although wages are
higher the increase in prices causes workers to demand even higher salaries. If
higher wages are granted, a spiral where prices subsequently increase may occur
repeating the cycle until wage levels can no longer be supported.

Stopping a Wage-price Spiral

Governments and economies favor stable inflation—or price increases. A wage-

price spiral often makes inflation higher than is ideal. Governments have the
option of stopping this inflationary environment through the actions of the
Federal Reserve or central bank. A country's central bank can use monetary
policy, the interest rate, reserve requirements, or open market operations, to
curb the wage-price spiral.

• Stagflation
Stagflation is characterized by slow economic growth and relatively high
unemployment—or economic stagnation—which is at the same time
accompanied by rising prices (i.e. inflation). Stagflation can also be
alternatively defined as a period of inflation combined with a decline in gross
domestic product (GDP).

Understanding Stagflation

The term "stagflation" was first used during a time of economic stress in the
United Kingdom by politician Iain Macleod in the 1960s while he was speaking
in the House of Commons. At the time, he was speaking about inflation on one
side and stagnation on the other, calling it a "stagnation situation." It was later
used again to describe the recessionary period in the 1970s following the oil
crisis, when the U.S. underwent a recession that saw five quarters of negative
GDP growth.1 Inflation doubled in 1973 and hit double digits in 1974;
unemployment hit 9% by May 1975.2

Stagflation led to the emergence of the Misery index. This index, which is the
simple sum of the inflation rate and unemployment rate, served as a tool to
show just how badly people were feeling when stagflation hit the economy.

Stagflation was long believed to be impossible because the economic theories

that dominated academic and policy circles ruled it out of their models by
construction. In particular, the economic theory of the Phillips Curve, which
developed in the context of Keynesian economics, portrayed macroeconomic
policy as a trade-off between unemployment and inflation. As a result of the
Great Depression and the ascendance of Keynesian economics in the 20th-
century economists became preoccupied with the dangers of deflation and
argued that most policies designed to lower inflation tend to make it tougher for
the unemployed, and policies designed to ease unemployment raise inflation.

The advent of stagflation across the developed world in the mid-20th century
showed that this was actually not the case. As it result, stagflation is a great
example of how real-world economic data can sometimes run roughshod over
widely accepted economic theories and policy prescriptions.

Since that time, as a rule, inflation persists as a general condition even during
periods of slow or negative economic growth. In the past 50 years, every
declared recession in the U.S. has seen a continuous, year-over-year rise in the
consumer price level.4 The sole, partial exception to this is the lowest point of
the 2008 financial crisis—and even then price decline was confined to energy
prices while overall consumer prices other than energy continued to rise.

DECEMBER 30,2013
 Q1(a).

What are the various concepts of GDP?

Gross Domestic Product:

Gross domestic product (GDP) is the total monetary or market value of all the
finished goods and services produced within a country's borders in a specific
time period. As a broad measure of overall domestic production, it functions as
a comprehensive scorecard of a given country’s economic health. Though GDP
is typically calculated on an annual basis, it is sometimes calculated on
a quarterly basis as well.

Various concepts of GDP:

• Nominal GDP: GDP evaluated at current market prices, in either the

local currency or in U.S. dollars at currency market exchanges rates
in order to compare countries' GDP in purely financial terms.
• GDP, Purchasing Power Parity (PPP): GDP measured in
"international dollars" using the method of Purchasing Power Parity
(PPP), which adjusts for differences in local prices and costs of living in
order to make cross-country comparisons of real output, real income,
and living standards.
• Real GDP: Real GDP is an inflation-adjusted measure that reflects the
quantity of goods and services produced by an economy in a given
year, with prices held constant from year to year in order to separate out
the impact of inflation or deflation from the trend in output over time.
• GDP Growth Rate: The GDP growth rate compares one year (or
quarter) of a country's GDP to the previous year (or quarter) in order to
measure how fast an economy is growing. Usually expressed as a percent
rate, this measure is popular for economic policy makers because GDP
growth is though to be closely connected to key policy targets such as
inflation and unemployment rates.
• GDP Per Capita: GDP per capita is a measurement of the GDP per
person in a country's population. It indicates the amount of output or
income per person in an economy can indicate average productivity or
average living standards. GDP per capita can be stated in nominal,
real (inflation adjusted), or PPP terms.

Q1(b).

What is the relationship between inflation rate, GDP and unemployment?

Relationship Between Inflation, GDP & Unemployment:

The relationship between inflation and economic output (GDP) plays out like a
very delicate dance. For stock market investors, annual growth in the GDP is
vital. If the overall economic output is declining, or merely holding steady, most
companies will not be able to increase their profits (which is the primary driver
of stock performance). However, too much GDP growth is also dangerous, as it
will most likely come with an increase in inflation, which erodes stock market
gains by making our money (and future corporate profits) less valuable. Most
economists today agree that 2.5 to 3.5% GDP growth per year is the most that
our economy can safely maintain without causing negative side effects. But
where do these numbers come from? To answer that question, we need to bring
a new variable, unemployment rate, into play.

Studies have shown that over the past 20 years, annual GDP growth over 2.5%
has caused a 0.5% drop in unemployment for every percentage point over
2.5%.3 It sounds like the perfect way to kill two birds with one stone—increase
overall growth while lowering the unemployment rate, right? Unfortunately,
however, this positive relationship starts to break down when employment gets
very low, or near full employment. Extremely low unemployment rates have
proved to be more costly than valuable because an economy operating at near
full employment will cause two important things to happen:

• Aggregate demand for goods and services will increase faster than
supply, causing prices to rise.
• Companies will have to raise wages as a result of the tight labor market.
This increase usually is passed on to consumers in the form of higher
prices as the company looks to maximize profits.

Aggregate demand and the Phillips curve share similar components. The rate of
unemployment and rate of inflation found in the Phillips curve correspond to the
real GDP and price level of aggregate demand.
Changes in aggregate demand translate as movements along the Phillips curve.
If there is an increase in aggregate demand, such as what is experienced during
demand-pull inflation, there will be an upward movement along the Phillips
curve. As aggregate demand increases, real GDP and price level increase, which
lowers the unemployment rate and increases inflation.

Q2(a). Discuss Aggregate Demand and factors that influence change in it?

AGGREGATE DEMAND :

Aggregate demand is an economic measurement of the total amount of demand

for all finished goods and services produced in an economy. Aggregate demand
is expressed as the total amount of money exchanged for those goods and
services at a specific price level and point in time.
Factors That Can Affect Aggregate Demand
The following are some of the key economic factors that can affect the
aggregate demand in an economy.

Changes in Interest Rates

Whether interest rates are rising or falling will affect decisions made by
consumers and businesses. Lower interest rates will lower the borrowing costs
for big-ticket items such as appliances, vehicles, and homes. Also, companies
will be able to borrow at lower rates, which tends to lead to capital spending
increases.

Conversely, higher interest rates increase the cost of borrowing for consumers
and companies. As a result, spending tends to decline or grow at a slower pace,
depending on the extent of the increase in rates.

Income and Wealth

As household wealth increases, aggregate demand usually increases as well.
Conversely, a decline in wealth usually leads to lower aggregate demand.
Increases in personal savings will also lead to less demand for goods, which
tends to occur during recessions. When consumers are feeling good about the
economy, they tend to spend more leading to a decline in savings.

Changes in Inflation Expectations

Consumers who feel that inflation will increase or prices will rise, tend to make
purchases now, which leads to rising aggregate demand. But if consumers
believe prices will fall in the future, aggregate demand tends to fall as well.

Currency Exchange Rate Changes

If the value of the U.S. dollar falls (or rises), foreign goods will become more
(or less expensive). Meanwhile, goods manufactured in the U.S. will become
cheaper (or more expensive) for foreign markets. Aggregate demand will,
therefore, increase (or decrease).

Q2(b).

What are the various types of investment and discuss its determinants?

Types Of Investments:

Business Fixed Investment:

Business fixed investment means investment in the machines, tools and
equipment that businessmen buy for use in further production of goods and
services.The stock of these machines or plant equipment etc. represents fixed
capital.

Business fixed investment is important in two respects. First, business fixed

investment is an important component of aggregate demand and therefore plays
a significant role in the determination of natural income and employment.
Business fixed investment is a volatile component of aggregate demand and, as
Keynes emphasized, fluctuation in levels of fixed business investment is
responsible for business cycles in a free market economy.

Residential Investment:
Residential investment refers to the expenditure which people make on
constructing or buying new houses or dwelling apartments for the purpose of
living or renting out to others. Residential investment varies from 3 per cent to 5
per cent of GDP in various countries.

Two important features of residential investment are worth noting. First, since
the average life of a housing unit is of 40 to 50 years, the stock of existing
housing units at a point of time is very large as compared to the new residential
investment in a year (i.e., flow of residential investment). Second, there is well
developed resale market for housing units so that people who construct or own
them can sell them in this secondary market.

Residential investment depends on price of existing housing units. The higher

the price of existing units, the higher will be investment in constructing and
buying new housing units. The price of housing units is determined by demand
for housing units which slopes downward and the supply of existing units which
is a fixed quantity and its supply curve is therefore vertical straight line.

n the long run demand for housing is determined by rate of population growth
and formation of new households. Income is another important factor
determining demand for houses and therefore greater residential investment.
Finally, interest is another important factor that determines demand for dwelling
units. Most houses, especially in cities, are purchased by borrowing funds from
banks for a long time, say 20 to 25 years.

Inventory Investment:
Firms hold inventories of raw materials, semi-finished goods to be processed
into final goods. The firms also hold inventories of finished goods to be sold
shortly. The change in the inventories or stocks of these goods with the firms is
called inventory investment. Now, why do firms hold inventories? The first
motive of holding inventories is smoothing of the level of production.
The firms experience temporary booms and busts in sales of their output.
Instead of adjusting their production each time to match the changes in sales of
the product they find cheaper to produce goods at a steady rate. With this steady
rate of production when sales are low, the firms will be producing more than
they are selling and therefore in these periods they will hold the extra goods
produced as inventories.

On the other hand, when sales are high with a steady rate of production, they
will be producing less than they sell. In such periods to meet the market demand
for goods, they will take out goods from inventories to meet the demand.

The second reason for holding inventories is that it is less costly for a firm to
buy inputs such as raw materials less frequently in large quantities to produce
goods and therefore it is required to hold inventories of raw materials and other
intermediate products.

The third reason for holding inventories by the firms is to avoid ‘running out of
stock’ possibilities when their sales of goods are high and therefore it is
profitable to sell at that time. This requires them to hold inventories of goods.

Autonomous Investment:
By autonomous investment we mean the investment which does not change
with the changes in the income level and is therefore independent of income.

Keynes thought that the level of investment depends upon marginal

efficiency of capital and the rate of interest. He thought changes in income
level will not affect investment. This view of Keynes is based upon his
preoccupation with short-run problem. He was of the opinion that changes in
income level will affect investment only in the long run.

Therefore, considering it as the short-run problem he treated investment as

independent of the changes in the income level.

This autonomous investment generally takes place in houses, roads, public

undertakings and in other types of economic infrastructure such as power,
transport and communication. This autonomous investment depends more on
population growth and technical progress than on the level of income. Most of
the investment undertaken by Government is of the autonomous nature.
Induced Investment:
Induced investment is that investment which is affected by the changes in the
level of income. The greater the level of income, the larger will be the
consumption of the community. In order to produce more consumer goods,
more investment has to be made in capital goods so that greater output of
consumer goods becomes possible.

To produce greater output, more capital goods are required to produce them. To
have more capital goods more investment has to be undertaken. This induced
investment is undertaken both in fixed capital assets and in inventories.

The essence of induced investment is that greater income and therefore greater
aggregate demand affects the level of investment in the economy. The induced
investment underlines the concept of the principle of accelerator, which is
highly useful in explaining the occurrence of trade cycles.

Q3(a).

What are the major instruments of fiscal policy?

Instruments of Fiscal Policy:

The tools of fiscal policy are taxes, expenditure, public debt and a nation’s budget.
They consist of changes in government revenues or rates of the tax structure so as to
encourage or restrict private expenditures on consumption and investment.

Contra cyclical Budgetary Policy:

The policy of managed budgets implies changing expenditures with constant tax rates
or changing tax rates with constant expenditures or a combination of the two. Budget
management may be used to tackle depression and inflationary situations. Deliberate
attempts are made under this policy to adjust revenues, expenditures and public debt
to eliminate unemployment during depression and to achieve price stability in
inflation.

Contra cyclical policy implies unbalanced budgets. An unbalanced budget during

depression implies deficit spending. To make it more effective, the government may
finance its deficits by borrowing from the banks.

The government may partly utilize the budget surplus to retire the outstanding
government debt. The belief is that a surplus budget has deflationary effect on national
income while a deficit budget tends to be expansionary.

Taxation Policy:
The structure of tax rates has to be varied in the context of conditions prevailing in an
economy. Taxes determine the size of disposable income in the hands of general
public and therefore, the quantum of inflationary and deflationary gaps. During
depression tax policy has to be such as to encourage private consumption and
investment; while during inflation, tax policy must curtail consumption and
investment.

During inflation, new taxes can be levied to wipe off the surplus purchasing power.
Caution, however, should be taken not to raise the taxes so high as to stifle new
investment and generate a business recession. Expenditure tax and excise duties are
anti-inflationary in character. During inflation fiscal authority should aim at
levying such taxes as reduce current excessive demand for specific commodities
rather than aggregate demand.

Public Debt:
A sound programmed of public borrowing and debt repayment is a potent weapon to
fight inflation and deflation. Government borrowing can be in the form of borrowing
from non-bank financial intermediaries, borrowing from commercial banking system,
drawings from the central bank or printing of new money.

Borrowing from the public through the sale of bonds and securities which curtails
consumption and private investment is anti-inflationary in effect. Borrowing from the
banking system is effective during depression if banks have got excess cash reserves.

Thus, if unused cash lying with banks can be lent to the government, it will cause a
net addition to the national income stream. Withdrawals of balances from treasury are
inflationary in nature but these balances are likely to be so small as to be of little
importance in the economic system. However, the printing of new money is highly
inflationary.

Public Expenditure:

Public expenditure can be used to stimulate production, income and employment.

Government expenditure forms a highly significant part of the total expenditure in the
economy. A reduction or expansion in it causes significant variations in the total
income. It can be instrumental in adjusting consumption and investment to achieve
full employment.

During inflation, the best policy is to reduce government expenditure in order to

control inflation by giving up such schemes as are justified only during deflation.
While expenditures are reduced, attempts are made to increase public revenues to
generate a budget surplus.

Though it is true that there is a limit beyond which it may not be possible to reduce
government spending (say on account of political, and military considerations), yet the
government can vary its expenditure to some extent to reduce inflationary pressures.
Q3.(b) Distinguish between expansionary and contractionary fiscal policy?

Q4(a).

Define recessionary and inflationary gap?

Recessionary:

A recessionary gap, or contractionary gap, is a macroeconomic term used when

a country's real gross domestic product (GDP) is lower than its GDP at full
employment. Recessionary gaps close when real wages return to equilibrium,
and the quantity of labor demanded equals the quantity supplied. Policymakers
may choose to implement a stabilization policy to close the recessionary gap
and increase real GDP.

Inflationary Gap:
An inflationary gap is a macroeconomic concept that measures the difference
between the current level of real gross domestic product (GDP) and
the GDP that would exist if an economy was operating at full employment. For
the gap to be considered inflationary, the current real GDP must be higher than
the potential GDP. Policies that can reduce an inflationary gap include
reductions in government spending, tax increases, bond and securities issues,
interest rate increases, and transfer payment reductions.

Q4(b).

Discuss various types of taxes. Elaborate progressive and proportional tax

system.

Types of Taxes

Consumption Tax
A consumption tax is a tax on the money people spend, not the money people
earn. Sales taxes, which state and local governments use to raise revenue, are a
type of consumption tax. An excise tax on a specific good, such as alcohol or
gasoline, is another example of a consumption tax. Some economists and
presidential candidates have proposed a federal consumption tax for the U.S.
that could offset or replace taxes on capital gains and dividends.

Progressive Tax
This is a tax that is higher for taxpayers with more money. In a progressive tax
system like the U.S. federal income tax, wealthy individuals pay tax at a higher
rate than less wealthy individuals. This is why wealthy Americans are taxed
more than middle-class Americans and middle-class Americans are taxed at a
higher rate than working-class Americans.

Regressive Tax
A regressive tax is one that is not progressive. This could either mean that the
tax is lower for wealthy individuals or that the tax is flat (everyone pays the
same rate). Why is a flat tax regressive? People with lower incomes would feel
the effect of a flat tax more strongly than people with higher incomes. To a
multi-millionaire, a 15% tax wouldn’t translate to a substantial decrease in
quality of life. To someone making $30,000 a year, a 15% tax would mean a
serious dent in spending power.
Proportional Tax
A proportional tax is the same as a flat tax. Taxpayers at all income levels
would pay the same “proportion” in taxes. As explained above, proportional
taxes are regressive taxes. These types of taxes are common in state-level sales
taxes but not common at the federal level. Anyone who remembers the 2012
presidential campaign will remember a famous proportional tax proposal, the 9-
9-9 Plan. That plan was for a 9% business transaction tax, a 9% personal
income tax and a 9% federal sales tax.

Property Tax
Property taxes are taxes you pay on homes, land or commercial real estate. If
you’re deciding whether you can afford to buy a home, you should take
property taxes into account. Unlike a mortgage, property tax payments don’t
amortize. You have to keep paying them for as long as you live in a home –
unless you qualify for property tax exemptions for seniors, veterans or disabled
residents.

Capital Gains Taxes

Capital gains taxes apply to investment income after an investment is sold and a
capital gain is realized. Because so many Americans don’t invest at all, they
don’t pay capital gains taxes. There are also taxes on dividends and interests
stemming from simple interest from a bank account or dividends and earnings
from investments.

Payroll Taxes
If you take your annual salary and divide it by the number of times you get paid
each year, chances are that number is higher than your actual paycheck. One
reason could be that your healthcare premiums or 401(k) contributions are
deducted from your paycheck. Another reason is payroll taxes. These taxes
cover your contributions to Medicare, Social Security, disability and survivor
benefits and to federal unemployment benefits. You’ll also have federal (and
maybe state and local) income taxes withheld from your paycheck. You can
learn all about payroll taxes here.

Income Taxes
Income taxes do what the name implies. They tax the income you earn.
Federal income taxes are both progressive and marginal. Marginal means that
there are different tax rates for different income brackets. The top earners pay
a high tax rate, but only on the amount of money they have in that top bracket.
 Q5(a).

When does deficit finance take place?

Deficit Financing
Deficit financing is a policy where the government finances expenditures (large
spending) via borrowing money instead of increasing taxes. When the
government is faced with a budget deficit because there is a gap between public
revenue and public expenditure, deficit financing begins.
In simpler terms, when the government spends more money than it gets back,
they look for options to make up the difference.
When it Occurs
deficit financing occurs when a government spends more money then it is
taking in. But, sometimes countries borrow money from foreign creditors when
their markets are undeveloped, which in doing so, they create a financial deficit
as well. This is because, in order to enhance economic growth, the government
does not have the backing of private investors and, thus, has to find means to
fund the growth themselves.
Which ever way a government creates a deficit, though, they need to find ways
to fix it. So how do they do it? Well, sometimes governments find it easier to
print more money than to increase taxes to cover the deficit. Obviously, the
public does not like when they have to pay more taxes and may even push back
on the idea of increasing the tax rates. This then leads to the government
printing money, known as minting.
It is said that deficit financing is inherently inflationary. Since deficit financing
raises aggregate expenditure and, hence, increases aggregate demand, the
danger of inflation looms large. This is particularly true when deficit financing
is made for the persecution of war.
This method of financing during wartime is totally unproductive since it neither
adds to society’s stock of wealth nor enable a society to enlarge its production
capacity. The end result is hyperinflation. On the contrary, resources mobilized
through deficit financing get diverted from civil to military production, thereby
leading to a shortage of consumer goods. Anyway, additional money thus
created fuels the inflationary fire.

However, whether deficit financing is inflationary or not depends on the nature

of deficit financing. Being unproductive in character, war expenditure made
through deficit financing is definitely inflationary. But if a developmental
expenditure is made, deficit financing may not be inflationary although it results
in an increase in money supply.
 Q5(b).

Differentiate between Classical and Keynes approach?

Q6.

Write short note on the following.

• The Multiplier

• The Crowding out effect

• IS and LM Curve

• Demand- push & pull inflation.

THE MULTIPLIER
In economics, a multiplier broadly refers to an economic factor that, when
increased or changed, causes increases or changes in many other related
economic variables. In terms of gross domestic product, the multiplier
effect causes gains in total output to be greater than the change in spending that
caused it.

The term multiplier is usually used in reference to the relationship between

government spending and total national income. Multipliers are also used in
explaining fractional reserve banking, known as the deposit multiplier.

A multiplier value of 2x would therefore have the result of doubling some

effect; 3x would triple it. Many examples of multipliers exist, such as the use of
margin in trading or the money multiplier in fractional reserve banking.

Many different multipliers exist in finance and economics. The fiscal

multiplier is the ratio of a country's additional national income to the initial
boost in spending or reduction in taxes that led to that extra income.
An investment multiplier similarly refers to the concept that any increase in
public or private investment has a more than proportionate positive impact on
aggregate income and the general economy. The multiplier attempts to quantify
the additional effects of a policy beyond those immediately measurable. The
larger an investment's multiplier, the more efficient it is at creating and
distributing wealth throughout an economy. The earnings multiplier frames a
company's current stock price in terms of the company's earnings per
share (EPS) of stock. It presents the stock's market value as a function of the
company's earnings and is computed as (price per share/earnings per share).This
is also known as the price-to-earnings (P/E) ratio. The equity multiplier is a
commonly used financial ratio calculated by dividing a company's total asset
value by total net equity. It is a measure of financial leverage. Companies
finance their operations with equity or debt, so a higher equity multiplier
indicates that a larger portion of asset financing is attributed to debt. The equity
multiplier is thus a variation of the debt ratio, in which the definition of debt
financing includes all liabilities.

CROWDING OUT EFFECT

The crowding out effect is an economic theory arguing that rising public sector
spending drives down or even eliminates private sector spending. There are
three main reasons for the crowding out effect to take place: economics, social
welfare, and infrastructure. Crowding in, on the other hand, suggests
government borrowing can actually increase demand by generating
employment, thereby stimulating private spending.
One of the most common forms of crowding out takes place when a large
government, like that of the U.S., increases its borrowing. The sheer scale of
this borrowing can lead to substantial rises in the real interest rate, which has
the effect of absorbing the economy's lending capacity and of discouraging
businesses from making capital investments.

Because firms often fund such projects in part or entirely through financing,
they are now discouraged from doing so because the opportunity cost of
borrowing money has risen, making traditionally profitable projects funded
through loans cost-prohibitive.

The crowding out effect has been discussed for over a hundred years in various
forms. During much of this time, people thought of capital as being finite and
confined to individual countries, which was largely the case due to lower
volumes of international trade compared to the present day. In that context,
increased taxation for public works projects and public spending could be
directly linked to a reduction in the capacity for private spending within a given
country, as less money was available.

On the other hand, macroeconomic theories like Chartalism and Post-Keynesian

hold that in a modern economy operating significantly below capacity,
government borrowing can actually increase demand by generating
employment, thereby stimulating private spending as well. This process is often
referred to as "crowding in." This theory has gained some currency among
economists in recent years after it was noted that, during the Great Recession,
massive spending on the part of the federal government on bonds and other
securities actually had the effect of reducing interest rates.

IS & LM Curve

The IS-LM model, which stands for "investment-savings" (IS) and "liquidity
preference-money supply" (LM) is a Keynesian macroeconomic model that
shows how the market for economic goods (IS) interacts with the loanable
funds market (LM) or money market. It is represented as a graph in which the
IS and LM curves intersect to show the short-run equilibrium between interest
rates and output.

The three critical exogenous, i.e. external, variables in the IS-LM model
are liquidity, investment, and consumption. According to the theory, liquidity is
determined by the size and velocity of the money supply. The levels
of investment and consumption are determined by the marginal decisions of
individual actors. The IS-LM graph examines the relationship between output,
or gross domestic product (GDP), and interest rates. The entire economy is
boiled down to just two markets, output and money; and their respective supply
and demand characteristics push the economy towards an equilibrium point.
The IS-LM graph consists of two curves, IS and LM. Gross domestic product
(GDP), or (Y), is placed on the horizontal axis, increasing to the right. The
interest rate, or (i or R), makes up the vertical axis. The IS curve depicts the set
of all levels of interest rates and output (GDP) at which total investment (I)
equals total saving (S). At lower interest rates, investment is higher, which
translates into more total output (GDP), so the IS curve slopes downward and to
the right.

The LM curve depicts the set of all levels of income (GDP) and interest rates at
which money supply equals money (liquidity) demand. The LM curve slopes
upward because higher levels of income (GDP) induce increased demand to
hold money balances for transactions, which requires a higher interest rate to
keep money supply and liquidity demand in equilibrium.

The intersection of the IS and LM curves shows the equilibrium point of interest
rates and output when money markets and the real economy are in balance.
Multiple scenarios or points in time may be represented by adding additional IS
and LM curves.

In some versions of the graph, curves display limited convexity or concavity.

Shifts in the position and shape of the IS and LM curves, representing changing
preferences for liquidity, investment, and consumption, alter the equilibrium
levels of income and interest rates.

DEMAND- PULL & COST PUSH INFLATION

There are four main drivers behind inflation. Among them are cost-push
inflation, or the decrease in the aggregate supply of goods and services
stemming from an increase in the cost of production, and demand-pull inflation,
or the increase in aggregate demand, categorized by the four sections of the
macroeconomy: households, business, governments, and foreign buyers. The
two other contributing factors to inflation include an increase in the money
supply of an economy and a decrease in the demand for money.

Inflation is the rate at which the general price level of goods and services rises.
This, in turn, causes a drop in purchasing power. This is not to be confused with
the change in the prices of individual goods and services, which rise and fall all
the time. Inflation happens when prices rise across the economy to a certain
degree.
Aggregate supply is the total volume of goods and services produced by an
economy at a given price level. When the aggregate supply of goods and
services decreases because of an increase in production costs, it results in cost-
push inflation.

Cost-push inflation means prices have been "pushed up" by increases in the
costs of any of the four factors of production—labor, capital, land, or
entrepreneurship—when companies are already running at full production
capacity. Companies cannot maintain profit margins by producing the same
amounts of goods and services when their costs are higher and their
productivity is maximized.

Demand-pull inflation occurs when there is an increase in aggregate demand,

categorized by the four sections of the macro economy: households, businesses,
governments, and foreign buyers.2 3

When concurrent demand for output exceeds what the economy can produce,
the four sectors compete to purchase a limited amount of goods and services.
That means the buyers "bid prices up" again and cause inflation. This excessive
demand, also referred to as "too much money chasing too few goods," usually
occurs in an expanding economy. The increase in aggregate demand that causes
demand-pull inflation can be the result of various economic dynamics.

JUNE 12,2014
 QUESTION NO :1
Define GNP and GDP . Explain the difference between GNP AND GDP. When GNP IS
HIGHER THAN GDP? When GNP IS lower than GDP?

Gross National Product

Gross national product (GNP) is an estimate of total value of all the final products and
services turned out in a given period by the means of production owned by a country's
residents. GNP is commonly calculated by taking the sum of personal consumption
expenditures, private domestic investment, government expenditure, net exports and any
income earned by residents from overseas investments, minus income earned within the
domestic economy by foreign residents. Net exports represent the difference between what a
country exports minus any imports of goods and services.

Gross Domestic Product (GDP)?

Gross domestic product (GDP) is the total monetary or market value of all the finished goods
and services produced within a country's borders in a specific time period. As a broad
measure of overall domestic production, it functions as a comprehensive scorecard of a given
country’s economic health

DIFFERENCE BETWEEN GNP AND GDP

WHEN GNP IS HIGHER THAN GDP

The larger the difference between a country's GNP and GDP, the greater the degree of

incomes and investment activity in that country involve transnational activities such

as foreign direct investment one way or another.

WHEN GNP IS LOWER THAN GDP

If a county has similar inflows and outflows of income from assets, then GNP and GDP

will be very similar. However, if a country has many multinationals who repatriate
income from local production, then GNP will be lower than GDP

QUESTION NO: 2(A)

Define consumption and average propensity to consume (APC) and marginal propensity to
consume (MPC)?

CONSUMPTION
Consumption can be defined in different ways, but it is best described as the final purchase of goods
and services by individuals.

AVERAGE PROPENSITY TO CONSUME ( APC)

The average propensity to consume (APC) measures the percentage of income that is
spent rather than saved. This may be calculated by a single individual who wants to
know where the money is going or by an economist who wants to track the spending
and saving habits of an entire nation.

the propensity to consume can be determined by dividing average household

consumption, or spending, by average household income, or earnings

MARGINAL PROPENSITY TO CONSUME( MPC)

In economics, the marginal propensity to consume (MPC) is defined as the proportion

of an aggregate raise in pay that a consumer spends on the consumption of goods and
services, as opposed to saving it. Marginal propensity to consume is a component of
Keynesian macroeconomic theory and is calculated as the change in consumption
divided by the change in income.

MPC is depicted by a consumption line, which is a sloped line created by plotting the
change in consumption on the vertical "y" axis and the change in income on the
horizontal "x" axis

QUESTION NO:2(B)
Define saving, average propensity to save(APS) and marginal propensity to save
(MPS)?

SAVING
Savings is the money a person has left over when they subtract their consumer
spending from their disposable income over a given time period. Savings can be used
to increase income through investing.
AVERAGE PROPENSITY TO SAVE ( APS)
The average propensity to save (APS) is an economic term that refers to the
proportion of income that is saved rather than spent on goods and services.
Also known as the savings ratio, it is usually expressed as a percentage of total
household disposable income (income minus taxes). The inverse of average
propensity to save is the average propensity to consume (APC).

MARGINAL PROPENSITY TO SAVE ( MPS)

In Keynesian economic theory, the marginal propensity to save (MPS) refers to the
proportion of an aggregate raise in income that a consumer saves rather than spends
on the consumption of goods and services. Put differently, the marginal propensity
to save is the proportion of each added dollar of income that is saved rather than
spent. MPS is a component of Keynesian macroeconomic theory and is calculated as
the change in savings divided by the change in income, or as the complement of
the marginal propensity to consume (MPC).

QUESTION NO :2 (C)
WHAT are determinants of consumptions?

DETERMINANTS OF CONSUMPTION
Following are the determinants of consumption which are as follows:

Psychological Characteristics of Human Nature: The subjective factors affecting

propensity to consume are internal to the economic system. The subjective factors include
characteristics of human nature, social practices which lead households to refrain or activate
to appending out of their income

The objective factors are external to economic system. The undergo rapid changes and bring
market in the consumption function. The main objective factors are as under

Real Income: Real income is the basic factor which determines community’s propensity to
consume. When real income of the community increases, consumption expenditure also
increases but by a smaller amount. The consumption function shifts upward.

Distribution of wealth: If there is unequal distribution of wealth in a country, the consumption

function will also be unequal. People with low income group have high propensity to consume and rich people
low propensity to consume. An equal distribution of wealth raises the propensity to consume.

Changes in Fiscal Policy: Taxes also play an important part in influencing the propensity to
consume. If the nature of taxes is such that they directly affect the poor people and reduce their income, then the
propensity to consume is high and if rich persons are not taxed at a progressive rate and they accumulate more
wealth, then the propensity to consume is low.
Change in the Rate of Interest: A change in the rate of interest exercises influence on the
propensity to consume. When the interest rate is raised, it generally induces people to decrease expenditure and
save more for lending purposes. On the other hand, when the interest rate is reduced, it usually encourages
expenditure as lending then becomes less attractive. So we conclude that an increase in the rate of interest
generally reduces propensity to consume or shifts the consumption function downward and a fall in the rate of
interest usually helps to the increase of propensity to consume or shifts the consumption function upward.

Credit Facilities: cheap credit facilities are available in the country, the consumption
function will move upward.

Deferred Payment:
Sometimes, particularly during wartime, consumer spending declines due to restraint on
spending. Once such restraints are removed, backlog of pent- up consumer demand might get
exposure leading to a rise in spending.

Availability of Goods: Propensity to consume is also affected by the availability of

consumption goods. If the goods are available in abundance, then the propensity to consume
increases. If they are scarce and are priced very high, then the propensity to consume will
decline.

Higher Living Standard: If the real income of the people increases in the country and
people adopt the use of new produce like television, washing machines, refrigerators, care,
etc., etc., the consumption function is high.

Expectation Change in Price: If people expect prices are going to rise in near future,
they hasten to spend large sum out of a given income just after the promulgation of first
Martial Law in our country. So we can say that when prices are expected to be high in
future, the propensity to consume increases or the consumption function shifts upward.
When they are expected to be low, the propensity to consume decreases or the consumption
function shifts downward.

Structural Factors:
The first important structural factor is income distribution. It is said that the marginal
propensity to consume (MPC) is high of low- income families and low for high-income
families. Thus, if there is a redistribution of income in favor of the poor-income families,
aggregate consumption would rise since the MPC of these people is high.
Secondly, demographic factors are responsible for differences in consumption spending with
identical incomes. Demographic factors include the size of family, stage in the family life
cycle, place of residence, occupation, race, etc. It is true that large families or families with
more children and aged persons consume more than small families. However, in the short-run
analysis, these demographic factors can be ignored.

QUESTION NO : 3 (A)

WHAT IS INFLATION? WHAT ARE ITS TYPES?

INFLATION
Inflation is the decline of purchasing power of a given currency over time. A quantitative estimate of
the rate at which the decline in purchasing power occurs can be reflected in the increase of an average
price level of a basket of selected goods and services in an economy over some period of time.

TYPES OF INFLATION

Thus, inflation has an impact on the cost of living and the development of the economy as a whole.
Starting from there, we can identify many types of inflation:

COST PUSH INFLATION

Cost-push inflation is a type of inflation that occurs when higher production costs (increase in the cost
of wages, raw materials etc.) push up the prices of goods and services.

The increased price of the factors of production leads to a decreased supply of these goods. While the
demand remains constant, the prices of commodities increase causing a rise in the overall price level.

DEMAND PULL INFLATION

Demand pull inflation can be defined as a type of inflation that occurs when price level increases due
to a greater demand for goods or services than there is supply available.

In other words, Demand-pull inflation occurs when aggregate demand for goods or services outstrips
aggregate supply. These constituents of the economy demand more goods than can be produced by
the economy. When supply cannot rise to meet demand, sellers will increase prices, thereby causing
inflation.

BUILT IN INFLATION

When the cost of wages of the workers increases, to keep up with their demand, the firm increases the
cost of production, which leads to the rise in the cost of goods.

CREEPING INFLATION

Also called low or mild inflation, this type of inflation occurs when prices rise not more than 3% a
year.

It’s actually beneficial to economic growth.

That’s because this mild inflation sets expectations that prices will continue to rise. As a result, it
sparks increased demand as consumers decide to buy now before prices rise in the future. By
increasing demand, mild inflation drives economic expansion.

WALKING INFLATION

This strong, or destructive, inflation is between 3-10% a year. It is harmful to the economy because it
heats-up economic growth too fast. People start to buy more than they need to avoid tomorrow's
much higher prices. This increased buying drives demand even further so that suppliers can't keep up.
More important, neither can wages. As a result, common goods and services are priced out of the
reach of most people

GALLOPING INFLATION
When inflation rises to 10% or more, it wreaks absolute havoc on the economy. Money loses value so
fast that business and employee income can't keep up with costs and prices. Foreign investors avoid
the country, depriving it of needed capital. The economy becomes unstable, and government leaders
lose credibility. Galloping inflation must be prevented at all costs.

HYPERINFLATION

Hyperinflation is when prices skyrocket more than 50% a month. It is very rare. In fact, most
examples of hyperinflation occur when governments print money to pay for wars. Examples of
hyperinflation include Germany in the 1920s, Zimbabwe in the 2000s, and Venezuela in the 2010s.2
The last time America experienced hyperinflation was during its civil war.3

WAGE INFLATION

Wage inflation is when workers' pay rises faster than the cost of living. This kind of inflation occurs
in three situations. First is when there is a shortage of workers. Secondly, is when labor unions
negotiate ever-higher wages. Thirdly is when workers effectively control their pay.9

A worker shortage occurs whenever unemployment is below 4%. Labor unions negotiated higher pay
for autoworkers in the 1990s.10 CEOs effectively control their pay by sitting on many corporate
boards, especially their own. All of these situations created wage inflation.

DEFLATION

Deflation is the opposite of inflation. It's when prices fall. It's caused when an asset bubble bursts.4

That's what happened in housing in 2006. Deflation in housing prices trapped those who bought their
homes in 2005.7 In fact, the Fed was worried about the overall deflation during the recession. That's
because deflation can turn a recession into a depression. During the Great Depression of 1929, prices
dropped 10% a year.8 Once deflation starts, it is harder to stop than inflation.

CORE INFLATION

The core inflation rate measures rising prices in everything except food and energy. That's because
gas prices tend to escalate every summer. Families use more gas to go on vacation. Higher gas costs
increase the price of food and anything else that has high transportation costs.

QUESTION NO :3 ( B)

WHAT IS UNEMPLOYMENT? WHAT ARE ITS TYPES?

UNEMPLOYMENT
Unemployment occurs when a person who is actively searching for employment is unable to find
work. Unemployment is often used as a measure of the health of the economy. The most
frequent measure of unemployment is the unemployment rate, which is the number of
unemployed people divided by the number of people in the labor force.

TYPES OF UNEMPLOYMENT
There are several types of unemployment which are as follows:
FRICTIONAL UNEMPLOYMENT
Frictional unemployment is caused by temporary transitions in workers’ lives, such as when a worker
moves to a new city and has to find a new job.

Frictional unemployment also includes people just entering the labor force, such as freshly graduated
college students. It is the most common cause of unemployment, and it is always in effect in an
economy.

STRUCTURAL UNEMPLOYMENT
Structural unemployment is caused by a mismatch in the demographics of workers and the types of
jobs available, either when there are jobs available that workers don’t have the skills for, or when
there are workers available but no jobs to fill.

Structural unemployment is most obvious in industries undergoing technological advancements. For

example, in the farming industry, much of the work is becoming mechanized, which means that fewer
farmers are needed and many are let go. When these farmers go to cities to find work, they may find
no other similar jobs in which to apply their skills.

CYCLICAL UNEMPLOYMENT
Cyclical unemployment is caused by declining demand: when there is not enough demand in an
economy for goods and services, businesses cannot offer jobs.

According to Keynesian economics, cyclical unemployment is a natural result of the business cycle in
times of recession: if all consumers become fearful at once, consumers will attempt to increase their
savings at the same time, which means there will be a decrease in spending, and businesses will not be
able to employ all employable workers.

SEASONAL UNEMPLOYMENT
Seasonal unemployment is caused by different industries or parts of the labor market being available
during different seasons. For instance, unemployment goes up in the winter months, because many
agricultural jobs end once crops are harvested in the fall, and those workers are left to find new jobs.

QUESTION NO : 3 ( C)

DICUSS THE RELATIONSHIP BETWEEN INFLATION AND

UNEMPLOYMENT?

RELATIONSHIP BETWEEN INFLATION AND UNEMPLOYMENT

When we relate this situation with the concept of unemployment then we can say that in case of long
run increase in demand will give maximum benefit to the company or the industry when the economy
has a starting point when the employment level in the economy is full. This is known as inflationary
gap. Inflation is least expected in the deflationary conditions when there is an unemployment
equilibrium. Hence inflation may only increase when there is high or full level of employment in the
industry. When there is full level of employment in the industry then there is very little chances of
increasing money supply to increase the national output. Hence when money supply in increased then
there is a modest scenario of inflation.

Phillips Curve is a curve that shows the relationship between inflation and unemployment in which
inflation is taken in the vertical axis and unemployment is taken at the horizontal axis. According to
the classical theory in economics, there are two types of curves, long run curve and short run curve.
Hence Phillips curve consists of two types of curves, Long Run Phillips of Curve and Short Run
Phillips Curve. Long Run Phillips curve and Short Run Phillips Curves are shown as follows:

Short Run Phillips Curve indicates that there is an inverse relationship between rate of inflation and
unemployment. This was a model developed in 1960s but later on some loop holes were found in this
concept there came a situation in which there was high rate of unemployment and high rate of
inflation simultaneously. This situation was known as stagflation. Hence in 1970s Long Run Phillips
Curve Model was recognized. (Inflation and Phillips Curve)

There is an appropriate reason that why Long Run Phillips Curve is vertical in nature. In case of long
run, there is ignorance to the gain in productivity. Wages and their contracts are renegotiated in long
run and there is no money illusion in this scenario. Now let us suppose that there is an increase in the
money supply at say x percent then there is an increase in the wages at x percent. Hence there is no
chance in the long run for the firms to change the level of output or employment. Hence in the long
run, there is no change in the net employment or unemployment of the economy i.e. there is no trade
off between inflation and unemployment in case of long run.

In case of Short Run Phillips Curve, there is an expected level of inflation according to given level of
unemployment and this curve slopes downwards. Main reason for this curve to be downward sloping
is that there is money illusion, in short run wages are not renegotiated which means that there are
same wage contracts which is not affected by the increase in the money supply and growth. We can
consider a situation in which when there is an increase in the money supply, then there is an increase
in inflation rate but increase in wages will be very low because the scenario is of short run. This
means that when there is a decrease in inflation rate in short run then the level of unemployment is
increased because of the reason that there is an increase in real wages. (Macroeconomics /
International Economy)

Hence we can say that Phillips Curve gives an exact relationship between the level of unemployment
and rate of inflation through Long Run Phillips Curve (LRPC) and Short Run Phillips Curve (SRPC).

CONCLUSION OF INFLATION AND UNEMPLOYMENT

We can conclude in the end that relationship between inflation and level of unemployment is
absolutely viable at the present scenario. Phillips Curve is considered to be the best possible technique
exploring this important relationship. There had been few changes that we had seen in Phillips curve
that earlier there was just a concept of Short Run Phillips Curve but it had few restrictions that there
may be increase in wages and money illusion to the people. Hence in order to remove these loopholes,
Long Run Phillips Curve was generated which covers the situation of wage increase and money
illusion as well.

Unemployment and Inflation are two important macroeconomic techniques. In order to have a look
the economic situation of any country, it is very much important to look forward rate of inflation of
its economy and natural level of unemployment in the country. As far as economic growth of any
country is concerned, as level of unemployment in its economy will be low, there will be more
growing economic condition in the country. Hence at last we can simply conclude that unemployment
and inflation are related and this relationship is explored by Phillips curve which must be considered
as one of major victory in terms of macroeconomics.

QUESTION NO :4

What is monetary policy? What are its instruments? Also discuss

expansionary and contractionary monetary policy.

MONETARY POLICY: Monetary policy is the process by which the monetary authority of a
country controls the supply of money, often targeting a rate of interest to attain a set of objectives
oriented towards the growth and stability of the economy.

MONETARY POLICY INSTRUMENTS:

The instruments of monetary policy used by the Central Bank depend on the level of development of
the economy, especially its financial sector. The commonly used instruments are discussed below.

• Reserve Requirement: The Central Bank may require Deposit Money Banks to hold a fraction (or
a combination) of their deposit liabilities (reserves) as vault cash and or deposits with it. Fractional
reserve limits the amount of loans banks can make to the domestic economy and thus limit the supply
of money.

• Open Market Operations: The Central Bank buys or sells ((on behalf of the Fiscal Authorities
(the Treasury)) securities to the banking and non-banking public (that is in the open market). One
such security is Treasury Bills. When the Central Bank sells securities, it reduces the supply of
reserves and when it buys (back) securities-by redeeming them-it increases the supply of reserves to
the Deposit Money Banks, thus affecting the supply of money.

• Lending by the Central Bank: The Central Bank sometimes provide credit to Deposit
Money Banks, thus affecting the level of reserves and hence the monetary base.

• Interest Rate: The Central Bank lends to financially sound Deposit Money Banks at a most
favorable rate of interest, called the minimum rediscount rate (MRR). The MRR sets the floor for
the interest rate regime in the money market (the nominal anchor rate) and thereby affects the supply
of credit, the supply of savings (which affects the supply of reserves and monetary aggregate) and
the supply of investment (which affects full employment and GDP).

• Direct Credit Control: The Central Bank can direct Deposit Money Banks on the maximum
percentage or amount of loans (credit ceilings) to different economic sectors or activities, interest rate
caps, liquid asset ratio and issue credit guarantee to preferred loans. In this way the available savings
is allocated and investment directed in particular directions.

• Moral Suasion: The Central Bank issues licenses or operating permit to Deposit Money Banks and
also regulates the operation of the banking system. It can, from this advantage, persuade banks to
follow certain paths such as credit restraint or expansion, increased savings mobilization and
promotion of exports through financial support, which otherwise they may not do, on the basis of
their risk/return assessment.
• Prudential Guidelines: The Central Bank may in writing require the Deposit Money Banks to
exercise particular care in their operations in order that specified outcomes are realized. Key elements
of prudential guidelines remove some discretion from bank management and replace it with rules in
decision making.

• Exchange Rate: The balance of payments can be in deficit or in surplus and each of these affect the
monetary base, and hence the money supply in one direction or the other. By selling or buying foreign
exchange, the Central Bank ensures that the exchange rate is at levels that do not affect domestic
money supply in undesired direction, through the balance of payments and the real exchange rate.

EXPANSIONARY MONETARY POLICY: Expansionary monetary policy is when a central bank

uses its tools to stimulate the economy. That increases the money supply, lowers interest rates, and
increases aggregate demand. It boosts growth as measured by gross domestic product. It lowers the
value of the currency, thereby decreasing the exchange rate. It is the opposite of contractionary
monetary policy.

CONTRACTIONARY MONETARY POLICY: Contractionary policy refers to either a reduction in

government spending, particularly deficit spending, or a reduction in the rate of monetary expansion
by a central bank. It is a type of policy or macroeconomic tool designed to combat rising inflation
or other economic distortions created by central bank or government interventions.

QUESTION NO : 5 (A)
What is meant by balance of payments? How would you correct an adverse balance of payments
of a country?

BALANCE OF PAYMENTS
The balance of payments (BOP) is a statement of all transactions made between
entities in one country and the rest of the world over a defined period of time, such as
a quarter or a year.

CORRECT AN ADVERSE BALANCE OF PAYMENTS

There are four well-known methods of correcting in adverse balance of payments

Trade Policy Measures

Trade policy measures to improve the balance of payments refer to the measures adopted to promote
exports and reduce imports. Exports may be encouraged by reducing or abolishing export
duties and lowering the interest rate on credit used for financing exports. Exports are also
encouraged by granting subsidies to manufacturers and exporters.

Besides, on export earnings lower income tax can be levied to provide incentives to the
exporters to produce and export more goods and services. By imposing lower excise
duties, prices of exports can be reduced to make then competitive in the world markets.
On the other hand, imports may be reduced by imposing or raising tariffs (i.e., import duties)
on imports of goods. Imports may also be restricted through imposing import quotas,
introducing licenses for imports. Imports of some inessential items may be totally
prohibited.

Expenditure-Reducing Policies:
The important way to reduce imports and thereby reduce deficit in balance of payments is to
adopt monetary and fiscal policies that aim at reducing aggregate expenditure in the
economy. The fall in aggregate expenditure or aggregate demand in the economy works to
reduce imports and help in solving the balance of payments problem.

The two important tools of reducing aggregate expenditure are the use of:
1) Tight monetary policy and

2) Contractionary fiscal policy

Tight Monetary Policy:

Tight monetary is often used to check aggregate expenditure or demand by raising the cost
of bank credit and restricting the availability of credit. For this bank rate is raised by the
Central Bank of the country which leads to higher lending rates charged by the commercial
banks.

Contractionary Fiscal Policy:

Appropriate fiscal policy is also an important means of reducing aggregate expenditure. An
increase in direct taxes such as income tax will reduce aggregate expenditure. A part of
reduction in expenditure may lead to decrease in imports. Increase in indirect taxes such as
excise duties and sales tax will also cause reduction in expenditure.

Expenditure – Switching Policies: Devaluation:

A significant method which is quite often used to correct fundamental disequilibrium in
balance of payments is the use of expenditure-switching policies. Expenditure switching
policies work through changes in relative prices. Prices of imports are increased by making
domestically produced goods relatively cheaper.

Expenditure switching policies may lower the prices of exports which will encourage exports
of a country. In this way by changing relative prices, expenditure-switching policies help in
correcting disequilibrium in balance of payments.

Exchange Control:
Finally, there is the method of exchange control. We know that deflation is dangerous;
devaluation has a temporary effect and may provoke others also to devalue. Devaluation also
hits the prestige of a country.

These methods are, therefore, avoided and instead foreign exchange is controlled by the
government. Under it, all the exporters are ordered to surrender their foreign exchange to the
central bank of a country and it is then rationed out among the licensed importers. None else
is allowed to import goods without a license. The balance of payments is thus rectified by
keeping the imports within limits.

QUESTION NO :5 ( B)
The balance of payments of a country must always balance . How then do you explain
the view that a country has favorable or an adverse balance of payments ?

The balance of payments of a country must always balance because it is based upon system
of double entry book keeping , the total debit must always be equal to total credits. This is
because two aspects of each transaction recorded are equal in amount but appear on the
opposite sides of the balance of payments. If there is any deficit in any individual
account, it would be covered by a surplus in other accounts, if there is any
difference between total debits and total credits, it would be settled under 'errors &
omissions'. Hence in the accounting sense, the balance of payments of a country
always balances.
The balance of payments will be favorable for that country when it’s total receipts are greater
than its total payments otherwise the balance of payments will be unfavorable When the
balance of payments is favourable for a country, that particular country would most probably
use its excess receipts on making investment in other countries, buy gold from the
international market or even give loans to countries in great need .

To correct the measure of adverse balance of payments the deficit balance using three types

EXPORT LED GROWTH

Labour Intensive Industries

Labour intensive industries should be established, because labour is cheaper in Pakistan, these
industries can be set up at lower cost. The products of these industries can be exported

Manufactured Goods
Instead of exporting primary goods like raw cotton, Pakistan should export manufactured
goods like textiles and garments, leather goods, food products and electrical goods.

Quality Products
Many of our goods cannot be exported because of poor quality. Thus, electric fans, cycles,
electric motors, shoes, ball pens, crockery etc. cannot be sold abroad. Pakistan is needed to improve
the quality of its products according to international standard.

Pricing of Goods
It is necessary for increasing exports that goods should be produced under optimal conditions
and offered at competitive prices in international market

Packing
High quality packing is essential for promoting exports. If packing is not attractive and
durable, it will not capture foreign market.
 REDUCTION IN IMPORTS

Import of Only Essential Items

Only essential items should be imported which are needed for our industrial production.
Import of luxuries should be banned. People should be educated to come out from the complex of
foreign goods.

Exchange Control
Exchange control is also an important step to minimize the imports. Exchange control should
be followed, so that there is no wastage of foreign exchange to import of un-necessary and luxuries.

MISCELLANEOUS

Decrease in Consumption
Taxes should be imposed to reduce the consumption of many items. Rich people in our
country are spending freely on unnecessary imported consumer items. So, foreign exchange reserves
are wasted.

Population Control
Many of our problems are arising due to fast increase in population. Sincere efforts should be
made to decrease growth rate of population. People should be educated in this regard.

QUESTION NO : 6

Derive IS CURVE . What are the factors which shifts the IS CURVE?

IS CURVE
The IS curve represents all combinations of income (Y) and the real interest rate (r) such that

the market for goods and services is in equilibrium. That is, every point on the IS curve is an

income/real interest rate pair (Y,r) such that the demand for goods is equal to the supply of

goods (where it is implicitly assumed that whatever is demanded is supplied) or, equivalently,

desired national saving is equal to desired investment. The graphical derivation of the IS
curve

is given below.
Consider an initial equilibrium in the goods market where r = 5% and income is equal

to Y0. This equilibrium is illustrated in the graph on the right with r on the vertical axis

and Y on the horizontal axis as the big black dot (middle dot). Now suppose Y

increases to Y1 (say supply increases). This increase in Y shifts the desired savings

curve down and right lowering the equilibrium real interest rate to 3%. The new

equilibrium in the goods market with higher income and a lower real interest rate is

illustrated in the graph on the right as the big blue dot (bottom dot). Similarly, if Y

decreases from Y0 to Y2 then the savings curve shifts up and left and the equilibrium

real interest rises. The new equilibrium in the goods market with lower income and a

higher real interest rate is illustrated in the graph on the right as the big red dot (top

dot). Notice that as income increases (decreases) the real interest must fall (rise) in

order to maintain equilibrium in the goods market. This is the relationship that is

represented in the downward sloping IS curve.

Every point on the IS curve represents an intersection between desired national saving and

desired investment for some income/interest rate pair (Y,r). As such the IS curve is derived

holding the determinants of saving and investment, other than Y and r, fixed. When these

factors change the IS curve will shift. Since points on the IS curve represent points where

aggregate demand is equal to aggregate supply any factor that increases the demand for goods

and services will shift the IS curve up and to the right and any factor that decreases
the demand
for goods and services will shift the IS curve down and to the left. From the
savings/investment

diagram it follows that any shift of the savings or investment curve that increases the real

interest rate, holding Y fixed, will shift up the IS curve. Functionally, the IS curve
is represented

as Pluses (+) above the exogenous variables indicate that increases in the variables

shift the IS curve up and to the right (increases demand).

11 JUNE ,2015
 Question no 01: Answer the following question?

• What is the difference between intermediate goods and final goods and services?
• Why are the imports subtracted when GDP is calculated in expenditure approach?
 • Why the national income is measured at factor prices and not at market prices?
• Why do you think house hold purchasing of new housing is included in the
investment components of GDP rather than the consumption components?

Answer

Part A

Intermediate Goods

Intermediate goods as the name suggests are goods which are either reprocessed or resold by the firm.

We all know the fact that – Of all the production undertaking during a particular accounting year in a
country, there is only a particular portion of products which results in final consumption. So, the
remaining portion is neither final goods nor capital goods.

These are used by the manufacturers in the form of material inputs, in order to produce other
commodities, called Intermediate goods. So, these goods are either a part of the final
product produced, or their identity is lost during the conversion process.

Intermediate goods are non-durable in nature. The producer supplies such goods to the industries for
the purpose of resale, after some value addition.

These are unprocessed or semi-processed products which are used as inputs in the process, so as to be
converted into another form. Hence, in the process of production, intermediate goods play a crucial
role.

Final Goods

A final good is a product which is ready for consumption, to satisfy the consumer’s wants or used as
an investment by the producers.

In layman terms, final goods are the goods available for purchase by the user, having no intention to
physically transform the goods or taking them as a resource to use in the production process. So, they
are produced to sell them to the ultimate consumer, using various channels of distribution.

In the calculation of Gross Domestic Products, the market value of newly-produced final goods during
the year has to be measured.

Services

A service is a transaction in which no physical goods are transferred from the seller to the buyer. The
benefits of such a service are held to be demonstrated by the buyer’s willingness to make the
exchange. Using resources, skill, ingenuity, and experience, service providers benefit service
consumers.

Part B

GDP is a measure of a country’s production.

GDP=C+I+G+Xn

C = Consumer Consumption

I = Gross Investment

G = Government Expenditures

Xn = Exports – Imports

Exports are what we produce and make a profit from by selling to buyers outside our country. Imports
are not produced by our country, so it shouldn’t be included in the GDP, so it makes sense to exclude
it from the calculation; ie. There should be no “- imports” in the calculation.

However, the calculation subtracts imports from the GDP. Imports somehow take away from what we
produced? That seems to say, calculate how much I have produced, X, and then don’t count some of it
because I imported Y. Which doesn’t make sense given that importing doesn’t remove goods and
services that have already been produced!

For example, let’s say I can take apples and make pies… I produced value in the form of the “pie”
quality. Importing the “pie” quality and tacking it on an apple creates an apple pie. However, I didn’t
make that “pie” so I can understand how it doesn’t get included in the GDP: the value of the “pie”
quality was not produced in this country, so it isn’t included in the GDP.

Part C

Net National Product at factor cost (NNPfc) is technically called National Income.

But we also have NNP at market price or NNPmp.

But the problem with market price is that market price is determined by net effect of Indirect Taxes
and Subsidies, and both Indirect Taxes and Subsidies are kind of transfer payments and not factor
payments, and these are made by the govt and not by the factors of production.

So Market Price does not show the actual contribution of the factors of production in the value of
goods and services produced.

But when income is determined as sum of factor payments made, it exactly shows the actual
contribution by different factors in production of goods and services, and hence presents a more fair
picture of actual productive activities in the economy.
Example –

Country A and B produced goods of factor cost $100.

Suppose Net Indirect Taxes (tax-subsidies) in country A is $20 and in country B is $5.

NNPmp of A is $120 and of B is $105.

But actual production was same $100.

Hence it is not fair to compare National Income at MP because the difference is just caused by taxes
and subsidies, and not actual production.

So, NNPfc is better than NNPmp.

Part D

A real estate purchase – specifically a house is considered a durable investment. Most people have
traditionally bought a house and lived in it for a number of years, raising a family, or pursuing their
career. Usually, depending on how long it has been held, and market conditions when it is sold it
usually is worth more than what it was purchased for, making it an investment. The recent market
collapse has affected that quite a bit, but housing like all investments will rise and fall according to
demand and economic issues.

To give you an example – my uncle purchased a house in 1974 for 70,000. In 2005 the house sold for
429,000. Nice return. However the buyers sold the house in 2014 and only were able to get 302,ooo. –
a huge loss. At one time that type of loss was unimaginable in most real estate markets – especially in
a major metro area with very low unemployment.

As to cars being considered an investment component – I would imagine that is because of the cost
being spread over a number of years through a loan. But it is the rare vehicle that appreciates in the
market. This has been true for decades. If it were my decision I would consider cars consumption
because they lose value nearly all the time, wear out, and fail due to the ravages of time – but that is
my opinion.

Question no 02 :

What are the fallacies in given statement?

• Expansionary monetary policy results in increase intrest rate.

• The aggregate demand curve is downward slopping because higher average price
level directly reduce our purchasing power by making goods and services more
expensive.
• A decrease in national saving necessarily result in equivalent decline in investment.
• When tax collection rise during economic prosperity they prevent the economy from
slowing down.
Answer

Part A

Because In expansionary monetary policy the central bank causes the supply of money and loanable
funds to increase, which lowers the interest rate, stimulating additional borrowing for investment and
consumption, and shifting aggregate demand right. The result is a higher price level and, at least in the
short run, higher real GDP. (b) In contractionary monetary policy, the central bank causes the supply
of money and credit in the economy to decrease, which raises the interest rate, discouraging
borrowing for investment and consumption, and shifting aggregate demand left. The result is a lower
price level and, at least in the short run, lower real GDP.

Part B

Because In macroeconomics, the focus is on the demand and supply of all goods and services
produced by an economy. Accordingly, the demand for all individual goods and services is also
combined and referred to as aggregate demand. The supply of all individual goods and services is
also combined and referred to as aggregate supply. Like the demand and supply for individual goods
and services, the aggregate demand and aggregate supply for an economy can be represented by a
schedule, a curve, or by an algebraic equation

Part C

A country’s national savings is the total of its domestic savings by household and companies (private
savings) as well as the government (public savings). If a country is running a trade deficit, it means
money from abroad is entering the country and is considered part of the supply of financial capital.

The demand for financial capital (money) represents groups that are borrowing the money. Businesses
need to borrow to finance their investments in factories, materials, and personnel. When the federal
government runs a budget deficit, it is also borrowing money from investors by selling Treasury
bonds. So both business investment and the federal government can demand (or borrow) the supply of
savings.

There are two main sources for the supply of financial capital in the U.S. economy: saving by
individuals and firms, called S, and the inflow of financial capital from foreign investors, which is
equal to the trade deficit (M – X), or imports minus exports. There are also two main sources of
demand for financial capital in the U.S. economy: private sector investment, I, and government
borrowing, where the government needs to borrow when government spending, G, is higher than the
taxes collected, T. This national savings and investment identity can be expressed in algebraic terms:

Part D

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
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 SRAS2, 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.

Question no 03:

Derive IS curve . What are the factor that shit IS curve?

Answer:

Derivation of the IS Curve:

The equilibrium condition in the goods market in terms of income expenditure approach is

Y = C + I + G … (5)

In terms of the leakage-injection approach the condition is

I + G = S + T … (6)

If we ignore the government sector (i.e., if G and T are zero), we can express equation (6) as

I® = S(Y) … (7)

Here investment is assumed to depend on r and S on Y.

We construct the IS curve to find combinations of r and Y that equate I with S.

While deriving the IS curve we have to remember three points:

• If the r falls, I increases.

• If I increases, Y increases through the multiplier. Y has to increase to ensure that
sufficient saving is generated to balance the new level of investment.
• So there is an inverse relation between r and Y.
 Question no 04:

What is the difference between monetary policy and fiscal policy, and how they are related?

Answer:

Key Differences Between Fiscal Policy and Monetary Policy

The following are the major differences between fiscal policy and monetary policy.

• The policy of the government in which it utilises its tax revenue and expenditure policy to
influence the aggregate demand and supply for products and services the economy is known
as Fiscal Policy. The policy through which the central bank controls and regulates the supply
of money in the economy is known as Monetary Policy.
• Fiscal Policy is carried out by the Ministry of Finance whereas the Monetary Policy
is administered by the Central Bank of the country.
• Fiscal Policy is made for a short duration, normally one year, while the Monetary Policy
lasts longer.
• Fiscal Policy gives direction to the economy. On the other hand, Monetary Policy brings price
stability.
• Fiscal Policy is concerned with government revenue and expenditure, but Monetary Policy is
concerned with borrowing and financial arrangement.
• The major instrument of fiscal policy is tax rates and government spending.
Conversely, interest rates and credit ratios are the tools of Monetary Policy.
• Political influence is there in fiscal policy. However, this is not in the case of
monetary policy.

DECEMBER 30 ,2016
 Q3. Ans
• Basis • Final Goods • Intermediate Goods
 • Meaning: • Final goods refer • Intermediate goods
to those goods refer to those goods
which are used which are used either
either for for resale or for
consumption or further production in
for investment. the same year.

• Nature: • They are • They are neither

included in both included in national
national and income nor in
domestic income. domestic income.

• Demand: • They have a • They have a derived

direct demand as demand as their
they satisfy the demand depends on
wants directly. the demand for final
goods.

• Value addition:
• They are ready • They are not ready for
for use by their use, i.e. some value
final users i.e. no has to be added to the
value has to be intermediate goods.
added to the final
goods.

• Production • They have • They are still within

Boundary: crossed the the production
production boundary.
boundary.

• Example: • Milk purchased • Milk used in dairy

by households shop for resale, coal
for consumption, used in factory for
car purchased as further.
an investment.

b) GDP is a measure of a country's production.

GDP=C+I+G+XnGDP=C+I+G+Xn

CC = Consumer Consumption
II = Gross Investment
GG = Government Expenditures
XnXn = Exports - Imports

Exports are what we produce and make a profit from by selling to buyers outside our country.
Imports are not produced by our country, so it shouldn't be included in the GDP, so it makes
sense to exclude it from the calculation; ie. there should be no "- imports" in the calculation.

However, the calculation subtracts imports from the GDP. Imports somehow take away from
what we produced? That seems to say, calculate how much I have produced, X, and then don't
count some of it because I imported Y. Which doesn't make sense given that importing doesn't
remove goods and services that have already been produced!

For example, let's say I can take apples and make pies... I produced value in the form of the
"pie" quality. Importing the "pie" quality and tacking it on an apple creates an apple pie.
However, I didn't make that "pie" so I can understand how it doesn't get included in the GDP:
the value of the "pie" quality was not produced in this country, so it isn't included in the GDP.

Q4. Ans
Nominal vs Real Interest Rates Comparison Table

Let’s look at the top 6 Comparison between Nominal vs Real Interest Rates

Nominal Interest Rate Real Interest Rate

The nominal interest rate does not include the Real Interest rates include the inflation effect
inflation effect.

Nominal interest rate = Real Interest rate + Real Interest rate = Nominal interest rate –
Inflation rate Inflation rate

The nominal interest rate cannot be less than The real interest rate can be less than zero if
zero. inflation is more than nominal rates.

Rates that are published by all financial Real rates are not published anywhere but these
institutions, banks, corporates, etc. are nominal are derived rates.
rates.

Nominal interest rates take monetary value into Real interest rates take opportunity value into
consideration. consideration.

Nominal rates will tell us what is happening in Real rates will tell us the actual return we will
the market and it is moving. It is not the actual get from the investment after adjusting the
return we will get. inflation effect.

Real Interest Rates

A real interest rate is the interest rate that takes inflation into account. This means it adjusts for
inflation and gives the real rate of a bond or loan. To calculate the real interest rate, you first need the
nominal interest rate. The calculation used to find the real interest rate is the nominal interest rate
minus the actual or expected inflation rate.

Suppose a bank loans a person $200,000 to purchase a house at a rate of 3%—the nominal interest
rate not factoring in inflation. Assume the inflation rate is 2%. The real interest rate the borrower is
paying is 1%. The real interest rate the bank is receiving is 1%. That means the purchasing power of
the bank only increases by 1%.
The real interest rate gives lenders and investors an idea of the real rate they receive after factoring in
inflation. This also gives them a better idea of the rate at which their purchasing power increases or
decreases. They can estimate their real rate of return by comparing the difference between a Treasury
bond yield and a Treasury Inflation-Protected Securities (TIPS) yield of the same maturity, which
estimates inflation expectations in the economy.

Nominal Interest Rates

A nominal interest rate refers to the interest rate before taking inflation into account. It is the interest
rate quoted on bonds and loans. The nominal interest rate is a simple concept to understand. If you
borrow $100 at a 6% interest rate, you can expect to pay $6 in interest without taking inflation into
account. The disadvantage of using the nominal interest rate is that it does not adjust for the inflation
rate.

Short-term nominal interest rates are set by central banks. These rates are the basis for other interest
rates that are charged by banks and other institutions to consumers. Central banks may decide to keep
nominal rates at low levels in order to spur economic activity. Low nominal rates encourage
consumers to take on more debt and increase their spending. This was the case following the Great
Recession when the U.S. Federal Reserve dropped its Fed Funds Rate to a range of 0% to 0.25%. The
rate remained in this range between Dec. 2008 and Dec. 2015

Q.5 ans
a) yes

Explanation:

ATM card increase the velocity of money. When the velocity of money is high money changes hands
quickly and therefore change in money will have a great effect on GDP

b) It will primarily be driven by your location ie the country and the within this the particular sector
from where your wealth or income stream derives. The former will through various metrics or indices
give you a national deflator or the value of your money -BY DOING NOTHING- it mostly likely will
deflate or lose value and yet possibly increase if a confluence of good POLITICS AND
LEADERSHIP foster an era of real growth and currency appreciation.

The second and to my mind - MORE IMPORTANT PIECE TO YOUR QUERY IS THE
OPPORTUNITY WHERE YOUR RESOURCES ARE DEPLOYED or UTILIZED AND where
THEY COULD BE IF INDEED YOUR MONEY IS EASILY SHIFTED OR REALLOCATED TO
ANOTHER ENDEAVOR.

The opportunity cost here is THE DIFFERENCE OF THE RETURNS YOU MAY RECIEVE VS
WHAT YOU ARE CURRENTLY RECIEVING. THIS IS FOR ME THE REAL OPPORTUNITY
COST OF YOUR MONEY. In the first instance the factors that will determine the ultimate value of
our currency is beyond ones ability to essentially alter. In the second instance it is in ones
determination on what it is he or she could do with money in possesion and the opportunity cost then
is the difference from its potential highest and best use vs, its current use. THE OPPORTUNITY
COST IS IN ITS ELEMENTAL THE DIFF BETWEEN DOING ABSOLUTELY NOTHING AND
DOING SOMETHING. What that something is - again is within ones - decision point.
Q.6 ans
It is clear that the main limitation on credit creation is the reserve ratio of cash to credit. Therefore, the
amount of credit that a system of banking can create depends upon the reserve ratio. The banks can
multiply a given amount of cash to many times of credit. If the public would demand no cash, credit
would go on expanding indefinitely. But the reserve ratio is a sort of leakage from the Stream of credit
creation.

We can, thus, think of a credit creation multiplier. The higher the reserve ratio, the smaller is the
credit creation multiplier. In our example above, with an original deposit of Rs. 1,000 the bank was in
a position to create credit of Rs. 5,000. The credit creation multiplier is obviously 5(Rs
5,000/Rs,1,000).

In general, the credit creation multiplier is related to the reserve ratio in the following way:

1/1-(1-reserve ratio) = 1/reserve ratio

If the reserve ratio is 1/3, credit creation multiplier is 3 a reserve ratio of 1/5 will give us a higher
value 5.

Multiple Credit or Money Expansion:

This process can also be shown in ‘T’ form. Suppose Mr. Z, who is a government employee gets his
pay cheque of Rs. 100. The cheque is used by the government is drawn on R.B. of India. Let us
assume Mr. Z has an account in Bank ‘A’ in which he deposits the cheque. Bank ‘A’ presents this
cheque to RBI for collection, as a result of which, the deposits of Bank ‘A’ increase by Rs. 100 and its
cash will also increase by Rs. 100.

The balance sheet of Bank ‘A’ (in T form) will be as follows:

By experience Bank A finds that Z will need hardly 10% of it in cash. It means Bank ‘A’ can lend Rs.
90%, The bank ‘A’ grants a loan? What happens? It does not take out cash and give it to the borrower.
It either allows the Borrower (X) to overdraw his account (if he has one with the bank) or it (Bank A)
opens an account in his name to the extent of loan taken (Rs. 90), if he is a new customer. Let us say
Bank ‘A’ grants a loan to X by opening an account in his favour.

The balance sheet of Bank ‘A’ will appear as follows:

This is only a temporary phase because no one borrows from a bank merely to open an account or
maintain it, one borrows to utilise the money. Let X who has borrowed Rs. 90 issues a cheque of Rs.
90 to R from whom he has purchased goods. Let R deposits the cheque in his account with bank ‘B’.

As such the balance sheet of Bank ‘A’ and ‘B’ will appear as follows:

Cash of Bank ‘B’ increases because it has collected from Bank ‘A’. The total deposits in the banking
system now is Rs. 190. Bank ‘B’ further behaves in the same way as bank ‘A’ above, i.e., keeping
10% of the deposits in cash to meet the requirements of the depositors. He may further grant a loan of
Rs. 81 of the borrower of Bank ‘B’ draws a cheque of Rs. 81 and thus cheque is deposited with Bank
*C’, the cash of Bank ‘B’ will go down by Rs. 81 and that of Bank ‘C’ will go up by Rs. 81.

The balance sheets of Banks A, B, C, will appear as follows:

Ans. 7
Government Expenditure Multiplier: G-Multiplier (With Diagram)

Article Shared by Nikita Dutta

ADVERTISEMENTS:
Like private investment, an increase in government spending results in an increase in national income.

Thus, its effect on national income is expansionary. There is a limit to private investment. Thus, to
stimulate income the gap has to be filled up by government expenditure.

However, the increase in income is greater than the increase in government spending. The impact of a
change in income following a change in government spending is called government expenditure
multiplier, symbolised by kG.

ADVERTISEMENTS:

KGG

In other words, an autonomous increase in government spending generates a multiple expansion of

income. How much income would expand depends on the value of MPC or its reciprocal, MPS. The
formula for KG is the same as the simple investment multiplier, represented by KI.

Its formula (i.e., KG) is:

The impact of a change in government spending is illustrated graphically in Fig. 3.19 where C + 1 +
G1 is the initial aggregate demand schedule. E 1 is the initial equilibrium point and the corresponding
level of income is, thus, OY1If the government plans to spend more, aggregate demand schedule
would then shift to C + I + g2. As this line cuts the 45° line at E2, the new equilibrium level of income,
thus, rises to OY2
The reason behind this expansionary effect of government spending on income is that the increase in
public expenditure constitutes an increase in income, thereby triggering successive increases in
consumption, which also constitutes increase in income. However, greater the MPC, greater will be
the increase in income.

Mathematical Example of Government Expenditure Multiplier:

ADVERTISEMENTS:

Given C = Rs. 20 + 0.50Y, I = Rs. 40, G = Rs. 10. Determine the equilibrium level of income.

Solution:

Equilibrium national income condition is

Ans 7

In the derivation of the IS curve we seek to find out the equilibrium level of national income as
determined by the equilibrium in goods market by a level of investment determined by a given rate of
interest. Thus IS curve relates different equilibrium levels of national income with various rates of
interest.

Derivation of IS Curve:

The IS-LM curve model emphasises the interaction between the goods and money markets.

The goods market is in equilibrium when aggregate demand is equal to income. The aggregate
demand is determined by consumption demand and investment demand.

ADVERTISEMENTS:

In the Keynesian model of goods market equilibrium we also now introduce the rate of interest as an
important determinant of investment. With this introduction of interest as a determinant of investment,
the latter now becomes an endogenous variable in the model. When the rate of interest falls the level
of investment increases and vice versa.

Thus, changes in the rate of interest affect aggregate demand or aggregate expenditure by causing
changes in the investment demand. When the rate of interest falls, it lowers the cost of
investment
projects and thereby raises the profitability of investment. The businessmen will therefore undertake
greater investment at a lower rate of interest.

The increase in investment demand will bring about increase in aggregate demand which in turn will
raise the equilibrium level of income. In the derivation of the IS curve we seek to find out the
equilibrium level of national income as determined by the equilibrium in goods market by a level of
investment determined by a given rate of interest.

Thus IS curve relates different equilibrium levels of national income with various rates of
interest. With a fall in the rate of interest, the planned investment will increase which will cause an
upward shift in aggregate demand function (C + I) resulting in goods market equilibrium at a higher
level of national income.

ADVERTISEMENTS:

The lower the rate of interest, the higher will be the equilibrium level of national income. Thus, the IS
curve is the locus of those combinations of rate of interest and the level of national income at which
goods market is in equilibrium. How the IS curve is derived is illustrated in Fig. 20.1. In panel (a) of
Fig. 20.1 the relationship between rate of interest and planned investment is depicted by the
investment demand curve II.

It will be seen from panel (a) that at rate of interest Or 0the planned investment is equal to OI0. With
OI0 as the amount of planned investment, the aggregate demand curve is C + I 0 which, as will be seen
in panel (b) of Fig. 20.1 equals aggregate output at OY 0 level of national income. Therefore, in the
panel (c) at the bottom of the Fig. 20.1, against rate of interest Or 0, level of income equal to OY0has
been plotted. Now, if the rate of interest falls to Or 1, the planned investment by businessmen increases
from OI0 to OI1 [see panel (a)].

With this increase in planned investment, the aggregate demand curve shifts upward to the new
position C + II in panel (b), and the goods market is in equilibrium at OY 1 level of national income.
Thus, in panel (c) at the bottom of Fig. 20.1 the level of national income OY 1 is plotted against the
rate of interest, Or1. With further lowering of the rate of interest to Or 2, the planned investment
increases to OI2 [see panel (a)].

With this further rise in planned investment the aggregate demand curve in panel (b) shifts upward to
the new position C +I2 corresponding to which goods market is in equilibrium at OY2 level of income.
Therefore, in panel (c) the equilibrium income OY2 is shown against the interest rate Or2.

ADVERTISEMENTS:

By joining points A, B, D representing various interest-income combinations at which goods market

is in equilibrium we obtain the IS curve. It will be observed from Fig. 20.1 that the IS curve is
downward sloping (i.e., has a negative slope) which implies that when rate of interest declines, the
equilibrium level of national income increases.
Factors that shift the IS curve: Factors which will increase or decrease
the level of saving or investment changing the equilibrium level
of interest rate for each level of income. For example an increase in
wealth causes desired savings to fall at every level if income.

Ans 8
Exchange rates are determined by demand and supply. But governments can
influence those exchange rates in various ways. The extent and nature of
government involvement in currency markets define alternative systems of
exchange rates. In this section we will examine some common systems and
explore some of their macroeconomic implications.
There are three broad categories of exchange rate systems. In one system,
exchange rates are set purely by private market forces with no government
involvement. Values change constantly as the demand for and supply of
currencies fluctuate. In another system, currency values are allowed to change,
but governments participate in currency markets in an effort to influence those
values. Finally, governments may seek to fix the values of their currencies,
either through participation in the market or through regulatory policy.

Free-Floating Systems

In a free-floating exchange rate system, governments and central banks do not

participate in the market for foreign exchange. The relationship between
governments and central banks on the one hand and currency markets on the
other is much the same as the typical relationship between these institutions and
stock markets. Governments may regulate stock markets to prevent fraud, but
stock values themselves are left to float in the market. The U.S. government, for
example, does not intervene in the stock market to influence stock prices.

Managed Float Systems

Governments and central banks often seek to increase or decrease their

exchange rates by buying or selling their own currencies. Exchange rates are
still free to float, but governments try to influence their values. Government or
central bank participation in a floating exchange rate system is called a managed
float.

Fixed Exchange Rates

In a fixed exchange rate system, the exchange rate between two currencies is set
by government policy. There are several mechanisms through which fixed
exchange rates may be maintained. Whatever the system for maintaining these
rates, however, all fixed exchange rate systems share some important features.

A Commodity Standard

In a commodity standard system, countries fix the value of their respective

currencies relative to a certain commodity or group of commodities. With each
currency’s value fixed in terms of the commodity, currencies are fixed relative
to one another.

Fixed Exchange Rates Through Intervention

The Bretton Woods Agreement called for each currency’s value to be
fixed relative to other currencies. The mechanism for maintaining
these rates, however, was to be intervention by governments and
central banks in the currency market.
Again suppose that the exchange rate between the dollar and the
British pound is fixed at $4 per £1. Suppose further that this rate is
an equilibrium rate,. As long as the fixed rate coincides with the
equilibrium rate, the fixed exchange rate operates in the same fashion
as a free-floating rate.

DECEMBER 30,2017
Q2 a) explain the difference between expansionary and CONTRACTIONARY fiscal policy.

DIFFERENCE BETWEEN EXPANSIONARY AND CONTRACTIONARY FISCAL POLICY:

An expansionary fiscal policy is one that causes aggregate demand to increase. This is achieved by the
government through an increase in government spending and a reduction in taxes. These two encourage
consumption as they increase people's purchasing power. This can be seen graphically as a rightwards shift of
the AD (aggregate demand) curve which leads to an increase in the equilibrium output of the economy and
hence, an increase in GDP.

Expansionary fiscal policy is the flip side of this coin, in which the government raises spending and lowers
taxes to boost economic growth. Reduced taxes help private enterprise to invest in major projects, employment,
and physical expansion. In today's world of 2016, the most appropriate action is a contractionary policy. The
global economy has recovered from the great recession of 2008 and it is important to prevent the same type of
economic bubbles that occurred in the past.

A contractionary fiscal policy is the opposite. The government decreases government spending and increases
taxes. This causes consumption to fall as purchasing power declines. This can be represented as a shift to the left
of the AD curve, reducing the equilibrium output of the economy and hence, reducing GDP. The government
will apply each policy depending on the country's needs.

Contractionary fiscal policy happens when the government and its public agencies lowers its expenditures, while
also decreasing spending or increasing taxes at the same time. When a government reduces its spending and/or
increases taxes, it leaves a lower amount of capital available for private business, thus causing a contraction of
the economy and usually a degree of higher unemployment. This type policy is typically used to control the
growth of inflation.

Q3. How are monetary tools used to combat unemployment and inflation?

Monetary policies are demand-side economic policies through which the central bank of a
country acts on the amount of money and interest rates in order to influence on the income
levels, output and unemployment in the economy, being the interest rate the link binding
money and income.

The main tools used by monetary policies are :

open market operations,

loans to commercial banks,

and the use of reserve requirements.

Ceteris paribus, an increase (decrease) in the money supply or a decrease

(increase) in interest rates will have a positive (negative) ripple effect on private
spending (consumption and investment). This will finally increase (decrease)
production and employment. However, this will increase prices, which may lead
to rapidly increasing inflation.

Monetarism is the main economic doctrine that defended this kind of policy.
However, Keynesianism, New Classical Macroeconomics and New
Keynesian Economics, criticize it and do not believe in their effectiveness as
it has been demonstrated that increasing money supply will result in inflation
and counteracting the positive effects of this policy. As Milton Friedman
said, “inflation is always and everywhere a monetary phenomenon”.
Monetary policy is the control of the money supply, by the Federal Reserve, (the
Fed). It has two tools available to impact monetary policy:
• through control of the reserve requirement [not changed from 10%, since
1992] or
• the federal funds rate, the interest rate banks pay for overnight loans
on reserve requirement shortfalls.
The Fed uses the member bank’s overnight lending rate to influence consumer
borrowing and commercial lending, thus increasing the speed at which money is
spent, increasing the money supply:
• When interest rates are low, banks make more loans, increasing the
money supply, increasing spending, raising employment and
eventually, inflation. If inflation gets above targets, the Fed will
increase the federal funds rate, increasing bank lending rates.
• When interest rates are higher, banks can make less loans, decreasing the
rate of growth of the money supply, reducing aggregate spending,
decreasing employment, reducing inflation. If employment gets too low,
the Fed will decrease the federal funds rate, lowering bank lending rates.

Q) Why are the imports subtracted from the GDP in expenditure

approach?
Ans GDP:
"GDP is the total market value, at current prices of final goods
and services which are produced within the country during a specific
period usually a year"
REASON WHY IMPORTS ARE SUBTRACTED:
Exports are what the country produce and make a profit from by selling to
buyers outside the country. Imports are not produced by our country,so it
should not be included in the gdp. Secondly, when we import something,
we consume it. So, when calculating consumption we are bound to count
import as a positive component of gdp. Since we did not produce imports
domestically, we subtract it to make it neutral. Thirdly, this is the
expenditure method which includes all the expenditures in the economy.
Indeed, when we import goods, we spend to consume even if we exclude
imports from calculations, we cannot exclude its part of consumption.
Thus, we need to subtract it unless otherwise gdp will overstated.

Q2 what is gdp deflator. How it differs from consumer price index?

Ans GDP Deflator:
 "GDP deflator is a measure of inflation. It is the ratio of
the value of goods and services an economy produces in a particular year
at current prices to that of prices prevailed during the base year"
This ratio help to show the extent to which the increase in the gross
domestic product has happened on the account of higher prices rather than
increase in the output. Since, the deflator covers the entire range of goods
and services produced in the economy, it is seen as a more comprehensive
measure of inflation.
•
Headings GDP DEFLATOR CONSUMER PRICE INDEX

Definition Gdp deflator is the measure of the CPI is the measure of only goods
prices of all goods and services and services bought by the
that are produced within the consumers outside the economy
economy

It includes Changes in the prices of exported Changes in the prices of imported

goods goods

Calculation It is calculated quarterly It is calculated monthly or

quarterly

Weighs prices It weighs prices of all currently It weighs against a fixed basket of
produced goods and services goods

Goods used to calculate The goods used to calculate GDP The goods used to calculate CPI
deflator changes dynamically must be updated periodically.

JANUARY 19 ,2018
Q1 Define velocity of money. discuss the role of velocity of money
in the quantity theory of money?
Ans : VELOCITY OF MONEY
"The velocity of money is a measurement of the rate at which money
is exchanged in an economy. "
EXPLANATION:
The velocity of money is important for measuring the rate at which
money in circulation is being used for purchasing goods and services.
It is used to help economists and investors gauge the health and
vitality of an economy. High money velocity is usually associated
with a healthy, expanding economy. Low money velocity is usually
associated with recessions and contractions.Economies that exhibit a
higher velocity of money relative to others tend to be more
developed. The velocity of money is also known to fluctuate with
business cycles. When an economy is in an expansion, consumers and
businesses tend to more readily spend money causing the velocity of
money to increase. When an economy is contracting, consumers and
businesses are usually more reluctant to spend and the velocity of
money is lower

QUANTITY THEORY OF MONEY:

The quantity theory of money also assumes that the quantity of
money in an economy has a large influence on its level of economic
activity. So, a change in the money supply results in either a change
in the price levels or a change in the supply of goods and services, or
both.
In addition, the theory assumes that changes in the money supply are
the primary reason for changes in spending.

ROLE OF VELOCITY OF MONEY ON QUANTITY THEORY

OF MONEY:
 B) What do you mean by money multiplier?
ANS MONEY MULTIPLIER:
"The money multiplier is the amount of money that banks generate
with each dollar of reserves.".

EXAMPLE
If the commercial banks gain deposits of £1 million and this leads to a
final money supply of £10 million. The money multiplier is 10.

EXPLANATION:
Also known as “monetary multiplier,” it represents the largest degree
to which the money supply is influenced by changes in the quantity of
deposits. It identifies the ratio of decrease and/or increase in the
money supply in relation to the commensurate decrease and/or
increase in deposits.

The money multiplier is the ratio of deposits to reserves in the

banking system.

The money multiplier will tell you how fast the money supply from
the bank lending will grow. The higher the reserve ratio is, the less
deposits will be available for lending, resulting in a smaller money
multiplier.
FORMULA
Money multiplier = 1 / R, where R is the reserve ratio

Q2 How does open market purchase of securities by Central Bank of

a country affect money supply?

Ans The open market operations conducted by the Federal Reserve

affect the money supply of an economy through the buying and
selling of government securities.

When the Federal Reserve purchases government securities on the

open market, it increases the reserves of commercial banks and allows
them to increase their loans and investments; increases the price of
government securities and effectively reduces their interest rates; and
decreases overall interest rates, promoting business investments.
If the Federal Reserve were to sell government securities on the open
market, the opposite would be true. It would decrease the reserves of
commercial banks and reduce their loans and investments, decreasing
the price of government securities and increasing their interest rates,
and increasing overall interest rates, reducing business investments.
The Federal Open Market Committee (FOMC) specifies and decides
on short-term objectives for open market operations. The FOMC sets
a target federal funds rate and uses open market operations to adjust
the supply of reserve balances to achieve that target.

B) Discuss the process of credit creation by the commercial banks?

Ans CREDIT CREATION PROCESS:
Commercial banks create credit by advancing loans and purchasing
securities. They lend money to individuals and businesses out of
deposits accepted from the public. However, commercial banks
cannot use the entire amount of public deposits for lending purposes.
They are required to keep a certain amount as reserve with the central
bank for serving the cash requirements of depositors. After keeping
the required amount of reserves, commercial banks can lend the
remaining portion of public deposits.

EXAMPLE
Suppose you deposit Rs. 10,000 in a bank A, which is the primary
deposit of the bank. The cash reserve requirement of the central bank
is 10%. In such a case, bank A would keep Rs. 1000 as reserve with
the central bank and would use remaining Rs. 9000 for lending
purposes.
The bank lends Rs. 9000 to Mr. X by opening an account in his
name, known as demand deposit account. However, this is not
actually paid out to Mr. X. The bank has issued a check-book to Mr.
X to withdraw money. Now, Mr. X writes a check of Rs. 9000 in
favor of Mr. Y to settle his earlier debts.

The check is now deposited by Mr. Y in bank B. Suppose the cash

reserve requirement of the central bank for bank B is 5%. Thus, Rs.
450 (5% of 9000) will be kept as reserve and the remaining balance,
which is Rs. 8550, would be used for lending purposes by bank B.

Thus, this process of deposits and credit creation continues till the
reserves with commercial banks reduce to zero.
Q3 A) What is the difference between expansionary and
contractionary fiscal policy?
ANS DIFFERENCE BETWEEN EXPANSIONARY AND
CONTRACTIONARY FISCAL POLICY:

An expansionary fiscal policy is one that causes aggregate demand to

increase. This is achieved by the government through an increase in
government spending and a reduction in taxes. These two encourage
consumption as they increase people's purchasing power. This can be
seen graphically as a rightwards shift of the AD (aggregate demand)
curve which leads to an increase in the equilibrium output of the
economy and hence, an increase in GDP.

A contractionary fiscal policy is the opposite. The government

decreases government spending and increases taxes. This causes
consumption to fall as purchasing power declines. This can be
represented as a shift to the left of the AD curve, reducing the
equilibrium output of the economy and hence, reducing GDP. The
government will apply each policy depending on the country's needs.

B) When government use expansionary fiscal policy and

contractionary fiscal policy?
Ans Expansionary fiscal policy is used to kick-start the economy
during a recession. It boosts aggregate demand, which in turn
increases output and employment in the economy. In pursuing
expansionary policy, the government increases spending, reduces
taxes, or does a combination of the two. Since government spending
is one of the components of aggregate demand, an increase in
government spending will shift the demand curve to the right. A
reduction in taxes will leave more disposable income and cause
consumption and savings to increase, also shifting the aggregate
demand curve to the right. An increase in government spending
combined with a reduction in taxes will, unsurprisingly, also shift the
AD curve to the right. The extent of the shift in the AD curve due to
government spending depends on the size of the spending multiplier,
while the shift in the AD curve in response to tax cuts depends on the
size of the tax multiplier. If government spending exceeds tax
revenues, expansionary policy will lead to a budget deficit.

A contractionary fiscal policy is implemented when there is demand-

pull inflation. It can also be used to pay off unwanted debt. In
pursuing contractionary fiscal policy the government can decrease its
spending, raise taxes, or pursue a combination of the two.
Contractionary fiscal policy shifts the AD curve to the left. If tax
revenues exceed government spending, this type of policy will lead to
a budget surplus.

Q4?A) What do you mean by business

cycle? ANS BUSINESS CYCLE:
"Business cycles are comprised of concerted cyclical upswings and
downswings in the broad measures of economic activity—output,
employment, income, and sales."

EXPLAINATION:
In essence, business cycles are marked by the alternation of the
phases of expansion and contraction in aggregate economic activity,
and the comovement among economic variables in each phase of the
cycle. Aggregate economic activity is represented by not only real
(i.e., inflation-adjusted) GDP—a measure of aggregate output—but
also the aggregate measures of industrial production, employment,
income, and sales.
How the business Cycle Works?
The four stages of the economic cycle are also referred to as the
business cycle. These four stages are expansion, peak, contraction,
and trough.

During the expansion phase, the economy experiences relatively rapid

growth, interest rates tend to be low, production increases, and
inflationary pressures build. The peak of a cycle is reached when
growth hits its maximum rate. Peak growth typically creates some
imbalances in the economy that need to be corrected. This correction
occurs through a period of contraction when growth slows,
employment falls, and prices stagnate. The trough of the cycle is
reached when the economy hits a low point and growth begins to
recover.
B) What is the difference between economic growth and economic
development?
Ans ECONOMIC GROWTH ECONOMIC DEVELOPMENT:
Meaning:Economic Growth is the positive change in the real output
of the country in a particular span of time. Economic Development
involves rise in the level of production in an economy along with the
advancement of technology, improvement in living standard.
Concept :Economic growth has a Narrow concept whereas economic
development has a Broad concept.
Scope: The scope of economic growth is Increase in the indicators
like GDP, per capita income etc. The scope of economic
development
Improvement in life expectancy rate, infant mortality rate,
literacy rate and poverty rates.
Term: Economic growth is a Short term process.Economic
development is a Long term process.
Applicable to: Economic growth is applied on Developed
Economies.Economic development is applied on Developing
Economies.
How it can be measured: Economic growth is measured by Upward
movement in national income. Economic development is measured by
Upward movement in real national income.
Which kind of changes are expected: Economic growth has
Quantitative changes whereas economic development has
Qualitative and quantitative changes.
Type of process: Economic growth is a Automatic process. Economic
development is a Manual process.
When it arises: Economic growth arises In a certain period of
time. Economic development is arises in a Continuous process.
Q5 Explain fallacies in each of the following statements:
A)GNP is always greater than than GDP
Ans GDP is generally always greater than GNP. As, GDP is the sum
total of all economic activities related to that country. GNP is only
what is happening within the borders of the country.
B) NNP is always greater than GNP
Ans Net national product (NNP) is never greater than Gross National
Product (GNP). Net National Product equals Gross National Product
minus the economic depreciation of the existing capital stock. That
last term is always positive, so GNP must be greater than NNP.

3) Personal income is always greater than national income

Ans Personal income tends to be only about 2 to 3 percent greater
than national income. This extra 2 to 3 percent comes largely from
productive activity of the government sector that is not attributable
directly to the earnings the factors of production and thus is not part
of national income.

4) National income is more than NNP.

ANS: national income at factor cost = national income at market
prices – indirect taxes + subsidies

NNP is measured at factor cost. It is thus the income received or

earned by productive factors. It differs from NNP at market prices due
to the presence of net indirect taxes. So, there is need to change NNP
at market prices by adding government subsidies on the production or
sale of society’s output and by subtracting taxes on the production or
sale of the social product.