MEP

1. Difference between Macroeconomics and Microeconomics

Microeconomics Microeconomics

 Studies individual income  Studies national income

 Analysis demand and supply of labour
 Deals with households and firms’ decision
 Studies individual price
 Analyses demand and supply of goods
 Analysis total employment in the economy
 Deals with aggregate decision
 Studies overall price level
 Analysis aggregate demand and aggerate
supply

2. Three main goals of macroeconomics/macroeconomic policies?

 Economic growth: This refers to the expansion of an economy's productive capacity over time,
typically measured by the increase in real GDP. Macroeconomic policies aim to promote
economic growth by encouraging investment, innovation, and productivity gains.

 Low unemployment: Unemployment occurs when people who are willing and able to work are
unable to find jobs. Macroeconomic policies aim to reduce unemployment by creating jobs and
expanding employment opportunities.

 Price stability: Price stability refers to a situation where prices for goods and services are
relatively stable over time, preventing the occurrence of high inflation or deflation.
Macroeconomic policies aim to maintain price stability by controlling inflation and promoting
economic stability.

3. Three methods of estimating national income? (Value added/product, Income and Expenditure
methods).

National income is a crucial economic indicator that represents the total value of goods and services
produced within a country during a specific period, typically a year. Estimating national income
involves measuring the monetary flow generated through various economic activities. There are
three primary methods for estimating national income:
 Value Added Method (Product Method): This method focuses on the value added at each stage
of production. It calculates the gross value added (GVA) for each sector of the economy,
including agriculture, industry, and services. GVA is the value of output minus intermediate
consumption, which represents the cost of materials and services purchased from other firms.
The sum of GVA from all sectors provides the gross domestic product (GDP) at market prices.
Finally, adjustments are made for net factor income from abroad to arrive at net national income
(NNI).
 Income Method: This method focuses on the income earned by factors of production, such as
land, labor, capital, and entrepreneurship. It calculates the total income received by individuals
and businesses from their participation in economic activities. This includes wages, salaries, rent,
interest, profits, and dividends. The sum of these income components provides the national
income.
  Expenditure Method: This method focuses on the total expenditure incurred on goods and
services produced within the country. It measures the aggregate spending by households,
businesses, and the government. This includes consumption, investment, and government
expenditure. The sum of these expenditures provides the gross national expenditure (GNE).
Finally, adjustments are made for net factor income from abroad to arrive at net national income
(NNI).

4. GDP = C+I+G+(X-M)
5. Concepts of national incomes?

National income is a broad concept that encompasses the total value of goods and services produced
within a country during a specific period, typically a year. It is a crucial economic indicator that
reflects the overall economic performance of a nation. There are several key concepts related to
national income, including:

 Gross Domestic Product (GDP): GDP is the most widely used measure of national income. It
represents the total market value of all final goods and services produced within a country's
borders during a specific period, regardless of the nationality of the producers. GDP is calculated
using three main methods: the value-added method, the income method, and the expenditure
method.

 Net National Product (NNP): NNP is derived from GDP by subtracting depreciation, which
represents the wear and tear of capital goods used in the production process. NNP represents
the total income earned by residents of a country from domestic production.

 Disposable Income (DI): DI is the income that individuals and businesses have available for
spending or saving after taxes and other deductions have been made. It is calculated by
subtracting personal income taxes, indirect taxes, and social insurance contributions from NNP.

 Personal Income (PI): PI is the total income received by individuals from all sources, including
wages and salaries, rent, interest, profits, and dividends. It is calculated by adding personal
income transfers, such as government benefits and social security payments, to NNP.

 National Income (NI): NI is a narrower measure of national income than GDP. It is calculated by
subtracting depreciation and net factor income paid abroad from NNP. Net factor income paid
abroad represents the earnings of foreign factors of production used in domestic production.

 Gross National Income (GNI): GNI is a broader measure of national income than GDP. It includes
net factor income received from abroad in addition to GDP. GNI represents the total income
earned by factors of production owned by residents of a country, regardless of where the
production occurs.

6. Factors of production and their factor payments?

The factors of production are the essential inputs used to create goods and services. These factors
are rewarded with payments for their contributions to the production process. The four primary
factors of production and their corresponding factor payments are:

 Land: Land refers to the natural resources used in production, such as fertile soil, mineral
deposits, and forests. The payment for land is known as rent.
  Labor: Labor refers to the physical and mental efforts exerted by individuals to produce goods
and services. The payment for labor is known as wages.

 Capital: Capital encompasses physical goods used in production, such as machinery, tools, and
equipment. The payment for capital is known as interest.

 Entrepreneurship: Entrepreneurship represents the innovative and risk-taking efforts of

individuals who organize and coordinate the other factors of production to create new
businesses and ventures. The payment for entrepreneurship is known as profit.

7. Circular flow of income, including capital markets

The circular flow of income is a simplified economic model that illustrates the flow of money, goods,
and services between two main sectors in an economy: households and businesses. It also includes
the role of financial markets in facilitating these flows.

 Households-Households are the providers of labor and resources to businesses. They receive
income from businesses in the form of wages, salaries, rent, and dividends. This income is then
spent on goods and services produced by businesses.
 Businesses firm-use the resources provided by households to produce goods and services. They
sell these goods and services to households in exchange for money. This money is then used to
pay for the factors of production, such as labor, land, capital, and entrepreneurship.

Government sector:

The government collects taxes from households and businesses to finance its operations The
government provides goods and services to households, such as education, healthcare, and
infrastructure. The government may borrow from financial markets to cover its budget deficits.

o Foreign Sector:

Exports represent goods and services produced domestically and sold to foreign countries. Imports
represent goods and services purchased from foreign countries and consumed domestically.Net
exports (exports minus imports) contribute to the national income or national expenditure.
8. Aggregate Demand and Aggregate Supply:

Aggregate Demand (AD) Aggregate demand represents the total demand for goods and services in
an economy at a given price level. It is the sum of the spending decisions made by households,
businesses, the government, and the foreign sector. The main components of aggregate demand are:
Consumption: The spending of households on goods and services.

 Investment: The spending of businesses on capital goods, such as machinery and

equipment, and on inventories of goods and services.

 Government spending: The spending of the government on goods and services, including
public infrastructure and social welfare programs.

 Net exports: The difference between exports (goods and services sold to foreign countries)
and imports (goods and services purchased from
foreign countries).

Aggregate demand is typically represented by a downward-

sloping demand curve, indicating that as the price level rises,
the quantity of goods and services demanded decreases. This is
because higher prices reduce the purchasing power of
consumers and businesses.

 Aggregate Supply (AS)

Aggregate supply represents the total quantity of goods and services that firms are willing and able
to produce and sell at a given price level. It is determined by factors such as:

 The cost of production: The cost of inputs, such as labor, capital, and raw
materials, influences the price at which firms are willing to sell their goods and services.

 Technology: Advancements in technology can lead to increased productivity and a lower cost
of production, allowing firms to supply more goods and services at a given price level.

 Factor prices: Changes in the prices of factors of production, such as wages, interest
rates, and rent, can affect the cost of production and influence the supply of goods and
services.

Aggregate supply is typically represented by an upward-sloping

supply curve, indicating that as the price level rises, the quantity of
goods and services supplied increases. This is because higher prices
incentivize firms to produce more goods and services.

9. Why AD curve slopes downward?

  The real wealth effect: When the price level falls, the real value of households' wealth increases.
This means that they can buy more goods and services with the same amount of money. As a
result, they tend to spend more, which shifts the AD curve to the right.

 The interest rate effect: When the price level falls, the central bank may lower interest rates in
order to stimulate the economy. Lower interest rates make it cheaper for businesses to borrow
money and invest, and for consumers to borrow money and buy goods and services. This also
shifts the AD curve to the right.

 The exchange rate effect: When the price level falls, domestic goods become more competitive
in international markets. This means that exports increase, and imports decrease. This net
increase in exports contributes to higher aggregate demand and shifts the AD curve to the right.

10. Why SRAS curve slopes upward?

 Sticky input prices: In the short run, some input prices, such as wages, are relatively inflexible.
This means that firms are unable to adjust their input costs immediately in response to changes
in output. As a result, when demand increases and firms produce more, they are forced to
accept higher prices for their inputs. This increase in input costs leads to a higher price level for
the goods and services they produce.

 Menu costs: Menu costs are the costs associated with changing prices. These costs can include
printing new menus, updating price tags, and informing customers of new prices. Because of
these costs, firms are often reluctant to change their prices frequently, even in response to
changes in demand. As a result, when demand increases and firms produce more, they may not
immediately raise their prices to the full extent of the increase in their input costs. This means
that the price level will rise, but not to the same extent as it would if input prices were perfectly
flexible.

11. Equilibrium at intersection of AD and AS curves.

In macroeconomics, the equilibrium at the intersection of the

aggregate demand (AD) and aggregate supply (AS) curves
represents a situation in which the total quantity of goods
and services demanded by consumers and businesses equals
the total quantity of goods and services produced and sold by
firms. This equilibrium point determines the prevailing price
level and quantity of output in the economy.

 The AD curve represents the total demand for goods and

services at a given price level. It is downward-sloping,
indicating that as the price level rises, the quantity of goods and services demanded decreases.
This is because higher prices reduce the purchasing power of consumers and businesses.
 The AS curve represents the total quantity of goods and services that firms are willing and able
to produce and sell at a given price level. It is upward-sloping, indicating that as the price level
rises, the quantity of goods and services supplied increases. This is because higher prices
incentivize firms to produce more goods and services.
The intersection of the AD and AS curves occurs at the price level and quantity that simultaneously
satisfy both demand and supply. At this equilibrium, firms are producing the quantity of goods and
services that consumers and businesses are willing to buy at the prevailing price level.
 Changes in either the AD or AS curve can lead to a shift in the equilibrium point. For instance, an
increase in aggregate demand, such as due to an increase in consumer spending, would shift the AD
curve to the right, causing the equilibrium price level to rise and the equilibrium quantity to increase.
Conversely, a decrease in aggregate supply, such as due to a rise in the cost of production, would
shift the AS curve to the left, causing the equilibrium price level to rise and the equilibrium quantity
to decrease.
The equilibrium at the intersection of the AD and AS curves is a crucial concept in macroeconomics,
as it provides a framework for understanding the determinants of macroeconomic stability and the
impact of various shocks on the economy.

12. Shift in AD-AS curves and change in equilibrium.

Shifts in the aggregate demand (AD) and aggregate supply (AS) curves can lead to changes in the
equilibrium point in the AD-AS model, which in turn affect the price level and output in the economy.

Shifts in the AD Curve

An increase in aggregate demand, represented by a rightward shift of the AD curve, can occur due to
various factors, such as:
 Increased consumer spending: A rise in consumer confidence or a decrease in interest rates can
lead to increased household spending, pushing the AD curve to the right.
 Increased investment: An expansionary fiscal policy, such as increased government spending or
tax cuts, can stimulate business investment, shifting the AD curve to the right.
 Net exports: An increase in exports or a decrease in imports, often due to changes in exchange
rates or economic conditions in foreign countries, can boost aggregate demand, shifting the AD
curve to the right.

Shifts in the AS Curve

An increase in aggregate supply, represented by a rightward shift of the AS curve, can occur due to
factors such as:
 Technological advancements: Improvements in production processes or the introduction of new
technologies can lower production costs, allowing firms to supply more goods and services at a
given price level, shifting the AS curve to the right.
 Favorable input prices: A decline in the cost of raw materials, labor, or other inputs can reduce
production costs, enabling firms to supply more goods and services at a given price level, shifting
the AS curve to the right.
 Government policies: Policies such as subsidies or tax breaks for businesses can reduce
production costs, leading to an increase in aggregate supply and a rightward shift of the AS
curve.

Impact of Shifts on Equilibrium

When the AD or AS curve shifts, the equilibrium point in the AD-AS model changes, resulting in a
new equilibrium price level and quantity of output.
A rightward shift of the AD curve, representing an increase in aggregate demand, leads to a higher
equilibrium price level and a higher equilibrium quantity of output. This is because the excess
demand at the original equilibrium point pushes prices upward, and firms respond to the higher
demand by producing more.
Conversely, a leftward shift of the AD curve, representing a decrease in aggregate demand, leads to a
lower equilibrium price level and a lower equilibrium quantity of output. This is because the excess
 supply at the original equilibrium point pushes prices downward, and firms respond to the reduced
demand by producing less.
Similarly, a rightward shift of the AS curve, representing an increase in aggregate supply, leads to a
lower equilibrium price level and a higher equilibrium quantity of output. This is because the excess
supply at the original equilibrium point pushes prices downward, and firms are willing to supply
more at the lower price level.
Conversely, a leftward shift of the AS curve, representing a decrease in aggregate supply, leads to a
higher equilibrium price level and a lower equilibrium quantity of output. This is because the excess
demand at the original equilibrium point pushes prices upward, and firms are able to produce less at
the higher price level.

13. Long run equilibrium with intersection of LRAS, SRAS and AD curves
In macroeconomics, long-run equilibrium refers to a situation in which the economy has reached a
stable state where all prices and wages have fully adjusted to the level of production and
employment. This equilibrium occurs at the intersection of three key curves: the long-run aggregate
supply (LRAS), the short-run aggregate supply (SRAS), and the aggregate demand (AD) curve.
Long-Run Aggregate Supply (LRAS)
The LRAS curve is a vertical line representing the economy's potential output. This is the maximum
level of output that the economy can produce when all factors of production are fully employed and
technology is at its most efficient level. In the long run, prices and wages are fully flexible, allowing
them to adjust to ensure that the economy operates at its potential output level.
Short-Run Aggregate Supply (SRAS)
The SRAS curve is upward-sloping, indicating that the quantity of goods and services supplied
increases with the price level in the short run. This is because firms may not be able to adjust their
production levels or input costs immediately in response to changes in demand. As a result, when
demand increases, firms may have to accept higher input prices and/or postpone price increases,
leading to a higher price level for the goods and services they produce.
Aggregate Demand (AD)
The AD curve is downward-sloping, indicating that the quantity of goods and services demanded
decreases with the price level. This is because a higher price level reduces the purchasing power of
consumers and businesses, causing them to demand less.
Intersection of LRAS, SRAS, and AD Curves
Long-run equilibrium occurs at the intersection of the LRAS, SRAS, and AD curves. This point
represents the price level and quantity of output that simultaneously satisfy both demand and
supply in the long run. At this equilibrium, the economy is producing at its potential output, and all
prices and wages have fully adjusted to ensure that the demand for goods and services equals the
supply.
Shifts in AD and SRAS
Changes in the AD or SRAS curve can cause the equilibrium point to shift, leading to changes in the
price level and output in the long run. For instance, an increase in aggregate demand, such as due to
an increase in consumer spending, would shift the AD curve to the right, causing the equilibrium
price level to rise and the equilibrium quantity to increase. Conversely, a decrease in aggregate
supply, such as due to a rise in the cost of production, would shift the SRAS curve to the left, causing
the equilibrium price level to rise and the equilibrium quantity to decrease.
Role of Long-Run Equilibrium
Long-run equilibrium is a crucial concept in macroeconomics because it provides a framework for
understanding the determinants of long-run economic growth and stability. By analyzing the factors
that can shift the LRAS, SRAS, and AD curves, policymakers can gain insights into how to promote
 long-term economic prosperity and minimize the occurrence of inflation, recession, and other
macroeconomic imbalances.

14. Change in short-run equilibrium by shift of AD or SRAS curves.

Shifts in the aggregate demand (AD) or short-run aggregate supply (SRAS) curves can lead to changes
in the short-run equilibrium in the AD-AS model. This, in turn, affects the price level and output in
the economy.
Shifts in the AD Curve An increase in aggregate demand, represented by a rightward shift of the
AD curve, can occur due to various factors, such as:
 Increased consumer spending: A rise in consumer confidence or a decrease in interest rates can
lead to increased household spending, pushing the AD curve to the right.
 Increased investment: An expansionary fiscal policy, such as increased government spending or
tax cuts, can stimulate business investment, shifting the AD curve to the right.
 Net exports: An increase in exports or a decrease in imports, often due to changes in exchange
rates or economic conditions in foreign countries, can boost aggregate demand, shifting the AD
curve to the right.
Conversely, a decrease in aggregate demand, represented by a leftward shift of the AD curve, can
result from factors such as:
 Decreased consumer spending: A decline in consumer confidence or an increase in
unemployment can lead to reduced household spending, pushing the AD curve to the left.
 Decreased investment: A contractionary fiscal policy, such as government spending cuts or tax
increases, can dampen business investment, shifting the AD curve to the left.
 Net exports: A decrease in exports or an increase in imports can reduce aggregate demand,
shifting the AD curve to the left.
Shifts in the SRAS Curve
An increase in aggregate supply, represented by a rightward shift of the SRAS curve, can occur due to
factors such as:
 Technological advancements: Improvements in production processes or the introduction of new
technologies can lower production costs, allowing firms to supply more goods and services at a
given price level, shifting the SRAS curve to the right.
 Favorable input prices: A decline in the cost of raw materials, labor, or other inputs can reduce
production costs, enabling firms to supply more goods and services at a given price level, shifting
the SRAS curve to the right.
 Government policies: Policies such as subsidies or tax breaks for businesses can reduce
production costs, leading to an increase in aggregate supply and a rightward shift of the SRAS
curve.
Conversely, a decrease in aggregate supply, represented by a leftward shift of the SRAS curve, can
result from factors such as:
 Technological disruptions: Natural disasters, technological setbacks, or other disruptions to
production can increase costs and reduce the quantity of goods and services firms can supply at
a given price level, shifting the SRAS curve to the left.
 Unfavourable input prices: Increases in the cost of raw materials, labor, or other inputs can raise
production costs, causing firms to supply less at a given price level, shifting the SRAS curve to the
left.
 Government policies: Policies such as increased taxes or regulations for businesses can increase
production costs, leading to a decrease in aggregate supply and a leftward shift of the SRAS
curve.
Impact of Shifts on Short-Run Equilibrium
 When the AD or SRAS curve shifts, the short-run equilibrium in the AD-AS model changes, resulting
in a new short-run equilibrium price level and quantity of output.
 A rightward shift of the AD curve, representing an increase in aggregate demand, leads to a
higher short-run equilibrium price level and a higher short-run equilibrium quantity of output.
This is because the excess demand at the original equilibrium point pushes prices upward, and
firms respond to the higher demand by producing more.
 Conversely, a leftward shift of the AD curve, representing a decrease in aggregate demand, leads
to a lower short-run equilibrium price level and a lower short-run equilibrium quantity of output.
This is because the excess supply at the original equilibrium point pushes prices downward, and
firms respond to the reduced demand by producing less.
15. Return to long-run equilibrium with (usually shift in AD) or without government intervention
(usually shift in SRAS).
The return to long-run equilibrium in the AD-AS model can occur through various mechanisms, with
or without government intervention. In general, long-run equilibrium is characterized by:
 Price flexibility: Prices and wages adjust fully to ensure that demand equals supply.
 Potential output: The economy produces at its maximum sustainable level of output.
 Full employment: All labour resources are utilized effectively.
Return with AD Shift
One way for the economy to return to long-run equilibrium is through a shift in the aggregate
demand (AD) curve. This can occur naturally over time as factors like consumer spending,
investment, and net exports adjust to their long-run trends. For instance, if an initial increase in
aggregate demand causes a short-run rise in prices, households and businesses may eventually adapt
their spending patterns and investment decisions to the new price level. This gradual adjustment in
AD would bring the economy back to its long-run equilibrium without requiring any government
intervention.
Return with SRAS Shift
Another mechanism for returning to long-run equilibrium involves a shift in the short-run aggregate
supply (SRAS) curve. This can happen if factors like technological advancements, input prices, or
government policies affect the cost of production and influence firms' willingness to supply goods
and services. For example, if an initial decrease in aggregate demand leads to a temporary decline in
prices, firms may respond by adopting new technologies or reducing their input costs to maintain
profitability. These adjustments in SRAS would gradually shift the curve back to its long-run position,
restoring equilibrium without government intervention.
Government Intervention
In some cases, government intervention may be necessary to facilitate the return to long-run
equilibrium. This is particularly relevant when the economy is experiencing persistent inflation or
unemployment. In such situations, policymakers can utilize fiscal or monetary policies to influence
aggregate demand or aggregate supply, nudging the economy back towards its long-run equilibrium.
For instance, expansionary fiscal policy, such as increased government spending or tax cuts, can
stimulate aggregate demand and help alleviate recessionary conditions. Conversely, contractionary
fiscal policy, such as government spending cuts or tax increases, can dampen aggregate demand and
help curb inflationary pressures.
Combination of Mechanisms
In reality, the return to long-run equilibrium often involves a combination of these mechanisms. The
economy may adjust naturally through shifts in AD or SRAS, while government intervention may play
a role in accelerating the process or mitigating the impact of shocks. The specific policies and actions
taken depend on the underlying economic conditions and the desired outcomes.
16. What is Multiplier? What is an investment multiplier? What is the govt expenditure multiplier?

In economics, a multiplier is a factor that amplifies the effect of an initial change in spending,
investment, or government expenditure on the overall level of economic activity. The multiplier
concept is based on the idea that when someone spends money, it sets off a chain reaction of
additional spending and economic activity.

Investment Multiplier
The investment multiplier specifically refers to the impact of an increase in investment on aggregate
demand and national income. When businesses invest in new capital goods, such as machinery,
equipment, or factories, they create demand for goods and services from other businesses. This
increased demand leads to an expansion of production, job creation, and increased incomes for
workers. The resulting increase in incomes further stimulates consumer spending, creating a ripple
effect throughout the economy.
The size of the investment multiplier depends on several factors, including:
 The marginal propensity to consume (MPC): The MPC is the proportion of additional income
that households consume rather than save. A higher MPC implies that a larger portion of the
increased income will be spent, further stimulating the economy.
 The marginal propensity to invest (MPI): The MPI is the proportion of additional income that
businesses invest rather than consume. A higher MPI implies that a larger portion of the
increased income will be reinvested in the economy, further fueling economic growth.
 The leakages from the economy: Leakages refer to the portion of income that is not spent or
invested within the domestic economy. Leakages include taxes, imports, and savings. A lower
level of leakages implies that more of the additional income remains within the economy to
circulate and generate further economic activity.
Government Expenditure Multiplier
The government expenditure multiplier refers to the impact of an increase in government spending
on aggregate demand and national income. When the government spends money on goods and
services, it directly creates demand for those goods and services. This increased demand, similar to
the investment multiplier, leads to a chain reaction of additional spending, production, job creation,
and increased incomes.
The size of the government expenditure multiplier also depends on the MPC and leakages. A higher
MPC and lower leakages will amplify the multiplier effect, leading to a greater increase in aggregate
demand and national income from an initial increase in government spending.
Policy Implications
The concept of multipliers has important implications for economic policy. Governments and
policymakers can utilize multipliers to stimulate economic growth or stabilize the economy during
times of recession or downturn. By increasing investment or government spending, they can
artificially boost aggregate demand and set off a chain reaction of economic activity.

17. Derivation of IS-LM curves.

The IS-LM model is a macroeconomic framework that combines the goods market (IS curve) and the
financial market (LM curve) to analyse the determinants of economic activity in the short run.
Derivation of the IS Curve
The IS curve represents the combinations of interest rates and output levels that satisfy equilibrium
in the goods market. This equilibrium occurs when aggregate demand (AD) equals aggregate supply
 (AS). AD is the total demand for goods and services in the economy, while AS is the total supply of
goods and services that firms are willing and able to produce and sell.
The IS curve is typically derived using the following equation:
Y = C + I(r) + G,
where:
 Y is the level of output (real GDP)
 C is consumption
 I(r) is investment, which is a function of the interest rate (r)
 G is government spending
This equation represents the aggregate demand function. The IS curve is obtained by plotting the
combinations of interest rates and output that satisfy this equation.

Derivation of the LM Curve

The LM curve represents the combinations of interest rates and output levels that satisfy equilibrium
in the financial market. This equilibrium occurs when the demand for money equals the supply of
money. The demand for money is the amount of money that households and businesses want to
hold, while the supply of money is determined by the central bank.
The LM curve is typically derived using the following equation:
M/P = L (r, Y),
where:
 M is the nominal money supply
 P is the price level
 L (r, Y) is the demand for money, which is a function of the interest rate (r) and output (Y)
This equation represents the money market equilibrium condition. The LM curve is obtained by
plotting the combinations of interest rates and output that satisfy this equation.
Intersection of the IS and LM Curves

The equilibrium in the IS-LM model occurs at the intersection of the IS and LM curves. This point
represents the interest rate and output level that simultaneously satisfy equilibrium in both the
goods and financial markets. At this equilibrium, AD equals AS, and the demand for money equals
the supply of money.
The IS-LM model is a simplified representation of the complex interactions in an economy, but it
provides a useful framework for understanding the determinants of macroeconomic equilibrium and
the impact of various shocks on the economy.

18. Liquidity trap.

A liquidity trap is a situation in an economy where interest rates are at or near zero, and monetary
policy is ineffective in stimulating economic growth. In this situation, people and businesses hold
onto cash rather than invest or spend it, even when interest rates are low, because they expect prices
to fall or because they fear adverse economic events. This excess demand for money drives down
interest rates to zero or close to zero, but the low interest rates do not stimulate investment or
spending.

1. Deflationary expectations: When people and businesses expect prices to fall, they are less likely
to spend money now, because they know that goods and services will be cheaper in the future.
This leads to a decrease in aggregate demand, which can push the economy into a recession.
 2. Excess liquidity: When there is an excess supply of money in the economy, people and
businesses have more cash than they need. This can lead to a situation where they are content
to hold onto their cash rather than invest or spend it, even when interest rates are low.

The existence of a liquidity trap can make it difficult for policymakers to stimulate the economy. In a
normal situation, the central bank can lower interest rates to stimulate borrowing and spending.
However, when interest rates are already at zero, the central bank has limited options.

There are a number of policy options that policymakers can consider to address a liquidity trap,
including:

 Fiscal policy: The government can increase spending or cut taxes to stimulate aggregate
demand.

 Quantitative easing (QE): The central bank can buy government bonds or other assets in
order to increase the money supply and lower interest rates.

 Unconventional monetary policy: The central bank can try other unconventional policy
measures, such as forward guidance or negative interest rates, to stimulate the economy.

19. Meaning and functions of money. Money multiplier. How commercial banks create credit (and
thereby money increase supply). Role of commercial banks.

Meaning and Functions of Money

Money is a medium of exchange that is widely accepted in the payment for goods and services. It is
also a unit of account, a means of storing value, and a standard of deferred payment.

The main functions of money are:

 Medium of exchange: Money is used to buy and sell goods and services. It is a convenient way to
avoid the barter system, where goods and services are exchanged directly for other goods and
services.

 Unit of account: Money is used to measure the value of goods and services. This allows us to
compare the prices of different goods and services and to make informed decisions about what
to buy.

 Means of storing value: Money can be stored and used at a later time to purchase goods and
services. This allows us to save money for future needs or for emergencies.

 Standard of deferred payment: Money is used to make payments in the future. This allows us to
buy goods and services now and pay for them later, such as when we take out a loan.

Money Multiplier

The money multiplier is the factor by which the money supply increases when a commercial bank
makes a loan or purchase. This is because the bank does not have to lend out all of its reserves when
it makes a loan. Instead, it can lend out a portion of its reserves and keep the rest as reserves. This
allows the bank to create new money, which increases the money supply.

The money multiplier is determined by the reserve requirement, which is the percentage of deposits
that banks are required to hold as reserves. The higher the reserve requirement, the lower the
money multiplier.
 How Commercial Banks Create Credit (and Thereby Money Increase Supply)

Commercial banks create credit (and thereby increase the money supply) by making loans and
purchases. When a bank makes a loan, it credits the borrower's account with the amount of the loan.
This creates a new deposit for the bank and increases the money supply.

Commercial banks also create credit when they purchase securities. When a bank purchases a
security, it pays for the security with a check. This check is deposited in the seller's account, which
creates a new deposit for the bank and increases the money supply.

The money supply is also increased by government spending and by foreign exchange operations.

Role of Commercial Banks

Commercial banks play a vital role in the economy. They provide a safe and convenient way for
people and businesses to save money. They also make loans to people and businesses, which helps
to stimulate economic growth.

In addition, commercial banks play a role in the transmission of monetary policy. When the central
bank increases or decreases the money supply, commercial banks respond by adjusting their lending
and borrowing practices. This can help to achieve the central bank's objectives of price stability and
economic growth.

20. Three reasons for demand for money --- Transaction, precautionary, and speculative.

The demand for money is a key concept in economics that refers to the desire of individuals and
businesses to hold money. There are three main reasons why people demand money:
o Transaction motive: The transaction motive is the most basic reason for holding money. People
need money to buy goods and services in the day-to-day transactions of life. This includes things
like groceries, rent, and transportation. The more transactions a person makes, the more money
they will need to hold.
 Precautionary motive: The precautionary motive is the desire to hold money for unexpected
expenses. This could include things like medical bills, car repairs, or job loss. The precautionary
motive is often driven by uncertainty about the future. People who are more uncertain about
their future income or expenses are more likely to hold precautionary balances.
 Speculative motive: The speculative motive is the desire to hold money in anticipation of future
changes in interest rates or exchange rates. For example, if someone expects interest rates to
rise, they may be more likely to hold money today so that they can invest it at a higher rate later.
Similarly, if someone expects the exchange rate to fall, they may be more likely to hold foreign
currency today so that they can buy it at a cheaper price later.

21. Business Cycles, government intervention in different phases to smooth business cycles. Business
strategies during business cycles.

Business Cycles

A business cycle is a series of alternating periods of expansion and contraction in economic activity.
During an expansion, the economy grows and unemployment falls. During a contraction, the
economy shrinks and unemployment rises. Business cycles are typically measured by the growth rate
of real gross domestic product (GDP).
 The causes of business cycles are complex and not fully understood. However, there are a number of
factors that are thought to contribute, including:

 Aggregate demand: Fluctuations in consumer spending, business investment, and government

spending can all affect the overall level of economic activity.

 Aggregate supply: Changes in technology, input costs, and government policies can affect the
cost of production and the willingness of firms to supply goods and services.

 External shocks: Events such as wars, natural disasters, and financial crises can have a significant
impact on the global economy and can trigger business cycles.

Government Intervention in Different Phases to Smooth Business Cycles

Governments can intervene in the economy to try to smooth out business cycles. During a recession,
the government can use expansionary fiscal policy to stimulate economic activity. This can involve
increasing government spending, cutting taxes, or both. The government can also use expansionary
monetary policy to lower interest rates and encourage borrowing and spending.

During an expansion, the government can use contractionary fiscal policy to reduce economic
activity. This can involve decreasing government spending, raising taxes, or both. The government
can also use contractionary monetary policy to raise interest rates and discourage borrowing and
spending.

The goal of government intervention is to promote economic stability and minimize the severity of
business cycles. However, policymakers must be careful not to overstimulate the economy, which can
lead to inflation, or to over-contract the economy, which can make the recession worse.

Business Strategies During Business Cycles

Businesses can also adopt a variety of strategies to cope with the ups and downs of the business
cycle. During a recession, businesses may focus on cost-cutting measures, such as layoffs, reduced
investment, and price cuts. They may also try to develop new products or services that are more
appealing to consumers in a downturn.

During an expansion, businesses may focus on expanding their operations, investing in new
technologies, and hiring more workers. They may also try to raise prices to take advantage of
increased consumer demand.

The specific strategies that businesses use will vary depending on their industry, their size, and their
financial position. However, all businesses need to be aware of the business cycle and take steps to
protect themselves from its effects.

22. Monetary policy .Central Bank’s instruments of monetary policy.

Monetary policy is a set of actions taken by a central bank to influence the availability and cost of
money and credit in the economy. The goal of monetary policy is to promote price stability, full
employment, and economic growth.

There are three main types of monetary policy tools:

1. Open market operations: Open market operations involve the buying and selling of government
securities by the central bank. When the central bank buys government securities, it injects
 money into the economy, which lowers interest rates. When the central bank sells government
securities, it absorbs money from the economy, which raises interest rates.

2. Reserve requirements: Reserve requirements are the percentage of deposits that commercial
banks are required to hold as reserves. When the central bank increases reserve requirements, it
reduces the amount of money that commercial banks have available to lend, which raises
interest rates. When the central bank decreases reserve requirements, it increases the amount
of money that commercial banks have available to lend, which lowers interest rates.

3. Discount rate: The discount rate is the interest rate that commercial banks borrow from the
central bank. When the central bank increases the discount rate, it becomes more expensive for
commercial banks to borrow money, which raises interest rates. When the central bank
decreases the discount rate, it becomes less expensive for commercial banks to borrow money,
which lowers interest rates.

In addition to these three main tools, central banks may also use other tools, such as forward
guidance and quantitative easing, to influence the economy.

Central banks typically use monetary policy to achieve the following objectives:

 Price stability: This means keeping inflation low and stable. Inflation is the rate at which prices
for goods and services are rising, and it can be a major problem for an economy.

 Full employment: This means keeping unemployment low. Unemployment is the rate of people
who are able and willing to work but are unable to find a job.

 Economic growth: This means increasing the total output of goods and services in the economy.
Economic growth is necessary to raise living standards and improve the quality of life for people.

Monetary policy is a powerful tool, but it can also be difficult to use effectively. Central banks must
be careful not to overstimulate the economy, which can lead to inflation, or to over-contract the
economy, which can make the recession worse.

23. Fiscal policy

o Crowding-out and crowding-in by government expenditures (fiscal deficit).
o Objectives and tools of fiscal policy.

Crowding-out and crowding-in are two opposing economic concepts related to the impact of
government expenditures on private investment and consumption.

Crowding-out occurs when an increase in government spending or a fiscal deficit leads to higher
interest rates, which can discourage private investment and consumption. This happens because the
government competes with private borrowers for funds in the financial markets. As the government
borrows more, the supply of funds available to private borrowers decreases, pushing up interest
rates. Higher interest rates can make borrowing more expensive for businesses and individuals,
potentially reducing their investment and spending decisions.

Crowding-in, on the other hand, occurs when an increase in government spending or a fiscal deficit
stimulates private investment and consumption. This can happen if the government's spending is
directed towards productive activities that generate economic growth and create jobs. The increased
economic activity and employment can lead to higher incomes and consumer spending, further
boosting demand and economic growth.
 The relative dominance of crowding-out or crowding-in depends on various economic factors,
including:

 The size and composition of the fiscal deficit: A larger fiscal deficit is more likely to lead to
crowding-out, as the government's demand for funds increases more significantly. The
composition of the fiscal deficit also matters, with spending on productive infrastructure and
education more likely to have a crowding-in effect than spending on consumption or subsidies.

 The state of the economy: In a period of economic downturn, government spending may have a
more pronounced crowding-in effect, as it can help stimulate aggregate demand and revive
economic activity. However, in a period of economic boom, government spending may be more
likely to lead to crowding-out, as the economy is already operating near its full capacity and
additional spending may put upward pressure on interest rates.

 The efficiency of financial markets: Well-functioning financial markets can facilitate the transfer
of funds between the government and private borrowers without causing significant interest rate
increases. This can reduce the crowding-out effect and allow government spending to have a
more stimulatory impact on the economy.

Objectives and Tools of Fiscal Policy

Fiscal policy is a set of actions taken by the government to influence the economy through its
spending and taxation decisions. The primary objectives of fiscal policy are to:

 Stabilize the economy: This involves managing aggregate demand to prevent economic
fluctuations, such as recessions and expansions.

 Promote economic growth: This involves encouraging investment, innovation, and

productivity to increase the economy's potential output.

 Redistribute income and wealth: This involves using taxes and transfers to reduce income
and wealth inequality and address social welfare concerns.

The main tools of fiscal policy are:

1. Government spending:

2. Taxation

3. Transfer payments:

4. Debt issuance

24. Types of unemployment?

Unemployment occurs when individuals who are able and willing to work are unable to find a job.
There are several different types of unemployment, each with its own causes and characteristics.

1. Frictional unemployment:

Frictional unemployment is the type of unemployment that results from the natural process of
individuals moving between jobs. It is caused by factors such as:
 Time to search for a new job: It takes time for individuals to find a new job that is a good fit for
their skills and experience.

 Locational mismatch: There may not be a job opening that is a good fit for an individual's skills
and experience in their current location.

 Skill mismatch: An individual's skills may not be in demand in their current location or industry.

Frictional unemployment is considered to be a natural and unavoidable part of the economy. It is

typically temporary and does not indicate any underlying problems with the economy.

2. Structural unemployment:

Structural unemployment occurs when there is a mismatch between the skills and experience of
workers and the demands of the labor market. This mismatch can be caused by factors such as:

 Technological change: Technological advancements can make some jobs obsolete and require
workers to acquire new skills.

 Globalization: Globalization can lead to job losses in certain industries as businesses move
production overseas.

 Shifts in consumer demand: Changes in consumer preferences can lead to a decline in demand
for certain goods and services, resulting in job losses in those industries.

Structural unemployment is typically more persistent than frictional unemployment and can be more
difficult to address. It may require retraining programs or other initiatives to help workers adapt to
the changing demands of the labor market.

3. Cyclical unemployment:

Cyclical unemployment occurs when there is a general downturn in economic activity. This can be
caused by factors such as:

 Recession: A recession is a period of economic decline characterized by decreased spending,

investment, and employment.

 Economic shocks: Events such as wars, natural disasters, or financial crises can lead to a
sudden and sharp decline in economic activity.

Cyclical unemployment is typically temporary and will decline as the economy recovers. However, it
can have a significant impact on workers and families.

4. Seasonal unemployment:

Seasonal unemployment occurs in industries that are affected by the seasons, such as agriculture,
tourism, and construction. It typically occurs during off-seasons when there is less demand for goods
and services in those industries. Seasonal unemployment is typically temporary and does not have a
significant impact on overall unemployment rates.

5. Underemployment:

Underemployment occurs when individuals are working in jobs that do not fully utilize their skills and
experience. This can lead to lower wages and less satisfaction with their jobs.

6. Discouraged worker:
 Discouraged workers are individuals who have given up looking for a job because they believe they
will not be able to find one. They are considered to be part of the labor force but are not actively
seeking employment.

Understanding the different types of unemployment is important for developing effective policies to
address the problem of unemployment and promote economic growth.

25. Demand-pull vs cost-push inflation?

Demand-pull inflation and cost-push inflation are two types of inflation that occur due to different
causes.

Demand-pull inflation occurs when the overall demand for goods and services in an economy
exceeds the overall supply. This can happen for a number of reasons, such as:

 An increase in consumer spending: If consumers have more money to spend, they will demand
more goods and services. This can drive up prices, as businesses try to meet the increased
demand.

 An increase in investment: If businesses invest more money in new equipment and factories,
they will create more demand for goods and services. This can also drive up prices.

 An increase in government spending: If the government spends more money on goods and
services, this will also increase demand and can lead to inflation.

Cost-push inflation occurs when the cost of production for goods and services increases. This can
happen for a number of reasons, such as:

 An increase in the price of raw materials: If businesses have to pay more for the raw materials
they use to produce goods, they will likely raise their prices to cover the increased costs.

 An increase in labor costs: If wages increase, businesses will have to pay more for their workers.
This can also lead to higher prices for goods and services.

 An increase in other input costs: Businesses may also experience cost increases from other
factors, such as transportation costs, rent, or utilities. These increased costs can also be passed
on to consumers in the form of higher prices.

The type of inflation that occurs in an economy can have a significant impact on the overall economy.
Demand-pull inflation is typically considered to be a more desirable type of inflation, as it can lead to
economic growth and job creation. However, if demand-pull inflation is not carefully managed, it can
lead to overheating and eventually stagflation.

Cost-push inflation, on the other hand, can be more difficult to control and can lead to a
stagflationary environment, characterized by high unemployment and high inflation.

Central banks typically use a variety of policy tools, such as monetary policy and fiscal policy, to try to
control inflation and maintain price stability. The specific policy mix that is used will depend on the
type of inflation that is occurring and the overall economic conditions.

26. Effects of inflation on economy and society?

 Inflation is the general increase in prices and fall in the purchasing value of money. It is a significant
phenomenon that affects various aspects of the economy and society. Here's a comprehensive
overview of the effects of inflation on economy and society:

Economic Effects of Inflation

Inflation can have both positive and negative impacts on the economy. Some of the key economic
effects of inflation include:

 Erosion of purchasing power: Inflation erodes the purchasing power of money, meaning that a
fixed amount of money can buy fewer goods and services over time. This can put a strain on
household budgets, particularly for low-income households.

 Uncertainty and instability: Inflation can create uncertainty and instability in the economy,
making it difficult for businesses to plan for the future and for consumers to make informed
purchasing decisions. This uncertainty can discourage investment and economic growth.

 Redistribution of wealth: Inflation can lead to a redistribution of wealth from lenders to

borrowers. This is because borrowers repay loans with money that has less purchasing power
than the money they borrowed.

 Impact on interest rates: Inflation can influence interest rates, which are the costs of borrowing
money. Central banks often raise interest rates to combat inflation, which can make borrowing
more expensive and slow down economic growth.

Social Effects of Inflation

Inflation can also have significant social consequences, particularly for vulnerable groups in society.
Some of the social effects of inflation include:

 Increased poverty: Inflation can increase poverty rates, as low-income households are more
likely to spend a larger portion of their income on essential goods and services, leaving less
money for other needs.

 Social unrest: Inflation can lead to social unrest and protests, as people become frustrated with
the rising cost of living and the erosion of their purchasing power.

 Erosion of savings: Inflation can erode the value of savings, making it difficult for people to save
for retirement or other long-term goals.

 Impact on education and healthcare: Inflation can strain budgets for education and healthcare,
making it more difficult for families to access quality education and healthcare services.

27. What is Phillips curve?

The Phillips curve is an economic concept

that describes the relationship between
inflation and unemployment. It was
developed by A.W. Phillips in 1958, who
 noticed an inverse relationship between the two variables. This means that as inflation increases,
unemployment decreases, and vice versa.

The Phillips curve is typically represented as a downward-sloping curve, with inflation on the vertical
axis and unemployment on the horizontal axis. This suggests that policymakers can trade off
between higher inflation and lower unemployment, or vice versa.

Despite its limitations, the Phillips curve remains a useful tool for understanding the relationship
between inflation and unemployment. It can also be used to guide policymakers in their decisions
about how to manage the economy.

Here are some of the factors that can affect the Phillips curve:

 Expectations: People's expectations about future inflation can affect the actual rate of inflation.
If people expect inflation to be high, they may demand higher wages, which can drive up prices.

 Technology: Technological advancements can lead to productivity gains, which can help to
reduce inflation.

 Globalization: Globalization can increase competition in the labor market, which can help to
keep wages down and reduce inflation.

 Government policy: Government policies, such as monetary policy and fiscal policy, can also
affect the Phillips curve. For example, expansionary monetary policy can stimulate economic
growth but also lead to higher inflation.

28. Balance of Payment and Balance of Trade?

The balance of payments (BoP) and balance of trade (BoT) are both important economic indicators
that measure the flow of money into and out of a country. However, they are distinct concepts with
different focuses.

Balance of Payments

The balance of payments is a broader measure that tracks all economic transactions between a
country and the rest of the world over a specific period, typically a year. It includes current account
transactions, which involve the exchange of goods and services, investment income, and transfers, as
well as capital and financial account transactions, which involve the movement of assets and
liabilities. The BoP is a record of all payments and receipts, and it must always balance to zero.

The BoP is divided into two main accounts:

 Current account: The current account records the flow of goods and services, investment
income, and transfers between a country and the rest of the world. A current account surplus
indicates that a country is exporting more than it is importing, while a current account deficit
indicates that a country is importing more than it is exporting.

 Capital and financial account: The capital and financial account records the movement of assets
and liabilities between a country and the rest of the world. This includes foreign direct
investment, portfolio investment, and other capital inflows and outflows.

Balance of Trade
 The balance of trade is a narrower measure that focuses specifically on the trade of goods and
services between a country and the rest of the world. It is calculated by subtracting the value of
imports from the value of exports. A trade surplus indicates that a country is exporting more goods
and services than it is importing, while a trade deficit indicates that a country is importing more
goods and services than it is exporting.

The BoT is a component of the current account. When the BoT is positive, it contributes to a current
account surplus. When the BoT is negative, it contributes to a current account deficit.

The key differences between the balance of payments and the balance of trade are:

 Scope: The BoP is a broader measure that includes all economic transactions between a country
and the rest of the world, while the BoT is a narrower measure that focuses specifically on the
trade of goods and services.

 Components: The BoP is divided into two main accounts: the current account and the capital and
financial account. The BoT is a component of the current account.

 Interpretation: A BoP surplus or deficit indicates the overall health of a country's economy, while
a BoT surplus or deficit indicates the country's trade performance.

29. How is foreign exchange rate determined by interaction of demand and supply in the foreign
exchange market.
o Fixed and flexible exchange rate systems?

The foreign exchange (FX) market is a global marketplace where currencies are bought and sold. The
exchange rate is the price of one currency in terms of another. For example, the exchange rate
between the US dollar (USD) and the euro (EUR) might be 1.20 USD/EUR, which means that it costs
1.20 USD to buy 1 EUR.

The exchange rate is determined by the interaction of supply and demand in the FX market. Just like
any other price, the exchange rate will adjust until the quantity of currency demanded equals the
quantity of currency supplied.

Demand for Foreign Currency

The demand for foreign currency comes from a variety of sources, including:

 Importers: Importers need foreign currency to pay for goods and services they import from
other countries.

 Investors: Investors may buy foreign currency to invest in foreign stocks, bonds, or real estate.

 Tourists: Tourists need foreign currency to travel to and spend money in other countries.

 Central banks: Central banks may buy foreign currency to intervene in the FX market and
influence the exchange rate.

Supply of Foreign Currency

The supply of foreign currency comes from a variety of sources, including:

 Exporters: Exporters earn foreign currency from the sale of goods and services to other
countries.

 Investors: Investors may sell foreign currency to repatriate profits from foreign investments.

 Tourists: Tourists sell foreign currency when they return home.

 Central banks: Central banks may sell foreign currency to intervene in the FX market and
influence the exchange rate.

Exchange Rate Adjustments

When the demand for a currency exceeds the supply, the currency will appreciate in value, meaning
that the exchange rate will rise. Conversely, when the supply of a currency exceeds the demand, the
currency will depreciate in value, meaning that the exchange rate will fall.

o Fixed Exchange Rate Systems

In a fixed exchange rate system, the government or a central bank sets a fixed exchange rate
between the domestic currency and one or more foreign currencies. The government or central bank
then intervenes in the FX market to buy or sell foreign currency as needed to maintain the fixed
exchange rate.

Fixed exchange rate systems can provide stability and predictability for businesses and consumers,
but they can also be difficult to maintain, especially during periods of economic turmoil. If the fixed
exchange rate is not set at an appropriate level, it can lead to imbalances in the economy and make it
difficult for the government to pursue its monetary policy goals.

o Flexible Exchange Rate Systems

In a flexible exchange rate system, the exchange rate is determined by the interaction of supply and
demand in the FX market. The government or central bank does not intervene in the FX market to
maintain a fixed exchange rate.

Flexible exchange rate systems can provide more flexibility for the government to pursue its
monetary policy goals, but they can also be more volatile than fixed exchange rate systems. This
volatility can make it more difficult for businesses and consumers to plan for the future.

The choice of exchange rate regime is a complex one that depends on a variety of factors, including
the country's economic conditions, its political goals, and its level of integration with the global
economy.