macro economics notes

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IQRA COMMERCE NETWORK IQRA COMMERCE NETWORK Sir Khalid Aziz

Sir Khalid Aziz 0322-3385752 0322-3385752

MACRO ECONOMICS

Q 5) a) Distinguish between GDP at market price and

GDP at factor price.

Net National Product (NNP)/National Income/GDP at market price:

Definition and Explanation of NNP:

"" Net naNet national Productional Produc t or natt or national incomeional income at market prices is the net market money value of all the final at market prices is the net market money value of all the final goods and services produced in a country during a year. It is found out by subtracting the amount of goods and services produced in a country during a year. It is found out by subtracting the amount of depreciation of the existing capital in a year from the market value of all final goods and services". depreciation of the existing capital in a year from the market value of all final goods and services".

For a continuous flow of money payments, it is necessary that a certain amount of money should be set For a continuous flow of money payments, it is necessary that a certain amount of money should be set aside from the gross national income for meeting the necessary expenditure of wear and tear of all capital aside from the gross national income for meeting the necessary expenditure of wear and tear of all capital equipment so that there should not be any deterioration in the capital and it should remain intact. If we equipment so that there should not be any deterioration in the capital and it should remain intact. If we deduct depreciation allowance from gross national product, we get Net National Product at current market deduct depreciation allowance from gross national product, we get Net National Product at current market price.

price.

Formula For Net National Product/National Income: Formula For Net National Product/National Income:

NNP at Market Price = GNP at Market Price -

NNP at Market Price = GNP at Market Price - DepreciationDepreciation

Depreciation Allowance and Maintaining Capital Intact.

Depreciation Allowance and Maintaining Capital Intact. Here a question can be asked as to what we Here a question can be asked as to what we actually mean by depreciation allowance and maintaining capital intact; (the words which we have used in actually mean by depreciation allowance and maintaining capital intact; (the words which we have used in explaining NNP).

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B-COM PART 1: ECONOMICS ANALYSIS B-COM PART 1: ECONOMICS ANALYSIS

SOLUTIONS FOR EXAMINATION REGULAR 2015: COMPILED BY

SOLUTIONS FOR EXAMINATION REGULAR 2015: COMPILED BY KHALID AZIZKHALID AZIZ

It is known to every one of us that when production is going on, the value of capital equipments does not It is known to every one of us that when production is going on, the value of capital equipments does not remain the same. A decrease in value because of wear and tear through, use, rusting, accident or remain the same. A decrease in value because of wear and tear through, use, rusting, accident or through actions of elements, gradually take place in the building and other equipments of business. A through actions of elements, gradually take place in the building and other equipments of business. A certain sum of money based on the value of the capital equipment and its longevity is set aside every certain sum of money based on the value of the capital equipment and its longevity is set aside every year from the gross annual income so that when machinery is worn out, a new capital equipment can be year from the gross annual income so that when machinery is worn out, a new capital equipment can be set up from the sum thus accumulated. This fund which is set aside for covering the wear and tear, set up from the sum thus accumulated. This fund which is set aside for covering the wear and tear, deterioration and obsolescence of the machinery is named as

deterioration and obsolescence of the machinery is named asDepreciation AllowanceDepreciation Allowance. We can make. We can make this concept more clear by taking a simple example.

this concept more clear by taking a simple example.

Example of NNP: Example of NNP:

Suppose, a person buys a machinery for manufacturing cloth for $10000 only. He expects that this Suppose, a person buys a machinery for manufacturing cloth for $10000 only. He expects that this

machinery will last ten years and after that period, it will be partially or completely worn out. He sets aside machinery will last ten years and after that period, it will be partially or completely worn out. He sets aside $1000 every year from the gross national income as a depreciation reserve of the capital equipment. $1000 every year from the gross national income as a depreciation reserve of the capital equipment.

After the expiry of ten

After the expiry of ten years, he accumulates $10000 and with that money he replaces the old capitalyears, he accumulates $10000 and with that money he replaces the old capital equipment which has lived its useful life and maintains capital intact.

equipment which has lived its useful life and maintains capital intact. The sum of money, i.e., $1000 whichThe sum of money, i.e., $1000 which he annually deducts from the gross annual income, is known as

he annually deducts from the gross annual income, is known as depreciation depreciation alallowalowance.nce.

It is often pointed out by economists that the calculation of depreciation allowance every year is a difficult It is often pointed out by economists that the calculation of depreciation allowance every year is a difficult task.

task.

For example, a person expects

For example, a person expects the longevity of the capital equipment, say for ten years. There is athe longevity of the capital equipment, say for ten years. There is a possibility that machinery may last longer or it may go out of use earlier. So they say what needed is an possibility that machinery may last longer or it may go out of use earlier. So they say what needed is an approximate decision regarding the' depreciation allowance. This decision should be based on high approximate decision regarding the' depreciation allowance. This decision should be based on high degree of judgment and guessing about the future.

degree of judgment and guessing about the future.

Maintaining Capital Intact.

Maintaining Capital Intact. By maintaining capital intact we do not mean that capital equipments shouldBy maintaining capital intact we do not mean that capital equipments should remain the same. It should neither increase nor decrease. This can only by possible in a static society. In remain the same. It should neither increase nor decrease. This can only by possible in a static society. In a progressive society, the total capital equipment of a country must increase every year, otherwise the a progressive society, the total capital equipment of a country must increase every year, otherwise the national income will be affected adversely.

national income will be affected adversely.

In Economics, by the phrase

In Economics, by the phrase'mainta'maintainiini ng ng capital capital intact'intact'is meant to make good the physicalis meant to make good the physical

deterioration which has taken place in the capital equipment while creating income during a given period. deterioration which has taken place in the capital equipment while creating income during a given period. This can only be made by setting aside a certain amount of money every year from the annual gross This can only be made by setting aside a certain amount of money every year from the annual gross income so that when the income creating equipment becomes obsolete, a new capital equipment may be income so that when the income creating equipment becomes obsolete, a new capital equipment may be created out. If the depreciation allowance is not set aside every year, the flow of income would not remain created out. If the depreciation allowance is not set aside every year, the flow of income would not remain intact. It will decline gradually and the whole country will become poor.

intact. It will decline gradually and the whole country will become poor.

NNP = GNP

NNP = GNP – – Depreciation Depreciation

GDP/National Income at Factor Cost:

Definition and Explanation:

National income can be estimated in terms of either output or total income. When national income is National income can be estimated in terms of either output or total income. When national income is measured by adding together all income payments made to the factors of production in a year, it is called measured by adding together all income payments made to the factors of production in a year, it is called national income at factor cost. National income thus is the sum total of all income payments made to the national income at factor cost. National income thus is the sum total of all income payments made to the factors of production. In the words of

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The main components of national income at factor cost are as follows: The main components of national income at factor cost are as follows:

The factor incomes are generally divided into four categories: The factor incomes are generally divided into four categories:

(i) Compensation to employees (ii) Interest (iii) rents and (iv) profits. (i) Compensation to employees (ii) Interest (iii) rents and (iv) profits.

(i) Compensation to employees:

(i) Compensation to employees: It is the largest component of national income. It consists of wages andIt is the largest component of national income. It consists of wages and salaries paid by the firms to the workers for their labor services.

salaries paid by the firms to the workers for their labor services.

(ii) Interest:

(ii) Interest: Interest is the payment for the use of funds in a year. The payment is made by privateInterest is the payment for the use of funds in a year. The payment is made by private businesses to households who have lent money to them.

businesses to households who have lent money to them.

(iii) Rent:

(iii) Rent: Rent is all income earned by individuals for the use of their real assets such as building, farmsRent is all income earned by individuals for the use of their real assets such as building, farms etc.

etc.

(iv) Profit:

(iv) Profit: Profit is the amount which is left after compensation to employees, rent, interest have been Profit is the amount which is left after compensation to employees, rent, interest have been paid out. The sum of compensation to .employees, interest, rent and profit is supposed to equal national paid out. The sum of compensation to .employees, interest, rent and profit is supposed to equal national income at factor cost.

income at factor cost.

Q 5) b) Explain any one approach of

Q 5) b) Explain any one approach of measurement of

measurement of

GDP.

Expenditure Method:

Definition and Explanation: Definition and Explanation:

The expenditur

The expenditure ae approachpproachmeasures national income as total spending on final goods and servicesmeasures national income as total spending on final goods and services produced within nation during an year. The expenditure approach to measuring national income is to add produced within nation during an year. The expenditure approach to measuring national income is to add up all expenditures made for final goods and services at current market prices by households, firms and up all expenditures made for final goods and services at current market prices by households, firms and government during a year. Total aggregate final expenditure on final output thus is the sum of four broad government during a year. Total aggregate final expenditure on final output thus is the sum of four broad categories of expenditures:

categories of expenditures:

(i) consumption (ii) investment (iii) government and (iv) Net export. (i) consumption (ii) investment (iii) government and (iv) Net export.

(i) Consumption expenditure (C):

(i) Consumption expenditure (C): Consumption expenditure is the largest component of national Consumption expenditure is the largest component of national

income. It includes expenditure on all goods and services produced and sold to the final consumer during income. It includes expenditure on all goods and services produced and sold to the final consumer during the year.

the year.

(ii) Investment expenditure (I):

(ii) Investment expenditure (I): Investment is the use of today's resources to expand tomorrow's Investment is the use of today's resources to expand tomorrow's production or consumption. Investment expenditure is expenditure incurred on by business firms on (a) production or consumption. Investment expenditure is expenditure incurred on by business firms on (a) new plants, (b) adding to the stock of inventories and (c) on newly constructed houses.

new plants, (b) adding to the stock of inventories and (c) on newly constructed houses.

(iii) Government expenditure (G):

(iii) Government expenditure (G): It is the second largest component of national income. It includes all It is the second largest component of national income. It includes all government expenditure on currently produced goods and services but excludes transfer payments while government expenditure on currently produced goods and services but excludes transfer payments while computing national income.

computing national income.

(iv) Net exports (X - M): (iv) Net exports (X - M):

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SOLUTIONS FOR EXAMINATION REGULAR 2015: COMPILED BY KHALID AZIZKHALID AZIZ Precautions For Expenditure Method:

Precautions For Expenditure Method:

While estimating national income through expenditure method, the following precautions should be taken: While estimating national income through expenditure method, the following precautions should be taken:

(i) The expenditure on second hand goods should not be included as they do not contribute to the current (i) The expenditure on second hand goods should not be included as they do not contribute to the current year's production of goods.

year's production of goods.

(ii) Similarly, expenditure on purchase of old shares and bonds is not included as these also do not (ii) Similarly, expenditure on purchase of old shares and bonds is not included as these also do not represent expenditure on currently produced goods and services.

represent expenditure on currently produced goods and services.

(iii) Expenditure on transfer payments by government such as unemployment benefit, old age pensions, (iii) Expenditure on transfer payments by government such as unemployment benefit, old age pensions, interest on public debt should also not be included because no productive service is rendered in

interest on public debt should also not be included because no productive service is rendered in exchange by recipients of these payments.

exchange by recipients of these payments.

Q 6) a) If consumption function

Q 6) a) If consumption function id C = 500 + 0.75 y,

id C = 500 + 0.75 y,

find the value of multiplier

C = 500 + 0.75 y C = 500 + 0.75 y Multiplier is represented by k Multiplier is represented by k Therefore k = 1/(1-MPC) Therefore k = 1/(1-MPC) MPC = b = 0.75 MPC = b = 0.75 C = a + by C = a + by Hence, Hence, k = 1/(1 - 0.75) k = 1/(1 - 0.75) k = 4 k = 4

Q 6) b) Explain Keynesian theory of income and

employment.

Keynesian Theory of Income and Employment: Keynesian Theory of Income and Employment:

Definition and Explanation: Definition and Explanation:

John Maynard Keynes

John Maynard Keynes was the main critic of the classical macro economics. He in his book ' was the main critic of the classical macro economics. He in his book 'GeneralGeneral Theory of Employment, Interest and Money

Theory of Employment, Interest and Money ' out-rightly rejected the' out-rightly rejected the Say's Law of Market Say's Law of Market that supplythat supply creates its own demand. He severely criticized

creates its own demand. He severely criticized A.C. Pigou'sA.C. Pigou's version that cuts in real wages help inversion that cuts in real wages help in promoting employment in the

promoting employment in the economy. He also opposed the idea that saving and investment can beeconomy. He also opposed the idea that saving and investment can be brought about through changes in the rate of interest. In addition to this, the assumption of full

brought about through changes in the rate of interest. In addition to this, the assumption of full employment in the economy is not realistic.

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It was at that time when

It was at that time when J. M. KeynesJ. M. Keynes wrote his famous book 'wrote his famous book 'General Theory General Theory '. In it he presented an'. In it he presented an explanation of the Great Depression of 1930's and suggested measures for the solution. He also explanation of the Great Depression of 1930's and suggested measures for the solution. He also presented his own theory of income and employment. According to

presented his own theory of income and employment. According to Keynes:Keynes:

"In the short period, level of national income and so of employment is determined by aggregate demand "In the short period, level of national income and so of employment is determined by aggregate demand and aggregate supply in the country. The equilibrium of national income occurs where aggregate demand and aggregate supply in the country. The equilibrium of national income occurs where aggregate demand is equal to aggregate supply. This equilibrium is also called effective demand point".

is equal to aggregate supply. This equilibrium is also called effective demand point".

What is Effective Demand? What is Effective Demand?

EE ffective demffective demand and represents that aggregate demand or total spending (consumption expenditure and represents that aggregate demand or total spending (consumption expenditure and investment expenditure) which matches with aggregate supply (national income at factor cost).

investment expenditure) which matches with aggregate supply (national income at factor cost).

In other words, effective demand is the signification of the equilibrium

In other words, effective demand is the signification of the equilibrium between aggregate demand (C+I)between aggregate demand (C+I) and aggregate supply (C+S). This equilibrium position (effective demand) indicates that the entrepreneurs and aggregate supply (C+S). This equilibrium position (effective demand) indicates that the entrepreneurs neither have a tendency to increase production nor a tendency to decrease production. It implies that the neither have a tendency to increase production nor a tendency to decrease production. It implies that the national income and employment which correspond to the effective demand are equilibrium levels of national income and employment which correspond to the effective demand are equilibrium levels of national income and employment.

national income and employment.

Unlike classical theory of income and employment, Keynesian theory of income and employment Unlike classical theory of income and employment, Keynesian theory of income and employment

emphasizes that the equilibrium level of employment would not necessarily be full employment. It can be emphasizes that the equilibrium level of employment would not necessarily be full employment. It can be below or above the level of full employment.

below or above the level of full employment.

Determinants of Income: Determinants of Income:

The determinants of effective demand and so of equilibrium level of national income and employment are The determinants of effective demand and so of equilibrium level of national income and employment are the aggregate demand and aggregate supply.

the aggregate demand and aggregate supply.

(1) Aggregate Demand (C+l): (1) Aggregate Demand (C+l):

A

A gg gg regreg ate ate demand demand refers to the sum of expenditure, households, firms and the government is refers to the sum of expenditure, households, firms and the government is

undertaking on consumption and investment in an economy. The aggregate demand price is the amount undertaking on consumption and investment in an economy. The aggregate demand price is the amount of money which the entrepreneurs expect to receive as a result of the sale of output produced by the of money which the entrepreneurs expect to receive as a result of the sale of output produced by the employment of certain number of workers. An increase in the level of employment raises the expected employment of certain number of workers. An increase in the level of employment raises the expected proceeds and a decrease in the level of employment lowers it.

proceeds and a decrease in the level of employment lowers it.

The aggregate demand curve AD (C+I) would be positively sloping signifying that as the level of The aggregate demand curve AD (C+I) would be positively sloping signifying that as the level of

employment increases, the level of output also increases, thereby increasing of aggregate demand (C+l) employment increases, the level of output also increases, thereby increasing of aggregate demand (C+l) for goods. The aggregate demand (C+l), thus, depends directly on the level of real national income and for goods. The aggregate demand (C+l), thus, depends directly on the level of real national income and indirectly on the level of employment.

indirectly on the level of employment.

(2) Aggregate Supply (C+S): (2) Aggregate Supply (C+S):

The

Theaggregate supply aggregate supply refers to the flow of output produced by the employment of workers in an refers to the flow of output produced by the employment of workers in an

economy during a short period. In other words, the aggregate supply is the value of final output valued at economy during a short period. In other words, the aggregate supply is the value of final output valued at factor cost. The aggregate supply price is the minimum amount of money which the entrepreneurs must factor cost. The aggregate supply price is the minimum amount of money which the entrepreneurs must receive

receive to cover the costs of output produced by the employment of certain number of workers.to cover the costs of output produced by the employment of certain number of workers.

The aggregate supply is denoted by (OS) because a part of this is consumed (C) and the other part is The aggregate supply is denoted by (OS) because a part of this is consumed (C) and the other part is

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SOLUTIONS FOR EXAMINATION REGULAR 2015: COMPILED BY KHALID AZIZKHALID AZIZ Determination of Level of Employment and Income:

Determination of Level of Employment and Income:

According to Keynes, the equilibrium

According to Keynes, the equilibrium levels of national income and employment alevels of national income and employment are determined by there determined by the interaction of aggregate demand curve (AD) and aggregate supply curve (AS). The equilibrium level of interaction of aggregate demand curve (AD) and aggregate supply curve (AS). The equilibrium level of income determined by the equality of AD and AS does not necessarily indicate the full employment level. income determined by the equality of AD and AS does not necessarily indicate the full employment level. The equilibrium position between aggregate demand and aggregate supply can be below or above the The equilibrium position between aggregate demand and aggregate supply can be below or above the level of full employment as is shown in the curve below.

level of full employment as is shown in the curve below.

Diagram/Figure: Diagram/Figure:

In figure (32.3), the aggregate demand curve (C+l), intersects the aggregate supply curve (OS) at point In figure (32.3), the aggregate demand curve (C+l), intersects the aggregate supply curve (OS) at point E

E11_{which is an effective demand point. At point E}_{which is an effective demand point. At point E}11_{, the equilibrium of national income is OY}_{, the equilibrium of national income is OY}11_{. Let us}_{. Let us}

assume that in the generation of OY

assume that in the generation of OY11_{level of income, some of the workers willing to work have not been}_{level of income, some of the workers willing to work have not been}

absorbed. It means that E

absorbed. It means that E11_{(effective demand point) is an under employment equilibrium and OY}_{(effective demand point) is an under employment equilibrium and OY}11_{is under}_{is under}

employment level of income. employment level of income.

The unemployed workers can be absorbed if the level of output can be increased from OY

The unemployed workers can be absorbed if the level of output can be increased from OY11_{to OY}_{to OY}22_which_which

we assume is the full employment level. We further assume that due to spending by the government, the we assume is the full employment level. We further assume that due to spending by the government, the aggregate demand curve (C+I+G) rises. As a result of this, the economy moves from lower equilibrium aggregate demand curve (C+I+G) rises. As a result of this, the economy moves from lower equilibrium point E

point E11_{to higher equilibrium point E}_{to higher equilibrium point E}22_{. The OY is now the new equilibrium level of income along with full}_{. The OY is now the new equilibrium level of income along with full}

employment. Thus E

employment. Thus E22_{denotes full employment equilibrium position of the economy.}_{denotes full employment equilibrium position of the economy.}

Thus government spending can help to achieve full employment. In case the equilibrium level of national Thus government spending can help to achieve full employment. In case the equilibrium level of national income is above the level of full employment, this means that the output has increased in money terms income is above the level of full employment, this means that the output has increased in money terms only. The value of the output is just the same to the national income at full employment level.

only. The value of the output is just the same to the national income at full employment level.

Importance of Effective Demand: Importance of Effective Demand:

The principle of effective demand is the most important contribution of

The principle of effective demand is the most important contribution of J.M. Keynes.J.M. Keynes. Its importance in Its importance in macro economics, in brief, is as under:

macro economics, in brief, is as under:

(i)

(i) Determinant of employment.Determinant of employment. Effective demand determines the level of employment in the country. AsEffective demand determines the level of employment in the country. As effective demand increases employment also increases. When effective demand falls, the level of

effective demand increases employment also increases. When effective demand falls, the level of employment also decreases.

employment also decreases.

(ii)

(ii) Say's Law falsified.Say's Law falsified. It is with the help of the principle of effective demand that Says Law of MarketIt is with the help of the principle of effective demand that Says Law of Market has been falsified. According to the concept of effective demand whatever is produced in the economy is has been falsified. According to the concept of effective demand whatever is produced in the economy is not automatically consumed. It is partly saved. As a result, the existence of full employment is not

not automatically consumed. It is partly saved. As a result, the existence of full employment is not possible.

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SOLUTIONS FOR EXAMINATION REGULAR 2015: COMPILED BY KHALID AZIZKHALID AZIZ (iv) Capitalistic economy.

(iv) Capitalistic economy. The principle of effective demand makes clear that in a rich community, the The principle of effective demand makes clear that in a rich community, the gap between income and expenditure is large. If required investment is not made to fill this gap, it will gap between income and expenditure is large. If required investment is not made to fill this gap, it will lead to deficiency of effective demand resulting in unemployment.

lead to deficiency of effective demand resulting in unemployment.

Criticism on Keynesian Theory: Criticism on Keynesian Theory:

From mid 1970 onward, the Keynesian theory of employment came under sharp criticism from the From mid 1970 onward, the Keynesian theory of employment came under sharp criticism from the monetarists.

monetarists. Milton Friedman,Milton Friedman, the Chief advocate of monetarists rejected the Keynesianism as a whole. the Chief advocate of monetarists rejected the Keynesianism as a whole. The monetarists returned back to the old classical theory for the explanation of the rise in general price The monetarists returned back to the old classical theory for the explanation of the rise in general price level and stated that inflation is always and every where a monetary phenomenon.

level and stated that inflation is always and every where a monetary phenomenon.

The monetarists are of the view that J. M. Keynes laid more emphasis on the determinants of aggregate The monetarists are of the view that J. M. Keynes laid more emphasis on the determinants of aggregate demand and to a greater extent ignored the determinants of aggregate supply. The monetarists

demand and to a greater extent ignored the determinants of aggregate supply. The monetarists

encouraged the supply side policy and thus favored free enterprise economy for solving the problems of encouraged the supply side policy and thus favored free enterprise economy for solving the problems of unemployment and inflation.

unemployment and inflation.

J. R. Hicks

J. R. Hicks describes Keyne's ' describes Keyne's 'General Theory General Theory ' as depression economics. Further, the 'General Theory' as depression economics. Further, the 'General Theory of Keynes is applicable to the developed economies. The Keynesians concepts are not very useful for of Keynes is applicable to the developed economies. The Keynesians concepts are not very useful for policy purposes in less developed countries.

policy purposes in less developed countries.

Q 7) a) What do you meant by marginal efficiency of

capital? Describe its determinants.

Concept of Marginal Efficiency of Capital (MEC):

Definition and Explanation:

Marg

Marg ininal al effiefficici ency cency c apital apital (ME(ME CC ) is ) is a a KK eyneseynes ian coian concept.ncept. According to J.M. Keynes, nations output According to J.M. Keynes, nations output depends on its stock capital. An increase in the stock of capital increases output. The question is how depends on its stock capital. An increase in the stock of capital increases output. The question is how much increase in investment raises output? Well, this depends on the productivity of new capital i.e. on much increase in investment raises output? Well, this depends on the productivity of new capital i.e. on the marginal efficiency of capital. Marginal efficiency of capital is the rate return expected to be obtainable the marginal efficiency of capital. Marginal efficiency of capital is the rate return expected to be obtainable on a new capital asset over its life time.

on a new capital asset over its life time.

J.M. Keynes

J.M. Keynes defines marginal efficiency of capital as the: defines marginal efficiency of capital as the:

“The rate of discount which makes the present value of the prospective yield

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According to

According to J.M. KeynesJ.M. Keynes, the behavior of investment in respect of new investment depends upon the, the behavior of investment in respect of new investment depends upon the various stock of capital available in the economy at a particular period of time. As the stock of capital various stock of capital available in the economy at a particular period of time. As the stock of capital increases in the economy, the marginal efficiency of capital goes on diminishing. The MEC curve is increases in the economy, the marginal efficiency of capital goes on diminishing. The MEC curve is negatively sloped as a shown in the figure 30.7.

negatively sloped as a shown in the figure 30.7.

Investment ($ in billion)

Investment ($ in billion) Marginal Efficiency of CapitalMarginal Efficiency of Capital

20 10% 20 10% 25 9% 25 9% 40 7% 40 7% 70 5% 70 5% 100 2% 100 2% Diagram/Curve: Diagram/Curve:

In the above table, it is shown when stock of capital is equal to $20 billion, the marginal efficiency of In the above table, it is shown when stock of capital is equal to $20 billion, the marginal efficiency of capital is 10% while at a capital stock of $100 billion, it declines to 2%. This investment demand schedule capital is 10% while at a capital stock of $100 billion, it declines to 2%. This investment demand schedule when depicted graphically in figure 30.7 gives us the investment demand curve which goes on sloping when depicted graphically in figure 30.7 gives us the investment demand curve which goes on sloping downward from left to right.

downward from left to right.

FACTORS

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SOLUTIONS FOR EXAMINATION REGULAR 2015: COMPILED BY KHALID AZIZKHALID AZIZ because marginal efficiency of capital increases.

because marginal efficiency of capital increases.

6. THE QUANTITY OF CAPITAL GOODS

:-6. THE QUANTITY OF CAPITAL GOODS :- If the capital goods are already in the large quantity to meet If the capital goods are already in the large quantity to meet the demand of the market, then it will not be beneficial for the investors to invest the money in the project the demand of the market, then it will not be beneficial for the investors to invest the money in the project and the marginal efficiency of capital will fall.

and the marginal efficiency of capital will fall.

7. RATE OF POPULATION GROWTH

:-7. RATE OF POPULATION GROWTH :- If the rate of population growth is high then the demand of If the rate of population growth is high then the demand of various goods will increase . So it will increase the marginal efficiency of capital. It falls with the slow bith various goods will increase . So it will increase the marginal efficiency of capital. It falls with the slow bith rate.

rate.

8. TECHNOLOGICAL ADVANCEMENT

:-8. TECHNOLOGICAL ADVANCEMENT :- Inventions and technological improvement encourages Inventions and technological improvement encourages investment in various projects.So marginal efficiency of capital increases.

investment in various projects.So marginal efficiency of capital increases.

9. RATE OF TAXES

:-9. RATE OF TAXES :- If government imposes the taxes on various goods, it will increase the cost of If government imposes the taxes on various goods, it will increase the cost of production and will reduce the profit . So with the fall in profit the rate of investment and marginal production and will reduce the profit . So with the fall in profit the rate of investment and marginal efficiency of capital both falls.

efficiency of capital both falls.

10. LABOUR EFFICIENCY

:-10. LABOUR EFFICIENCY :- Efficiency of labour increases the marginal efficiency of capital lowers. Efficiency of labour increases the marginal efficiency of capital lowers.

11. GOVERNMENT INTERFERENCE

:-11. GOVERNMENT INTERFERENCE :- If the government interferes in the private business and imposes If the government interferes in the private business and imposes some restrictions then people will hesitate to invest and marginal efficiency of capital falls. On the other some restrictions then people will hesitate to invest and marginal efficiency of capital falls. On the other hand if it encourages the private business then marginal efficiency of capital will increase.

hand if it encourages the private business then marginal efficiency of capital will increase.

Q 7) : b) What do

Q 7) : b) What do you mean by expansionary and

you mean by expansionary and

contractionary fiscal policies? Explain how these

policies can be used to

policies can be used to achieve economic objective.

achieve economic objective.

Fiscal Policy

Fiscal policy can be defined as governments actions to influence an economy through the use of taxation Fiscal policy can be defined as governments actions to influence an economy through the use of taxation

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When an economy is in a recession, expansionary fiscal policy is in order. Typically this type of fiscal When an economy is in a recession, expansionary fiscal policy is in order. Typically this type of fiscal policy results in increased government spending and/or lower taxes. A recession results in a recessionary policy results in increased government spending and/or lower taxes. A recession results in a recessionary gap meaning that aggregate demand (ie, GDP) is at a level lower than it would be in a full employment gap meaning that aggregate demand (ie, GDP) is at a level lower than it would be in a full employment situation. In order to close this gap, a government will typically increase their spending which will directly situation. In order to close this gap, a government will typically increase their spending which will directly increase the aggregate demand curve (since government spending creates demand for goods and increase the aggregate demand curve (since government spending creates demand for goods and services). At the same time, the government may choose to cut taxes, which will indirectly affect the services). At the same time, the government may choose to cut taxes, which will indirectly affect the aggregate demand curve by allowing for consumers to have more money at their disposal to consume aggregate demand curve by allowing for consumers to have more money at their disposal to consume and invest. The actions of this expansionary fiscal policy would result in a shift of the aggregate demand and invest. The actions of this expansionary fiscal policy would result in a shift of the aggregate demand curve to the right, which would result closing the recessionary gap and helping an economy grow. curve to the right, which would result closing the recessionary gap and helping an economy grow.

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Contractionary fiscal policy is essentially the opposite of expansionary fiscal policy. When an economy is Contractionary fiscal policy is essentially the opposite of expansionary fiscal policy. When an economy is in a state where growth is at a rate that is getting out of control (causing inflation and asset bubbles), in a state where growth is at a rate that is getting out of control (causing inflation and asset bubbles), contractionary fiscal policy can be used to rein it in to a more sustainable level. If an economy is growing contractionary fiscal policy can be used to rein it in to a more sustainable level. If an economy is growing too fast or for example, if unemployment is too low, an inflationary gap will form. In order to eliminate this too fast or for example, if unemployment is too low, an inflationary gap will form. In order to eliminate this inflationary gap a government may reduce government spending and increase taxes. A decrease in inflationary gap a government may reduce government spending and increase taxes. A decrease in spending by the government will directly decrease aggregate demand curve by reducing government spending by the government will directly decrease aggregate demand curve by reducing government demand for goods and services. Increases in tax levels will also slow growth, as consumers will have less demand for goods and services. Increases in tax levels will also slow growth, as consumers will have less money to consume and invest, thereby indirectly reducing the aggregate demand curve

money to consume and invest, thereby indirectly reducing the aggregate demand curve

Q 8) : Write short notes on any tw

Q 8) : Write short notes on any two of the following:

o of the following:

(i)

Accelerator

Accelerator Coefficient

Coefficient

The Principle of

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This version of the acceleration principle has been more broadly interpreted by Hicks as the ratio of This version of the acceleration principle has been more broadly interpreted by Hicks as the ratio of

induced investment to changes in output it calls forth. Thus the accelerator v is equal to ∆l/∆Y or the induced investment to changes in output it calls forth. Thus the accelerator v is equal to ∆l/∆Y or the

capital- output ratio. capital- output ratio.

It depends on the relevant change in output (∆T) and the change in investment (∆I). It shows that the It depends on the relevant change in output (∆T) and the change in investment (∆I). It shows that the

demand for capital goods is not derived from consumer goods alone but from any direct demand of demand for capital goods is not derived from consumer goods alone but from any direct demand of

national output. national output.

In an economy, the required stock of capital depends on the change in the demand for output. Any In an economy, the required stock of capital depends on the change in the demand for output. Any

change in output will lead to a change in the capital stock.’ Th

change in output will lead to a change in the capital stock.’ This change equals v times the change inis change equals v times the change in

output. Thus ∆I = v∆ Y, where v is the accelerator. output. Thus ∆I = v∆ Y, where v is the accelerator.

If a machine has a value of Rs 4 crores and produces output worth Rs 1 crore, then the value of v is 4. An If a machine has a value of Rs 4 crores and produces output worth Rs 1 crore, then the value of v is 4. An

entrepreneur who wishes to increase his output by Rs 1 crores every year must invest Rs 4 crores on this entrepreneur who wishes to increase his output by Rs 1 crores every year must invest Rs 4 crores on this

machine. This equally applies to an economy where if the value of the accelerator is greater than one, machine. This equally applies to an economy where if the value of the accelerator is greater than one,

more capital is required per unit of output so that the increase in net investment is greater than the more capital is required per unit of output so that the increase in net investment is greater than the

increase in output that causes it. increase in output that causes it.

Gross investment in the economy will equal replacement investment plus net investment. Assuming Gross investment in the economy will equal replacement investment plus net investment. Assuming

replacement investment (i.e., replacement demand for machines due to obsolescence and depreciation) replacement investment (i.e., replacement demand for machines due to obsolescence and depreciation)

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The table traces changes in total output, capital stock, net investment and gross investment over ten time The table traces changes in total output, capital stock, net investment and gross investment over ten time

periods. Assuming the value of the acceleration v=4, the required capital stock in each period is 4 times periods. Assuming the value of the acceleration v=4, the required capital stock in each period is 4 times

the corresponding output of that period, as shown in column (3). the corresponding output of that period, as shown in column (3).

The replacement investment is assumed to be equal to 10 per cent of the capital stock in period t, shown The replacement investment is assumed to be equal to 10 per cent of the capital stock in period t, shown

as 40 in each time period. Net investment in column (5) equals v times the change in output between one as 40 in each time period. Net investment in column (5) equals v times the change in output between one

period and the preceding period. period and the preceding period.

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A

A ss ss umptionumptionss ::

The acceleration principle is based upon the following

The acceleration principle is based upon the following assumptions:assumptions:

1. The acceleration principle assumes a constant capital-output ratio. 1. The acceleration principle assumes a constant capital-output ratio.

2. It assumes that resources are easily available. 2. It assumes that resources are easily available.

3. It assumes that there is no excess or idle capacity in plants. 3. It assumes that there is no excess or idle capacity in plants.

4. It is assumed that the increased demand is permanent. 4. It is assumed that the increased demand is permanent.

5. It also assumes that there is elastic supply of credit and capital. 5. It also assumes that there is elastic supply of credit and capital.

6. It further assumes that an increase in output immediately leads to a rise in net investment. 6. It further assumes that an increase in output immediately leads to a rise in net investment.

(ii) Kinds of Unemployment

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SOLUTIONS FOR EXAMINATION REGULAR 2015: COMPILED BY KHALID AZIZKHALID AZIZ Classical unemployment

Classical unemployment

Classical unemployment is caused when wages are ‘too’ high. This explanation of unemployment Classical unemployment is caused when wages are ‘too’ high. This explanation of unemployment

dominated economic theory before the 1930s, when workers themselves were blamed for not accepting dominated economic theory before the 1930s, when workers themselves were blamed for not accepting lower wages, or for asking for too high wages. Classical unemployment is also called

lower wages, or for asking for too high wages. Classical unemployment is also calledrealreal wage

wage unemployment. unemployment.

Seasonal unemployment Seasonal unemployment

Seasonal unemployment exists because certain industries only produce or distribute their products at Seasonal unemployment exists because certain industries only produce or distribute their products at certain times of the year. Industries where seasonal unemployment is common include farming, tourism, certain times of the year. Industries where seasonal unemployment is common include farming, tourism, and construction.

and construction.

Frictional unemployment Frictional unemployment

Frictional unemployment, also called

Frictional unemployment, also calledsearch unemployment search unemployment , occurs when workers lose their current job, occurs when workers lose their current job and are in the process of finding another one. There may be little that can be done to reduce this type of and are in the process of finding another one. There may be little that can be done to reduce this type of unemployment, other than provide better information to reduce the search time. This suggests that unemployment, other than provide better information to reduce the search time. This suggests thatfullfull employment

employmentis impossible at any one time because some workers will always be in the process ofis impossible at any one time because some workers will always be in the process of changing jobs.

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Negative output gap

Negative output gap – – downward pressure on inflation downward pressure on inflation

If actual GDP is less than potential GDP there is a negative output gap. Some factor resources such as If actual GDP is less than potential GDP there is a negative output gap. Some factor resources such as labour and capital machinery are under-utilized and the main problem is likely to be higher than average labour and capital machinery are under-utilized and the main problem is likely to be higher than average unemployment.

unemployment.

A rising number of people out of

A rising number of people out of work indicate an excess supply of labour, which causes pressure on work indicate an excess supply of labour, which causes pressure on realreal wage rates. We have seen millions of people in the labour market have to accept lower pay rises in

wage rates. We have seen millions of people in the labour market have to accept lower pay rises in recent years, many have seen wage freezes or actual wage cuts at a time when businesses have been recent years, many have seen wage freezes or actual wage cuts at a time when businesses have been under huge pressure to control their costs.

under huge pressure to control their costs.

Positive output gap

Positive output gap – – upward pressure on inflation upward pressure on inflation

• If actual GDP is greater than potential GDP then

• If actual GDP is greater than potential GDP thenthere is a positive output gap.there is a positive output gap.

• Some resources including labour are likely to be working beyond their normal capacity e.g. making extra • Some resources including labour are likely to be working beyond their normal capacity e.g. making extra

use of shift work and overtime. use of shift work and overtime.

• The main problem is likely to be an acceleration of demand

• The main problem is likely to be an acceleration of demand-pull and cost-push inflation.-pull and cost-push inflation.

• A positive output gap is associated with countries where an economy is over

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Column (3) of the Table shows that when income is zero or very low, people dissave (minus Rs 20 crores Column (3) of the Table shows that when income is zero or very low, people dissave (minus Rs 20 crores

or Rs 10 crores). They have to consume even if they are not earning or their consumption expenditure or Rs 10 crores). They have to consume even if they are not earning or their consumption expenditure

(Rs 70 crores) is more than their income (Rs 60 crores). (Rs 70 crores) is more than their income (Rs 60 crores).

When income (Rs 20 crores) equals consumption expenditure (Rs 120 crores), savings are zero. As When income (Rs 20 crores) equals consumption expenditure (Rs 120 crores), savings are zero. As

income increases further by Rs 60 crores, their savings increase by Rs 10 crores. It shows that as income income increases further by Rs 60 crores, their savings increase by Rs 10 crores. It shows that as income

increases savings also increase but by less than proportionately. increases savings also increase but by less than proportionately.

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The propensity to save curve is shown in Fig. 1 where income is taken on the horizontal axis and saving The propensity to save curve is shown in Fig. 1 where income is taken on the horizontal axis and saving

on the vertical axis. The entire S curve with a definite position and slope is the propensity to save curve. on the vertical axis. The entire S curve with a definite position and slope is the propensity to save curve.

The figure shows that below point Y, savings are negative because people disserve. At Y, savings are The figure shows that below point Y, savings are negative because people disserve. At Y, savings are

zero. Above Y, savings increase with the rise in income. The S curve is linear (straight line) because the zero. Above Y, savings increase with the rise in income. The S curve is linear (straight line) because the

rise in income and savings is at constant rates (Rs 60 crores and Rs 10 crores respectively). rise in income and savings is at constant rates (Rs 60 crores and Rs 10 crores respectively).

The propensity to save is of two types: The average propensity to save and the marginal propensity to The propensity to save is of two types: The average propensity to save and the marginal propensity to

save, which we explain below. save, which we explain below.

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income,

income, i.e., i.e., S/S/ Y. FY. For exor example, ample, in Tain Table ble 1 w1 when hen income income increaincreases ses from from Rs 1Rs 180 80 crores crores to Rto Rs 240s 240

crores, savings

crores, savings increase from Rs increase from Rs 10 crores 10 crores to Rs. to Rs. 20 crores 20 crores so that so that Y = Y = Rs. 60 Rs. 60 (=240-180) crores(=240-180) crores

and

and S S = = Rs Rs 10 10 (= (= 2020 – – 10) crores and the MPS = 10/60 = 0.17. It means that 17 per cent of income is 10) crores and the MPS = 10/60 = 0.17. It means that 17 per cent of income is

saved, as shown in column (5) of the Table. It is constant at 0.17 because AS/AY= 10/60 is constant. saved, as shown in column (5) of the Table. It is constant at 0.17 because AS/AY= 10/60 is constant.

Diagrammatically, the MPS is measured by the gradient or slope of the S curve at a point or over a small Diagrammatically, the MPS is measured by the gradient or slope of the S curve at a point or over a small

range. This is shown in Fig. 3 by AB/BC where AB is the change in saving

range. This is shown in Fig. 3 by AB/BC where AB is the change in saving S and ВС is the change inS and ВС is the change in

income Y. income Y.