1.

Explain whether the following statements are true, false, or uncertain: (5x4 = 20)

a. APC falls as income rises

Answer: True.

The Average Propensity to Consume (APC) is the fraction of total income spent on
consumption, expressed as APC= C/Y, where

C is consumption, and Y is income. As income rises, a smaller proportion is spent on

consumption while a larger proportion is saved, meaning APC declines. This follows
Keynes’s theory, which suggests that individuals tend to save more as their income
increases, leading to a fall in the APC.

b. Devaluation improves trade balance

Answer: Uncertain.

Devaluation makes a country’s exports cheaper and imports more expensive. Whether this
improves the trade balance depends on the Marshall-Lerner Condition. If the price
elasticity of demand for exports and imports is high (elastic), devaluation will improve the
trade balance. However, if demand is inelastic, the trade balance could initially worsen
(due to higher import costs) before improving over time (the J-curve effect).

c. Aggregate demand curve slopes upward

Answer: False.

The Aggregate Demand (AD) curve slopes downward, not upward. A lower price level
increases the quantity of goods and services demanded due to the wealth effect (people
feel wealthier), the interest rate effect (lower interest rates encourage investment), and the
exchange rate effect (exports become cheaper, and imports become more expensive).

d. An adverse supply shock generates both inflation and unemployment

Answer: True.

An adverse supply shock, such as a spike in oil prices, reduces the economy’s productive
capacity, leading to cost-push inflation (higher costs raise prices) and a decrease in output,
which increases unemployment. This combination of inflation and unemployment is
known as stagflation.

When does general equilibrium of a macro economy occur? Show the general
equilibrium point in the IS-LM-FE diagram. (5 marks)
General equilibrium in a macro economy occurs when all markets—goods market, money
market, and labor market—are simultaneously in equilibrium. Specifically:

The goods market is in equilibrium when investment equals savings, as represented by the
IS curve.

The money market is in equilibrium when money demand equals money supply, as
represented by the LM curve.

The labor market is in equilibrium when the demand for labor equals the supply of labor,
which determines the full employment level, represented by the FE line (Full Employment
line).

In the IS-LM-FE model, equilibrium is achieved at the intersection of three curves:

IS Curve: This represents equilibrium in the goods market. It shows the combinations of
interest rates and output where investment equals savings.

LM Curve: This represents equilibrium in the money market. It shows the combinations of
interest rates and output where money demand equals money supply.

FE Line: This represents the equilibrium in the labor market at the full employment level of
output. It is a vertical line in the IS-LM diagram, reflecting that full employment output is
independent of the interest rate.

The general equilibrium occurs at the intersection of the IS curve, LM curve, and the FE line.
At this point:

The output is at the full employment level are at a level where both the goods and money
markets are in equilibrium.

Diagram: Below is the description of the IS-LM-FE diagram:

IS curve: Downward sloping, reflecting the inverse relationship between interest rates and
output in the goods market.
LM curve: Upward sloping, showing the positive relationship between interest rates and
output in the money market.

FE line: A vertical line representing full employment output which does not depend on the
interest rate.

At the point where the IS, LM, and FE lines intersect, all three markets are simultaneously in
equilibrium, and the economy is at its full employment level.

What determines real output and real rate of interest if the economy isn’t in general
equilibrium? (5 marks)

If the economy is not in general equilibrium, the interaction between the goods market
(represented by the IS curve) and the money market (represented by the LM curve)
determines both the real output and the real interest rate.

Goods Market (IS curve): The IS curve shows the relationship between real interest rates
and output for equilibrium in the goods market (where savings equals investment). A
change in either investment or consumption will shift the IS curve, affecting the real output
and interest rate.

If there is excess demand in the goods market (e.g., an increase in investment), output will
increase, leading to a higher real interest rate.

Money Market (LM curve): The LM curve shows the relationship between interest rates and
output for equilibrium in the money market. An excess supply or demand for money will
shift the LM curve, which will change both the real output and interest rates.

If there is an excess supply of money (e.g., due to expansionary monetary policy), interest
rates will fall, and output will rise until equilibrium is restored.

Adjustment Process:

If the economy is not in equilibrium (for instance, if the interest rate is too low), there will be
excess demand for money, causing upward pressure on interest rates.

If the interest rate is too high, there will be excess supply in the money market, leading to a
fall in interest rates.
The economy will adjust to an equilibrium output and interest rate through changes in
investment, consumption, and monetary factors.

When the economy is not in general equilibrium, these adjustments in the goods and
money markets drive the real output and real interest rates until a new equilibrium is
reached at the intersection of the IS and LM curves. However, this may or may not coincide
with full employment, depending on the position of the FE line.

What economic forces act to bring the economy back to general equilibrium? (10
marks)

Several economic forces act to bring the economy back to general equilibrium if there are
disturbances that push it away from this equilibrium. These forces operate through market
adjustments in the goods market, money market, and labor market.

Adjustment in the Goods Market (IS curve):

Changes in Investment and Consumption: When there is a shock in the goods market, such
as an increase in consumer spending or investment, the IS curve shifts.

For example, if there is an increase in government spending (fiscal expansion), this leads to
higher demand for goods and services, causing the IS curve to shift to the right.

The increase in demand raises output and interest rates temporarily.

However, the higher interest rates reduce investment, leading the economy back toward its
equilibrium.

Crowding Out: A higher interest rate can crowd out private investment, reducing demand in
the goods market and driving the economy back to equilibrium.

Adjustment in the Money Market (LM curve):

Changes in Money Demand and Supply: If there is an excess supply of money (e.g., due to
monetary expansion), the LM curve will shift to the right, reducing interest rates and
increasing output.

Lower interest rates increase investment and consumption, pushing the economy back
toward equilibrium.

Conversely, if the money supply is reduced (contractionary monetary policy), interest rates
rise, reducing consumption and investment, which brings the economy back to equilibrium
by slowing down output.

Adjustment in the Labor Market (FE line):

Wage and Price Flexibility: If the economy is not at full employment, wage and price
adjustments help bring the economy back to equilibrium.

If there is unemployment (output below full employment), wages tend to fall over time,
reducing costs for firms, which then hire more workers. This increases output until the
economy reaches the full employment level.

If the economy is overheated (output above full employment), wages rise, which increases
costs for firms, leading them to reduce production. Output falls back to the full
employment level.

Inflation and Expectations:

Expectations of Inflation: When inflation expectations rise, it can lead to higher interest
rates as lenders demand compensation for the expected loss of purchasing power. This
dampens investment and consumption, reducing demand and bringing the economy back
toward equilibrium.

Price Adjustments: In the short run, rigid prices might prevent the economy from quickly
reaching equilibrium. However, in the long run, flexible prices ensure that the economy
moves back to full employment as firms adjust their prices in response to changes in
demand and cost pressures.

Policy Responses:
Monetary Policy: Central banks can use monetary policy to adjust the money supply and
interest rates to bring the economy back to equilibrium. For example, if output is below full
employment, the central bank might lower interest rates or increase the money supply to
stimulate investment and consumption.

Fiscal Policy: Governments can use fiscal policy (changes in government spending or
taxation) to influence aggregate demand and bring the economy back to equilibrium. For
example, in a recession, governments can increase spending or cut taxes to boost
demand.

International Factors:

Exchange Rates and Trade: Changes in exchange rates can also help restore equilibrium.
For example, if domestic interest rates rise, capital inflows increase, appreciating the
currency and reducing exports. This leads to lower demand for domestic goods, helping
cool down an overheated economy.

Global Demand Shifts: Changes in global demand for a country’s exports can also affect
output and help bring the economy back to equilibrium through adjustments in trade flows.

In conclusion, the economy tends to move back to general equilibrium through a

combination of market forces, wage and price adjustments, and policy interventions.
These forces work to align demand with supply in both the goods and money markets,
while the labor market adjusts toward full employment. The interaction between the IS, LM,
and FE curves shows how these forces operate in the broader macroeconomic context.

a. What does the IS curve show? (12 marks)

The IS curve represents equilibrium in the goods market, where the total output (real GDP)
equals total demand for goods and services (C + I + G + NX). It shows the combinations of
real interest rates and output (income) that equate planned investment and savings in the
economy. Essentially, the IS curve captures the relationship between aggregate output and
the interest rate in the goods market.

The key points about the IS curve include:

Derivation from Keynesian Cross: The IS curve is derived from the Keynesian Cross model,
where aggregate expenditure (AE) intersects with output (Y). Investment (I) is negatively
related to the interest rate ®, so a higher interest rate discourages investment, leading to
lower output.
Downward Slope: The IS curve slopes downward because lower interest rates reduce the
cost of borrowing, stimulating investment and increasing aggregate demand and output.
Conversely, higher interest rates increase the cost of borrowing, leading to lower
investment and output.

Equilibrium in the Goods Market: At every point on the IS curve, the goods market is in
equilibrium, meaning that planned expenditure equals output (Y = AE). If the interest rate is
above the equilibrium level, planned investment falls, leading to lower aggregate demand
and output.

Shifts in the IS Curve:

Fiscal Policy: Expansionary fiscal policies (such as an increase in government spending or

a decrease in taxes) shift the IS curve to the right, as higher government spending raises
aggregate demand. Contractionary fiscal policies shift it to the left.

Private Sector Changes: Changes in consumer confidence, private investment, or external

demand (such as an increase in exports) also shift the IS curve.

To summarize, the IS curve highlights how interest rates and output interact in the goods
market and how changes in fiscal policies or private sector behavior can shift the curve
This equation shows that real output (Y) is a function of the real interest rate ® and other
factors such as consumption, government spending, and net exports. As the interest rate
changes, investment changes, leading to changes in output. The downward slope of the IS
curve comes from the fact that a higher interest rate reduces investment, leading to lower
output.

. Define nominal and real exchange rates. How are these two related? (6 marks)

Nominal Exchange Rate: The nominal exchange rate is the rate at which one currency can
be exchanged for another. It represents the current market price of one currency in terms of
another currency. For example, if 1 USD = 100 JPY, this is the nominal exchange rate.

Real Exchange Rate: The real exchange rate adjusts the nominal exchange rate for
differences in price levels between two countries. It reflects the relative purchasing power
of currencies in terms of goods and services. The real exchange rate can be expressed as:

Where:

The nominal exchange rate is the current market exchange rate between two currencies.

The domestic price level represents the prices of goods and services in the home country.

The foreign price level represents the prices of goods and services in the foreign country.

Relationship: The nominal and real exchange rates are related through the relative price
levels between countries. While the nominal exchange rate reflects the market price of
currency, the real exchange rate adjusts for inflation and provides a measure of the relative
purchasing power of one country’s currency compared to another.

If the nominal exchange rate increases, but domestic inflation is higher than foreign
inflation, the real exchange rate may remain constant or even decrease.

Conversely, if domestic inflation is lower, the real exchange rate could increase, even if the
nominal rate stays the same.

In practice, the real exchange rate is important for determining the competitiveness of a
country’s goods in international markets. A lower real exchange rate makes a country’s
exports cheaper and more competitive globally, while a higher real exchange rate has the
opposite effect.

Explain the nominal exchange rate determination process in a free-floating system.

(10 marks)
In a free-floating exchange rate system, the nominal exchange rate is determined by the
forces of supply and demand for currencies in the foreign exchange (forex) market. There is
no government intervention, and the exchange rate fluctuates freely according to market
forces.

Demand for Foreign Currency: The demand for foreign currency arises from:

Imports: When domestic consumers or businesses want to buy foreign goods, they need to
exchange their local currency for the foreign currency.

Investments: Investors may demand foreign currency to invest in foreign assets such as
stocks, bonds, or real estate.

Tourism: When residents travel abroad, they exchange their domestic currency for the
foreign currency.

Speculation: Traders in forex markets may demand foreign currency in anticipation of a

change in the exchange rate, hoping to profit from currency fluctuations.

Supply of Foreign Currency: The supply of foreign currency in the domestic economy
comes from:

Exports: Foreign consumers who buy domestic goods must exchange their currency for the
domestic currency.

Foreign Investments: Foreign investors may bring in their currency to invest in domestic
assets.

Tourism: Foreign tourists visiting the country exchange their currency for the domestic
currency.

Speculation: Just as with demand, speculative activities can influence the supply of a
currency.

Equilibrium in the Forex Market: The nominal exchange rate is determined by the point
where the demand for a currency equals its supply. If there is more demand for a currency
than its supply, its value will appreciate, leading to a higher exchange rate. Conversely, if
supply exceeds demand, the currency will depreciate.

Factors Affecting Nominal Exchange Rate:

Interest Rates: Higher interest rates attract foreign investment, increasing the demand for
the domestic currency and causing it to appreciate. Lower interest rates have the opposite
effect.

Inflation Rates: A country with higher inflation will see its currency depreciate as its goods
become less competitive internationally, reducing demand for its currency.

Economic Growth: Strong economic growth attracts foreign investment, increasing the
demand for the domestic currency and appreciating the nominal exchange rate.

Speculation: If investors believe that a currency will appreciate in the future, they buy that
currency, which increases demand and leads to an appreciation of the currency. On the
other hand, if they believe that the currency will depreciate, they will sell it, causing it to
depreciate.

Political Stability: Countries with stable political systems tend to attract more foreign
investment, increasing demand for the domestic currency and appreciating its value.
Countries with political instability see the opposite effect, as investors move their funds to
safer markets, causing the currency to depreciate.

Example of a Free-Floating System:

Consider the U.S. dollar (USD) and the euro (EUR). If European demand for American goods
and services increases, Europeans will need more USD to pay for these imports. This
increased demand for USD will cause the value of the USD to appreciate against the EUR.

Conversely, if U.S. demand for European goods rises, Americans will need more EUR to pay
for those imports, increasing the demand for EUR and causing the EUR to appreciate
against the USD.

Thus, in a free-floating system, the nominal exchange rate adjusts constantly to reflect
changing supply and demand conditions in the forex market. Over time, these changes
balance out the flows of goods, services, and capital between nations.

What are the factors on which capital mobility between two countries depends? (4
marks):

Capital mobility refers to the ease with which financial assets or capital can flow between
countries. Several key factors influence capital mobility:
Interest Rate Differentials: When a country offers higher interest rates compared to others,
it attracts foreign capital as investors seek higher returns. Conversely, lower interest rates
in comparison to other countries can cause capital to flow out.

Exchange Rate Expectations: Investors may move capital between countries based on
expectations of currency appreciation or depreciation. If investors expect a country’s
currency to appreciate, they may move capital to that country to benefit from currency
gains.

Economic and Political Stability: Countries with strong economies and stable political
environments attract foreign investment, as they are perceived as lower risk. Countries
with unstable political systems or weak economies typically experience capital flight as
investors seek safer investments.

Regulatory Environment: Capital controls, such as taxes on capital flows or restrictions on

foreign investments, can limit capital mobility. Countries with fewer restrictions on capital
movements tend to experience higher capital mobility.

In summary, capital mobility between two countries depends on differences in interest

rates, exchange rate expectations, the level of economic and political stability, and the
regulatory framework governing capital flows.

Explain salient features of the Keynesian consumption function. What are the major
shortcomings of this function? (8 + 4 = 12 marks)

Key Features of the Keynesian Consumption Function:

Linear Relationship: The Keynesian consumption function suggests a linear relationship

between consumption © and disposable income (Yd), expressed as:

Marginal Propensity to Consume (MPC): The MPC is a key feature of the function, showing
how much consumption changes in response to changes in income. For example, if the
MPC is 0.8, then for every additional $1 of income, consumption increases by $0.80.
Autonomous Consumption: Keynesian theory recognizes that individuals may consume
even when their disposable income is zero. This is represented by

, which reflects consumption financed by savings, credit, or government assistance.

Short-Term Focus: The Keynesian consumption function is designed to explain short-term

consumption behavior, assuming that consumption depends primarily on current income.

Shortcomings of the Keynesian Consumption Function:

Ignores Wealth Effects: The Keynesian consumption function does not consider that
households’ consumption decisions are also influenced by their wealth (e.g., real estate,
stocks, and savings). As wealth increases, people may consume more even if their current
income has not changed.

No Role for Expectations: Keynesian consumption theory focuses on current income but
ignores the role of future expectations. Modern theories suggest that individuals plan
consumption over their entire lifetime, rather than basing it solely on current income.

Fails to Account for Interest Rates: The Keynesian consumption function does not directly
account for the influence of interest rates on consumption decisions. In reality, higher
interest rates can discourage consumption by making borrowing more expensive and
encouraging saving.

Applies Only to the Short Run: The Keynesian consumption function is useful in explaining
short-run consumption behavior but is less effective in explaining long-term consumption
trends. Over the long term, individuals adjust their consumption based on expectations
about future income, wealth, and other factors.

In conclusion, while the Keynesian consumption function provides a simple and useful
explanation of short-term consumption behavior, it has significant limitations in
accounting for wealth effects, expectations, interest rates, and long-term behavior.

Briefly explain the life cycle theory of consumption. (8 marks)

The Life Cycle Theory of Consumption, proposed by Franco Modigliani, suggests that
individuals plan their consumption and saving behavior over their lifetime, rather than
focusing solely on current income. The key idea is that people aim to smooth their
consumption throughout their lives, even though their income may fluctuate at different
stages of life.

Consumption Smoothing: Individuals aim to maintain a stable level of consumption

throughout their life, balancing periods of higher income (working years) with periods of
lower income (retirement). They do this by saving during their working years and drawing
down their savings in retirement.

Lifetime Income Hypothesis: According to the life cycle theory, people make consumption
decisions based on their expected lifetime income, not just their current income. This
contrasts with the Keynesian consumption function, which focuses only on current
disposable income.

Wealth Accumulation and Decumulation: In the life cycle model, individuals accumulate
wealth during their working years to support consumption during retirement. After
retirement, they spend their savings (or wealth) to maintain their desired consumption
levels.

Role of Borrowing and Saving: In the early stages of life, when income is relatively low (e.g.,
during education or early career), individuals may borrow to finance consumption. During
middle age, as income rises, they save more. In retirement, they spend down their
accumulated wealth.

In summary, the life cycle theory of

consumption emphasizes that
individuals consider their lifetime
income and wealth, rather than just current income, when making consumption decisions.
It provides a more comprehensive explanation of consumption behavior over a person’s
lifetime.
Do you think that high debt burden of the government will impose high tax burden on
future generations? Justify your answer. (5 marks)

Yes, a high debt burden incurred by the government can potentially impose a high tax
burden on future generations, but this outcome depends on several factors.

Increased Future Taxes: When a government borrows heavily, it needs to repay the debt
along with interest. If the government is unable to reduce its debt through economic growth
or spending cuts, it may be forced to raise taxes in the future to meet its debt obligations.
This means that future generations may face higher taxes to service the debt accumulated
by previous generations.

Crowding Out Private Investment: A large government debt can lead to higher interest rates
as the government competes with the private sector for available funds in financial markets
(known as the crowding out effect). Higher interest rates make borrowing more expensive
for businesses, which may reduce private investment and slow down economic growth.
Lower economic growth could result in lower tax revenues, exacerbating the debt problem
and leading to higher taxes.

Intergenerational Equity: High government debt raises concerns about intergenerational

equity. Current generations benefit from government spending (e.g., on public services,
infrastructure, or welfare programs) without fully bearing the cost, while future generations
may have to shoulder the burden of repaying the debt through higher taxes or reduced
public services.

Potential Mitigating Factors:

If the debt is used to finance productive investments, such as infrastructure or education, it

could boost future economic growth. Higher growth would generate higher tax revenues,
making it easier to repay the debt without imposing a significant tax burden on future
generations.

If inflation erodes the real value of the debt, the government may be able to repay it more
easily, reducing the need for higher taxes.

What is meant by the Balance of Payments (BOP)? (5 marks)

The Balance of Payments (BOP) is a comprehensive record of a country’s economic

transactions with the rest of the world over a specific period, typically a year. It includes all
financial exchanges between residents of a country and the global economy, including
trade in goods and services, capital transfers, and financial assets.
The BOP consists of two major components:

Current Account: This reflects the flow of goods, services, and income between a country
and the rest of the world. It includes:

Trade Balance: Exports minus imports of goods and services.

Income from Foreign Investments: Earnings from foreign investments and wages earned
abroad.

Net Transfers: Foreign aid, remittances, and other transfers.

Capital and Financial Account: This records the flow of capital between the domestic
economy and the global economy. It includes:

Foreign Direct Investment (FDI): Investment in productive assets such as factories and
infrastructure.

Portfolio Investment: Purchases of financial assets like stocks and bonds.

Official Reserves: Changes in a country’s reserves of foreign currencies and gold.

The balance of payments must always balance, meaning that a surplus in one account
(e.g., a current account surplus) must be offset by a deficit in the other account (e.g., a
financial account deficit). Any imbalances are typically corrected by changes in a country’s
foreign exchange reserves.

In summary, the BOP provides a snapshot of a country’s economic interactions with the
world, showing how it earns and spends foreign currency and whether it is a net lender or
borrower from the global economy.

Differentiate between fixed and flexible exchange rate systems. (5 marks)

Fixed Exchange Rate System:

Definition: In a fixed exchange rate system, the value of a country’s currency is pegged or
fixed to another currency (such as the US dollar) or to a basket of currencies. The central
bank intervenes in the foreign exchange market to maintain the fixed rate by buying or
selling its own currency.
Stability: A fixed exchange rate provides stability in international trade and investment by
reducing exchange rate uncertainty. This is beneficial for countries reliant on exports or
those with significant foreign debt denominated in foreign currencies.

Intervention: The central bank must maintain large reserves of foreign currency to defend
the fixed exchange rate, particularly during times of external shocks or speculative attacks.

Examples: Countries like China and Saudi Arabia have adopted variants of fixed or semi-
fixed exchange rate systems.

Flexible (or Floating) Exchange Rate System:

Definition: In a flexible exchange rate system, the value of the currency is determined by
market forces—specifically, supply and demand in the foreign exchange market. There is
no government intervention in setting the exchange rate.

Volatility: Flexible exchange rates are subject to fluctuations based on economic

conditions, interest rates, inflation, and other factors. While this allows for automatic
adjustment of trade imbalances, it introduces exchange rate risk for international
businesses.

Market-driven Adjustments: Since the exchange rate is determined by market forces, there
is no need for the central bank to maintain large foreign reserves, as it does in a fixed
exchange rate system.

Examples: Major economies like the United States, Japan, and the Eurozone operate under
floating exchange rate regimes.

In summary, a fixed exchange rate system prioritizes stability but requires active
intervention by the central bank, while a flexible exchange rate system allows for market-
driven adjustments with greater currency volatility

What is meant by Purchasing Power Parity (PPP)? How is it useful in determining

exchange rates? (5 marks)

Purchasing Power Parity (PPP) is an economic theory that suggests that in the long run,
exchange rates between two currencies should move toward the rate that equalizes the
purchasing power of both currencies. In other words, the exchange rate should adjust so
that a basket of goods costs the same in both countries when priced in a common
currency.PPP Formula: The basic formula for calculating PPP is:

If a basket of goods costs $100 in the US and €80 in the Eurozone, the PPP exchange rate
would be $100/€80 = 1.25. This means that 1 USD should exchange for 1.25 EUR to
maintain purchasing power parity.

Types of PPP:

Absolute PPP: This theory states that the price of an identical basket of goods should be
the same in different countries when expressed in a common currency.

Relative PPP: This version suggests that the rate of change in the price levels between two
countries will be reflected in changes in the exchange rate. For instance, if inflation in one
country is higher than in another, its currency should depreciate accordingly.

Importance of PPP:

Exchange Rate Determination: PPP helps in the long-run determination of exchange rates
by showing what the exchange rate should be if all goods were traded freely without tariffs
or other barriers, and transportation costs were zero.

Comparison of Living Standards: PPP is used by organizations like the International

Monetary Fund (IMF) and World Bank to compare living standards across countries by
adjusting GDP figures for differences in cost of living.

Forecasting Exchange Rates: Though short-term exchange rates are influenced by

speculative flows and interest rates, PPP serves as a useful tool in forecasting the long-
term movements of exchange rates based on price level differences.

In summary, PPP is a concept that helps explain how exchange rates should theoretically
adjust to equalize the purchasing power of currencies, making it a valuable tool in
international economics for comparing prices and forecasting exchange rate movements in
the long term.

What is economic growth? Why is it so important? (4 + 6 = 10 marks)

Economic Growth refers to the increase in the production of goods and services in an
economy over a period, typically measured as the percentage increase in a country’s real
Gross Domestic Product (GDP). It indicates the overall expansion of an economy’s
productive capacity, allowing it to produce more goods and services compared to the
previous period.

Economic growth can be measured in real terms, adjusted for inflation, to reflect the true
increase in output. It is often illustrated through the growth rate of GDP, which shows the
percentage change in economic output from one year to the next.

Importance of Economic Growth:

Higher Standards of Living: Economic growth is essential because it leads to a higher

standard of living for a country’s population. As output increases, individuals and
households have more goods and services available, leading to improved material well-
being.

Reduction in Poverty: Sustained economic growth leads to job creation and income growth,
which helps in reducing poverty. As economies expand, more employment opportunities
are created, providing better wages and reducing the unemployment rate.

Increased Government Revenues: With economic growth, incomes, and profits rise, which
leads to increased tax revenues for the government. This enables the government to spend
more on public services, such as healthcare, education, and infrastructure, improving the
overall quality of life.

Encourages Investment: Higher economic growth signals confidence in the economy and
encourages both domestic and foreign investment. Businesses are more willing to invest in
new technologies, machinery, and infrastructure, which further drives productivity and
growth.

Technological Advancements: Economic growth is often driven by technological progress,

which increases productivity and leads to new innovations. This not only improves
efficiency but also opens up new industries and markets.
Fiscal Stability: Growth helps in improving the government’s fiscal position. A growing
economy reduces the relative debt burden (debt-to-GDP ratio), making it easier for the
government to manage its finances and service its debt.

Global Competitiveness: A growing economy becomes more competitive internationally,

with stronger exports and the ability to influence global markets. This helps in enhancing a
country’s global standing and economic influence.

In summary, economic growth is vital because it drives prosperity, reduces poverty,

enhances government finances, and encourages innovation. A higher rate of growth leads
to a more dynamic economy and an improved quality of life for its citizens.

Decompose the major sources of economic growth according to the growth

accounting approach. (10 marks)

The Growth Accounting Approach breaks down economic growth into the contributions of
three key factors:

Capital Accumulation (K): The accumulation of physical capital, such as machinery,

buildings, and infrastructure, contributes to economic growth by increasing the productive
capacity of an economy. Investments in capital increase the amount of equipment and
technology that workers have at their disposal, leading to higher output per worker. The
contribution of capital to growth is typically measured by the capital stock or capital-to-
labor ratio.
Sources of Economic Growth:

Capital Deepening: When the capital per worker increases, it leads to higher productivity
and output. This is called capital deepening and reflects the growth coming from increased
investment in infrastructure, machinery, and technology.
Labor Quality Improvement: Improvements in human capital—such as education, skills
training, and health—enhance labor productivity, leading to economic growth. Workers
become more productive as they acquire more skills or become healthier, allowing them to
contribute more to the economy.

Technological Progress: The most important source of long-term economic growth is

technological progress. Innovations and technological improvements increase
productivity, allowing the same amount of labor and capital to produce more output. This is
often considered the primary driver of sustained growth.

Institutional Factors: The role of institutions, such as the rule of law, property rights,
political stability, and efficient markets, also contributes to economic growth by creating
an environment where capital accumulation, labor productivity, and technological
progress can thrive.

In conclusion, economic growth stems from the accumulation of capital, the expansion
and enhancement of labor, and improvements in total factor productivity. The growth
accounting approach helps economists isolate and quantify the relative importance of
each of these sources in driving economic growth.

a. NAIRU (Non-Accelerating Inflation Rate of Unemployment) (5 marks)

NAIRU (Non-Accelerating Inflation Rate of Unemployment) refers to the level of

unemployment at which inflation is stable, or, in other words, the unemployment rate that
does not push inflation higher or lower. It is a theoretical concept that suggests a trade-off
between inflation and unemployment in the short run but no such trade-off in the long run.

Concept: NAIRU is grounded in the Phillips Curve theory, which initially suggested that
lower unemployment leads to higher inflation. However, over time, economists recognized
that once inflation expectations are accounted for, there is a level of unemployment where
inflation remains constant.

Implications: If the unemployment rate falls below the NAIRU, inflation is expected to
accelerate as employers compete for scarce labor by raising wages, which translates into
higher prices. Conversely, if unemployment is above the NAIRU, inflation tends to
decelerate or remain low.

Policy Relevance: Central banks, like the Federal Reserve, often use the concept of NAIRU
to guide monetary policy. By adjusting interest rates, they aim to keep the unemployment
rate close to NAIRU, balancing between preventing runaway inflation and promoting job
growth.

b. Ricardian Equivalence (5 marks)

Answer:

The Ricardian Equivalence is an economic theory proposed by David Ricardo and later
developed by economist Robert Barro. It suggests that government borrowing and taxation
are equivalent in their effect on the economy because rational consumers anticipate future
tax liabilities arising from government debt and adjust their consumption accordingly.

Basic Idea: If the government increases spending without raising taxes (by borrowing),
consumers expect that they will face higher taxes in the future to pay off the debt. As a
result, they save more to pay for the expected future tax increase, reducing their current
consumption. This offsets the stimulating effect of government borrowing on the economy.

Policy Implications: Ricardian Equivalence challenges the effectiveness of fiscal policy in

stimulating demand through deficit spending. It suggests that government borrowing does
not affect overall demand, as consumers adjust their behavior based on the expectation of
future taxes.

Criticism: In practice, the Ricardian Equivalence may not hold due to factors like imperfect
foresight, liquidity constraints, and non-rational behavior by consumers