BECC-103 : INTRODUCTORY MACROECONOMICS

Course Code: BECC-103

Assignment Code: ASST/BECC 103/ 2023-24
Total Marks: 100
Assignment I

Answer the following Descriptive Category Questions in about 500 words each. Each question
carries 20 marks. Word limit does not apply in the case of numerical questions. 2x20=40

1) Point out the salient features of classical approach to macroeconomics, Why did 1t fail to explain
the Great Depression? What are the changes suggested by Keynes to the classical approach?

2) What are the objectives of monetary policy? In order to achieve these objectives, what are the
policy instruments adopted by the Central Bank?

Assignment 11

Answer the following Middle Category Questions in about 250 words each. Each question
carries 10 marks. Word limit does not apply in the case of numerical questions. 3x10=30

3) In the IS-LM model, why does an economy move towards equilibrium if it is in disequilibrium?
Explain. Use appropriate diagram to substantiate your answer.

4) Explain how equilibrium level of output is determined in the Keynesian model.

5) Give a brief account of the demand for money in the Keynesian system.
Assignment 111

Answer the following Short Category Questions in about 100 words each. Each question carries
6 marks. 5x6=30

6) Describe the impact of inflation on various segments of society.

7) For a three sector economy the following is given:
C =50+ 0.75Y,1=30,G=20
where C = consumption, I = investment, and G = government expenditure.
Find out the equilibrium output level.

8) Define investment multiplier. What are its limitations?

9) Write a short note on the various types of inflation in an economy.

10} Write a short note on the function of money in an economy.

 BECC-103: INTRODUCTORY
MACROECONOMICS

Course Code: BECC-103

Assignment Code: ASST/BECC 103/ 2023-24
Total Marks: 100

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Assignment I
Answer the following Descriptive Category Questions in about 500 words each.
Each question carries 20 marks. Word limit does not apply in the case of
numerical questions.

1) Point out the salient features of classical approach to macroeconomics. Why

did it fail to explain the Great Depression? What are the changes suggested by
Keynes to the classical approach?

The classical approach to macroeconomics, which was dominant before the Great
Depression, had several salient features. These features include the belief in Say's
Law, the assumption of flexible prices and wages, and the emphasis on the role of
aggregate supply in determining output and employment.

1. Say's Law: The classical economists believed in Say's Law, which states that
supply creates its own demand. According to this law, the production of goods
and services generates income, which in turn creates the demand for those
goods and services. Therefore, there can never be a general overproduction or
lack of demand in the economy.
Flexible prices and wages: The classical economists assumed that prices and
wages were flexible and adjusted quickly to changes in supply and demand.
They believed that any imbalances in the economy would be self-correcting
through price adjustments. For example, if there was excess supply in the
labour market, wages would decrease, leading to increased employment and
equilibrium.
Aggregate supply-driven: The classical approach emphasized the role of
aggregate supply in determining output and employment. They argued that the

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 factors of production, such as labor and capital, determined the economy's
productive capacity. Changes in aggregate demand, according to the classical
economists, would only lead to short-run fluctuations but not long-run changes
in output and employment.

However, the classical approach failed to explain the Great Depression for several
reasons:

1. Inability to account for aggregate demand: The classical approach did not
adequately consider the role of aggregate demand in the economy. It assumed
that any imbalances would be self-correcting through price adjustments.
However, during the Great Depression, there was a significant decrease in
aggregate demand, which could not be resolved through price adjustments
alone.

. Wage and price stickiness: The classical approach assumed that prices and
wages would adjust quickly to changes in supply and demand. However,
during the Great Depression, wages and prices were sticky, meaning they did
not adjust downward as quickly as the classical economists assumed. This
stickiness further exacerbated the decline in aggregate demand and prolonged
the economic downturn.

3. Lack of government intervention: The classical approach favoured limited

government intervention in the economy. They believed that markets would
naturally adjust and restore equilibrium. However, during the Great
Depression, this hands-off approach proved ineffective, as market forces alone
were not sufficient to restore economic stability and stimulate aggregate
demand.

John Maynard Keynes proposed significant changes to the classical approach in his
seminal work, "The General Theory of Employment, Interest, and Money." Some of
the key changes suggested by Keynes are:

1. Importance of aggregate demand: Keynes argued that aggregate demand

plays a crucial role in determining output and employment. He highlighted the
possibility of persistent involuntary unemployment due to insufficient
aggregate demand. According to Keynes, the level of aggregate demand should
be actively managed by policymakers to ensure full employment and economic
stability.

. Role of government intervention: Keynes advocated for active government

intervention to stabilize the economy. He argued that during economic
downturns, the government should increase its spending and/or reduce taxes to
stimulate aggregate demand. By doing so, the government could offset the
decline in private spending and restore economic growth.

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3. Sticky wages and prices: Unlike the classical economists, Keynes recognized
the stickiness of wages and prices. He argued that in the face of declining
aggregate demand, wages and prices might not adjust downward quickly
enough to restore equilibrium. This could lead to a prolonged period of
unemployment and economic stagnation. Keynes suggested that government
policies should focus on directly increasing aggregate demand to overcome this
problem.

Liquidity preference and interest rates: Keynes introduced the concept of

liquidity preference, which refers to individuals' desire to hold money rather
than invest it. He argued that the interest rate was a key determinant of
investment decisions and that changes in interest rates could influence
aggregate demand. Keynes suggested that the central bank should actively
manage interest rates to stimulate investment and aggregate demand.

Saving and investment: Keynes emphasized the role of saving and investment
in determining aggregate demand. He argued that saving and investment were
not always in equilibrium, leading to fluctuations in economic activity. Keynes
suggested that government policies should aim to bring saving and investment
into balance to achieve full employment and economic stability.

Role of expectations: Keynes recognized the importance of expectations in

shaping economic behavior. He argued that pessimistic expectations could lead
to a decline in investment and aggregate demand, further exacerbating
economic downturns. To address this, Keynes suggested that the government
should actively manage expectations through communication and policy
measures to restore confidence and stimulate economic activity.

Multiplier effect: Keynes introduced the concept of the multiplier effect,

which refers to the magnification of changes in autonomous spending
throughout the economy. He argued that increases in government spending or
investment could have a multiplier effect, leading to a larger overall increase in
aggregate demand. This concept highlighted the potential effectiveness of fiscal
policy in stimulating economic growth and reducing unemployment.

Active fiscal policy: Keynes advocated for active fiscal policy, where the
government adjusts its spending and taxation policies to stabilize the economy.
During periods of economic downturn, Keynes recommended increasing
government spending and reducing taxes to boost aggregate demand.
Conversely, during times of inflationary pressure, he suggested reducing
government spending and increasing taxes to cool down the economy.

Importance of employment: Keynes emphasized the significance of

employment as a central economic objective. He believed that maintaining full
employment was essential for societal well-being and economic stability.
Keynes challenged the classical view that unemployment was a result of

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 voluntary choices or market inefficiencies, asserting that it could persist due to
inadequate aggregate demand.

The changes suggested by Keynes to the classical approach represented a departure

from the laissez-faire economic policies of the time. Keynes argued for active
government intervention to stabilize the economy, manage aggregate demand, address
wage and price stickiness, and promote full employment. His ideas laid the foundation
for Keynesian economics, which had a significant influence on economic theory and
policy in the post-Great Depression era.

2) What are the objectives of monetary policy? In order to achieve these

objectives, what are the policy instruments adopted by the Central Bank?
The objectives of monetary policy are to achieve and maintain price stability, promote
sustainable economic growth, and ensure financial stability. Central banks, such as the
Federal Reserve (Fed) in the United States, the European Central Bank (ECB), and the
Bank of Japan (BOJ), use various policy instruments to pursue these objectives.

1. Price stability: Price stability is a primary objective of monetary policy. It

refers to maintaining low and stable inflation over the medium to long term.
Price stability promotes economic etficiency, facilitates effective planning and
investment decisions, and preserves the purchasing power of money. Central
banks aim to keep inflation within a target range determined by their respective
monetary policy frameworks.

. Economic growth: Monetary policy also aims to promote sustainable

economic growth. Central banks strive to create an environment conducive to
strong and stable economic expansion by influencing borrowing costs,
stimulating investment and consumption, and ensuring adequate availability of
credit. The objective is to foster a favorable economic environment that
supports job creation, income growth, and overall prosperity.

Financial stability: Central banks are tasked with maintaining financial

stability, which involves ensuring the smooth functioning of financial systems,
minimizing systemic risks, and safeguarding the integrity of the banking and
financial sectors. Central banks monitor and respond to risks associated with
excessive leverage, asset price bubbles, and disruptions in financial markets.
They employ policy tools to mitigate systemic risks and promote the soundness
and stability of the financial system.

To achieve these objectives, central banks employ several policy instruments:

1. Open Market Operations (OMO): Open Market Operations involve buying

or selling government securities (bonds) in the open market. When the central
bank buys government bonds, it injects liquidity into the banking system,
thereby increasing the money supply and reducing interest rates. Conversely,
when the central bank sells government bonds, it absorbs liquidity from the

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system, reducing the money supply and increasing interest rates. OMO is a
primary tool used by central banks to manage short-term interest rates and
control the overall money supply.

Reserve Requirements: Central banks mandate that commercial banks

maintain a certain percentage of their deposits as reserves. By adjusting reserve
requirements, central banks can influence the amount of funds that banks can
lend and the overall money supply. Lowering reserve requirements allows
banks to lend more, stimulating economic activity, while raising reserve
requirements restricts lending and reduces money supply growth.

Discount Window Lending: Central banks provide short-term loans to

commercial banks through their discount windows. This lending facility allows
banks to borrow funds from the central bank to meet liquidity needs. By
adjusting the interest rate charged on these loans, the central bank can
encourage or discourage banks from accessing this source of liquidity.
Discount window lending supports financial stability and helps manage short-
term liquidity shocks in the banking system.

Interest Rate Policy: Central banks set and adjust benchmark interest rates to
influence borrowing costs, credit availability, and overall economic activity.
The central bank's policy rate serves as a reference for other interest rates in the
economy, such as commercial lending rates and mortgage rates. By raising or
lowering the policy rate, central banks can encourage or discourage borrowing
and spending, affecting investment, consumption, and inflationary pressures.

Forward Guidance: Central banks provide forward guidance by

communicating their intended policy actions and expectations regarding future
economic conditions. By providing clarity and signaling their future policy
intentions, central banks influence market expectations and guide the behavior
of financial market participants. Forward guidance helps manage market
volatility, anchors interest rate expectations, and supports policy effectiveness.
Quantitative Kasing (QE): In exceptional circumstances, such as during
financial crises or periods of severe economic downturns, central banks may
implement quantitative easing. QE involves the purchase of long-term
government bonds or other assets from the market, injecting substantial
liquidity into the economy. This unconventional policy tool aims to lower long-
term interest rates, stimulate investment and lending, and support economic
recovery.

Macroprudential Tools: Central banks may employ macroprudential tools to

address specific risks in the financial system. These tools focus on the stability
of the financial system as a whole and aim to mitigate systemic risks. Examples
include setting limits on loan-to-value ratios, debt-to-income ratios, or capital

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 requirements for banks. By using macroprudential tools, central banks aim to
prevent excessive risk-taking and maintain financial stability.

Capital Controls: In some cases, central banks may implement capital

controls as a policy instrument. Capital controls involve imposing restrictions
on cross-border capital flows, such as limits on foreign exchange transactions,
capital outflows, or foreign investment. These measures aim to manage
financial vulnerabilities, stabilize exchange rates, or protect domestic
industries. Capital controls are typically used in exceptional circumstances and
are subject to specific economic and policy considerations.

Communication and Transparency: Central banks must prioritize

communication and transparency as two of their most important tools. The
ability to communicate decisions, objectives, and economic outlooks about
monetary policy in a way that 1s both clear and effective helps set market
expectations and anchors public confidence. In order to explain their policy
stance and offer direction to market participants, enterprises, and members of
the general public, officials from central banks frequently give speeches, host
press conferences, and publish reports.

It is essential to keep in mind that the specific policy instruments and the extent to
which they are successful can differ between central banks and the monetary policy
frameworks that each employs. The selection of instruments is determined by a
number of different considerations, including the mandate of the central bank, the
current state of the economy, the structure of the financial market, and the overall
policy framework.

In order to accomplish their goals of price stability, sustainable economic growth, and
financial stability, central banks use a combination of these policy instruments to
guide monetary policy. The precise mix and calibration of these instruments are
determined by regular evaluations of the state of the economy, the dynamics of the
market, and the policy framework that is in place at the central bank. The ability of
central banks to influence interest rates, manage liquidity, control the money supply,
and promote economic circumstances that are stable is made possible by effective
coordination and application of these instruments.

Assignment 11

Answer the following Middle Category Questions in about 250 words each. Each
question carries 10 marks. Word limit does not apply in the case of numerical
questions.

3) In the IS-ILM model, why does an economy move towards equilibrium if it is in

disequilibrium? Explain. Use appropriate diagram to substantiate your answer.
The IS-LM model is a macroeconomic framework that combines the goods market
(IS) and the money market (LM) to analyze the equilibrium level of output and

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interest rates in an economy. When an economy is in a state of disequilibrium,
meaning that the actual output and interest rates differ from the equilibrium levels,
certain adjustments occur that drive the economy towards equilibrium. In this
response, [ will explain the forces at play and use a diagram to illustrate the process.

In the IS-LM model, the IS curve represents the equilibrium in the goods market and
shows the combinations of output (Y) and interest rates (r) that bring about a balance
between aggregate demand (AD) and output. The LM curve represents the equilibrium
in the money market and shows the combinations of output and interest rates that
bring about a balance between money supply (MS) and money demand (MD).

When an economy is in disequilibrium, it means that either the output or the interest
rate (or both) deviates from their equilibrium levels. Let's consider two scenarios:

1. Disequilibrium in the goods market:

Suppose that the actual output is below the equilibrium level. In this case, the
aggregate demand is less than the output produced by firms. As a result, inventories
start to accumulate, indicating that firms are producing more than what 1s being
demanded. To reduce their inventories, firms cut back on production. This reduction
in production leads to a decrease in income, which in turn reduces consumption
expenditure.

In the IS-LM diagram, this adjustment can be illustrated as a movement along the IS
curve towards the equilibrium point. As output decreases, the new combination of
output and interest rates brings about an increase in aggregate demand, which helps
restore equilibrium in the goods market.

2. Disequilibrium in the money market:

Suppose that the actual interest rate 1s above the equilibrium level. In this case, the
money supply exceeds the money demand. As a result, individuals and firms have
more money than they desire to hold. To adjust their portfolios, they start to invest the
excess money in interest-bearing assets such as bonds. This increased demand for
bonds drives up their prices and lowers their yields (interest rates).

In the IS-LLM diagram, this adjustment can be shown as a movement along the LM
curve towards the equilibrium point. As interest rates decrease, the new combination
of output and mterest rates brings about an increase in investment expenditure, which
helps restore equilibrium in the money market.

The adjustment process described above is known as the "IS-LM adjustment

mechanism." It highlights the interplay between the goods market and the money
market in driving an economy towards equilibrium. The adjustment mechanism works
in a continuous cycle until equilibrium is achieved in both markets.

To summarize the adjustment process in the IS-LM model:

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 1. Disequilibrium in the goods market leads to adjustments in production and
income, which influence consumption and aggregate demand.

Disequilibrium in the money market leads to adjustments in interest rates,

which influence investment and money demand.

These adjustments occur through movements along the IS and LM curves in

the IS-LLM diagram.

. The adjustments in both markets continue until output and interest rates reach
their equilibrium levels, where aggregate demand equals output and money
supply equals money demand.

It's important to note that the IS-LM model provides a simplified representation of the
economy and does not capture all real-world complexities. Nevertheless, it serves as a
useful tool for understanding the general forces at play in driving an economy towards
equilibrium when it is in a state of disequilibrium.

In conclusion, the IS-LM model demonstrates how an economy moves towards

equilibrium when it is in a state of disequilibrium. Through adjustments in the goods
market and the money market, the economy experiences changes in output, income,
Interest rates, consumption, and investment, ultimately working towards the
restoration of equilibrium. The IS-LLM adjustment mechanism, depicted in the IS-LM
diagram, highlights the interaction between these markets and illustrates the process of
adjustment.

4) Explain how cquilibrium level of output is determined in the Keynesian model.

In the Keynesian model, the equilibrium level of output is determined by the

intersection of aggregate demand (AD) and aggregate supply (AS). This model
focuses on the short run and emphasizes the role of aggregate demand in influencing
output and employment levels in the economy. In this response, I will explain the key
components of the Keynesian model and how they contribute to the determination of
the equilibrium level of output.

The Keynesian model starts with the assumption that the level of output is primarily
determined by aggregate demand, which is composed of four main components:
consumption (C), investment (I), government spending (G), and net exports (NX).

1. Consumption (C): Consumption expenditure represents the spending by

households on goods and services. In the Keynesian model, consumption is
influenced by disposable income (Yd), which is the income that households
have after paying taxes. Keynes argued that as income increases, consumption
also increases, but at a diminishing rate. This relationship is captured by the
consumption function: C = CO + cYd, where CO represents autonomous
consumption (consumption that occurs even when income is zero) and ¢

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 represents the marginal propensity to consume (the fraction of additional
income that is spent on consumption).

Investment (I): Investment expenditure represents the spending by firms on

capital goods, such as machinery and equipment, as well as on new
construction projects. Keynes considered investment to be influenced by
factors such as interest rates, business expectations, and the availability of
credit. According to Keynes, investment is a volatile component of aggregate
demand and can be subject to fluctuations based on changes in business
sentiment. In the Keynesian model, investment is considered to be autonomous
and not directly influenced by income.

. Government spending (G): Government spending includes expenditures on

goods and services, as well as transfer payments. In the Keynesian model,
government spending 1s assumed to be autonomous and independent of
income. It is often used as a policy tool to stimulate or stabilize the economy
during periods of low aggregate demand.

Net exports (NX): Net exports represent the difference between exports (X)
and imports (M). In the Keynesian model, net exports are influenced by factors
such as exchange rates, domestic and foreign income levels, and trade policies.
Net exports can be positive (surplus) or negative (deficit) depending on
whether a country's exports exceed its imports or vice versa.

To determine the equilibrium level of output in the Keynesian model, we need to

examine the relationship between aggregate demand (AD) and aggregate supply (AS).
Aggregate supply represents the total amount of goods and services that firms are
willing and able to produce at different price levels. In the short run, Keynes assumed
that aggregate supply is relatively inflexible and that output can deviate from its long-
run potential level.

The equilibrium level of output occurs when aggregate demand (AD) equals aggregate
supply (AS). At this point, there are no imbalances between the demand for goods and
services and the supply of goods and services. In other words, the economy is
producing the level of output that is consistent with the spending plans of households,
firms, government, and the rest of the world.

Graphically, the equilibrium level of output is determined by the intersection of the

aggregate demand (AD) curve and the aggregate supply (AS) curve. The AD curve
represents the various combinations of output and price levels that correspond to
different levels of aggregate demand. It is downward sloping because, as the price
level decreases, consumption, investment, government spending, and net exports tend
to increase, leading to a higher aggregate demand.

The AS curve represents the various combinations of output and price levels that
correspond to different levels of aggregate supply. In the Keynesian model, the AS

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curve 1s relatively flat or horizontal, indicating that output can increase or decrease
without significant changes in the price level. This assumption is based on the idea of
underutilized resources and unemployed labor in the short run.

5) Give a brief account of the demand for money in the Keynesian system.
In the Keynesian system, the demand for money plays a crucial role in determining
the overall level of economic activity and interest rates. Keynes distinguished between
the demand for money as a medium of exchange and the demand for money as a store
of value. In this response, I will provide a brief account of the demand for money in
the Keynesian system, highlighting its determinants and implications.

1. Transactionary Demand for Money:

The demand for money as a medium of exchange, also known as transactionary
demand for money, arises from the need to conduct day-to-day transactions for
goods and services. Individuals and businesses hold money to facilitate their
regular expenditures, such as buying groceries, paying bills, or making business
transactions. According to Keynes, the transactionary demand for money 1s
primarily influenced by the level of income and the average price level.
« Income: As income increases, individuals and businesses tend to demand more
money to meet their higher transactionary needs. This is because higher income
implies a greater volume of transactions.

« Average Price Level: An increase in the average price level raises the amount
of money needed to make the same level of transactions. In response,
individuals and businesses may increase their demand for money.

2. Precautionary Demand for Money:

The demand for money as a store of value, referred to as the precautionary demand for
money, arises from the desire to hold liquid assets to meet unexpected or unforeseen
expenses. Individuals and businesses hold money to have a financial buffer or safety
net in case of emergencies, such as medical bills, repairs, or other unexpected costs.
Keynes argued that the precautionary demand for money is influenced by factors such
as uncertainty, income stability, and the availability of alternative liquid assets.

« Uncertainty: Higher levels of uncertainty, such as economic instability or

financial market volatility, increase the demand for money as a precautionary
measure. Individuals and businesses prefer to hold more money to mitigate the
risks associated with uncertain events.

Income Stability: The stability of income affects the precautionary demand for
money. Individuals with unstable or irregular income streams may have a
higher demand for money to smooth out their consumption in times of income
fluctuations.

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 Alternative Liquid Assets: The availability and attractiveness of alternative
liquid assets, such as short-term bonds or savings accounts, can influence the
precautionary demand for money. If these alternative assets provide higher
returns or better liquidity, individuals may reduce their demand for money.

3. Speculative Demand for Money:

The speculative demand for money arises from the desire to hold money as a store of
value in anticipation of future investment opportunities. Keynes argued that
individuals and firms may hold money instead of investing it when they expect a
decline in asset prices or an increase in interest rates. By holding money, they aim to
take advantage of potentially profitable investment opportunities that may arise in the
future.

« Asset Prices: If individuals and firms anticipate a decline in asset prices, such
as stocks or real estate, they may increase their speculative demand for money
to take advantage of future buying opportunities when prices are lower.

Interest Rates: Expectations of rising interest rates can also lead to an increase
in the speculative demand for money. When individuals and firms expect
higher interest rates, they may choose to hold money instead of investing it
immediately, as they anticipate earning higher returns in the future.

The total demand for money is the sum of the transactionary, precautionary, and
speculative demands. In the Keynesian system, the demand for money is typically
represented as a function of income and interest rates. Keynes argued that the demand
for money 1s relatively stable compared to the volatility of income and interest rates.
However, he acknowledged that shifts in expectations, economic conditions, and
financial markets could affect the demand for money.

Assignment I11

Answer the following Short Category Questions in about 100 words each. Each
question carries 6 marks.

6) Describe the impact of inflation on various segments of society.

Inflation, defined as the sustained increase in the general price level of goods and
services over time, has a significant impact on various segments of society. The
effects of inflation can be both positive and negative, depending on several factors
such as income level, occupation, and asset ownership. Here, we will explore the
impact of inflation on different segments of society.

1. Low-Income Individuals: Low-income individuals are often the most

vulnerable to the negative effects of inflation. They may struggle to cope with
rising prices for essential goods and services such as food, housing, and
healthcare. Inflation erodes the purchasing power of their limited income,
leading to a decline in their standard of living.

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 2. Middle-Class Workers: The middle class may experience a mixed impact
from inflation. On one hand, they might face higher costs for everyday
expenses, reducing their disposable income. However, if they are employed in
industries that are able to pass on the increased costs to consumers, their wages
may increase to keep up with inflation. Additionally, if they have investments
or assets that can serve as a hedge against inflation, such as real estate or
stocks, they may benefit from the increased value of these assets.

Retirees and Fixed-Income Earners: Retirees and individuals living on fixed

incomes are particularly susceptible to inflation. Their pension payments or
fixed interest rates on savings accounts may not keep pace with rising prices,
resulting in a decrease in their purchasing power. This can lead to financial
strain and difficulty meeting basic needs, especially for those who rely solely
on their fixed income.

Businesses and Entrepreneurs: Inflation can have varied effects on

businesses and entrepreneurs. While some businesses may be able to pass on
increased costs to consumers through higher prices, others may face challenges
in maintaining profit margins. Small businesses and startups often struggle to
adapt to inflationary pressures, as they may have limited pricing power or face
increased costs for raw materials and resources.

. Investors and Asset Owners: Inflation can positively impact individuals who
own assets that tend to appreciate during inflationary periods. Real estate,
stocks, and commodities like gold often serve as hedges against inflation, as
their values tend to rise with increasing prices. Investors who have diversified
portfolios may be able to protect their wealth and even benefit from inflation.

7) For a three sector economy the following is given:

C=50+0.75,1=30,G =20

Where C = consumption, I = investment, and G = government expenditure.

Find out the equilibrium output level.

To find the equilibrium output level in a three-sector economy, we need to consider

the aggregate expenditure (AE) and aggregate output (Y) equality.

The aggregate expenditure (AE) is the sum of consumption (C), investment (1), and
government expenditure (G). Mathematically, AE is represented as:

AE=C+I+G

Given the values:

C=50+0.75
1=30
G=20

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Substituting these values into the equation, we have:

AE =(50+0.75) + 30 + 20
=50.75 + 30 + 20
= 100.75

The equilibrium output level (Y) is equal to the aggregate expenditure (AE).
Therefore, the equilibrium output level in this three-sector economy is 100.75.

8) Define investment multiplier. What are its limitations?

The mvestment multiplier is an economic concept that measures the impact of changes
in investment on the overall economy. It represents the relationship between an initial
change in investment and the subsequent change in national income or output. The
multiplier effect arises from the interconnectedness of various sectors in an economy,
where changes in investment lead to changes in spending, income, and output across
different sectors.

The investment multiplier is calculated by dividing the change in national income by

the nitial change 1n investment. It indicates how much the total output or income will
increase as a result of a specific increase in investment. The formula for the
investment multiplier is:

Multiplier = 1 /(1 - Marginal Propensity to Consume)

The Marginal Propensity to Consume (MPC) represents the proportion of an
additional income that individuals and households choose to spend. The higher the
MPC, the larger the multiplier.

However, the investment multiplier has certain limitations that need to be considered:

1. Simplified assumptions: The investment multiplier is based on simplifying

assumptions, such as constant MPC and a closed economy. In reality, these
assumptions may not hold true, and the multiplier effect may be influenced by
factors like international trade, taxes, and saving patterns.

. Time lag: The multiplier effect takes time to fully propagate through the
economy. The impact of investment on income and output occurs gradually as
the spending cycles through various sectors. This time lag can make it
challenging to accurately predict and measure the exact magnitude of the
multiplier effect.

. Leakages and injections: The investment multiplier assumes that any increase
in income 1s spent and circulated in the economy. However, leakages such as
saving, taxes, and imports can reduce the multiplier effect by reducing the
subsequent rounds of spending.

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 4. Crowding out: The investment multiplier does not account for the possibility
of crowding out. If the government or private sector increases investment by
borrowing funds, it may lead to higher interest rates, reducing private
investment and offsetting some of the initial impact.

. Elasticity of supply: The investment multiplier assumes that the economy has
sufficient spare capacity and resources to respond to increased demand. If the
economy is already operating at full capacity, the multiplier effect may be
limited as additional demand cannot be met by increased output.

9) Write a short note on the various types of inflation in an economy,

Inflation refers to a sustained increase in the general price level of goods and services
in an economy over a period of time. It erodes the purchasing power of money and has
various impacts on individuals, businesses, and the overall economy. Inflation can be
classified into different types based on the causes and sources. Here are the main types
of inflation:

1. Demand-Pull Inflation: Demand-pull inflation occurs when aggregate demand

in the economy exceeds the available supply of goods and services. It is
typically driven by increased consumer spending, investment, or government
expenditure. When demand outpaces supply, businesses may respond by
raising prices, leading to an overall increase in the price level.

Cost-Push Inflation: Cost-push inflation arises from an increase in production

costs that is passed on to consumers in the form of higher prices. This can be
caused by various factors such as a rise in wages, increased raw material costs,
higher taxes, or regulations that increase business expenses. As production
costs increase, businesses may choose to maintain their profit margins by
raising prices.

Built-in Inflation: Built-in inflation is a self-perpetuating cycle of inflation

that is fuelled by expectations of future price increases. It is typically caused by
the anticipation of rising wages to keep up with expected increases in the cost
of living. For example, if workers expect prices to rise, they may negotiate
higher wages, which in turn can lead to higher production costs and subsequent
price increases.

Structural Inflation: Structural inflation occurs due to long-term imbalances

in the structure of an economy. It is often associated with factors such as
monopolies, labour market rigidities, supply chain inefficiencies, or
government policies that create distortions in the economy. Structural inflation
1s difficult to address and requires structural reforms to resolve underlying
issues.
Hyperinflation: Hyperinflation is an extreme and rapid form of inflation
where prices rise uncontrollably, often leading to a collapse in the value of the

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 currency. It is typically caused by severe economic crises, excessive money
supply growth, or loss of confidence in the currency.

Open or Imported Inflation: Open or imported inflation occurs when

inflationary pressures are imported from other countries. This can happen
through increased import prices due to exchange rate fluctuations, higher
global commodity prices, or inflationary trends in major trading partners.

10) Write a short note on the function of money in an economy.

Money plays a crucial role in any economy as it serves several important functions.
Here are the main functions of money:
1. Medium of Exchange: Money acts as a widely accepted medium of exchange
that facilitates transactions. It eliminates the need for barter, where goods and
services are directly exchanged, by providing a universally accepted medium
that can be used to buy and sell goods and services. Money enables the smooth
flow of economic activity by providing a convenient and efficient means of
exchange.

. Unit of Account: Money serves as a unit of account, providing a common

measure of value for goods, services, assets, and debts. It allows for the
standardized pricing and comparison of different goods and facilitates
economic calculations. Money's unit of account function enables individuals,
businesses, and the government to assess and compare the relative value of
Various economic resources.

. Store of Value: Money serves as a store of value, allowing individuals and

businesses to hold and accumulate wealth. Unlike perishable goods, money can
be stored and used to retain purchasing power over time. Money's store of
value function enables people to save, invest, and plan for the future, providing
a means of storing wealth in a relatively stable and liquid form.

Standard of Deferred Payment: Money acts as a standard of deferred

payment, allowing debts and obligations to be settled in the future. Contracts,
loans, and financial agreements are often denominated in monetary terms, and
money serves as the medium through which these obligations are discharged
over time. Money's function as a standard of deferred payment provides
stability and predictability to contractual arrangements.

Measure of Value: Money serves as a measure of value, enabling the

comparison of the worth or price of different goods and services. It facilitates
economic decision-making by assigning a numerical value to economic
resources, enabling individuals and businesses to assess costs, benefits, and
trade-offs. Money's measure of value function aids in making informed choices
and optimizing resource allocation.

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6. Means of Distribution and Redistribution: Money serves as a means of
distributing and redistributing income in an economy. Wages, salaries, profits,
and taxes are denominated in monetary terms, allowing for the allocation of
resources and the redistribution of wealth. Money facilitates the flow of income
from producers to workers, from consumers to businesses, and from the
government to various sectors through taxation and public spending.

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