Advanced Macroeconomics (806)
Advanced Macroeconomics (806)
Q.1 Explain in worlds how and why the income and interest sensitivities of the for real balance affect the slope of the LM curve.
The LM curve represents the equilibrium in the money market, where the supply of money is equal to the demand for money. It shows the combinations of interest rates and income levels that maintain this equilibrium. The slope of the LM curve is determined by the sensitivity of
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real balances to changes in income and
interest rates.
To
understand how and why the income and interest sensitivities of real balances
affect the slope of the LM curve, we need to delve into the components
involved:
1. Real Balances: Real
balances, also known as real money holdings, refer to the purchasing power of
money. It represents the amount of money an individual or entity holds in
relation to the price level. Real balances can be calculated by dividing
nominal money holdings by the price level.
2. Income Sensitivity: The
income sensitivity of real balances reflects how real balances respond to
changes in income. It is determined by the demand for money as an asset for
transactions purposes. As income increases, individuals and firms typically
require more money to facilitate increased spending. Consequently, the demand
for real balances tends to rise as income rises.
3. Interest Sensitivity: The
interest sensitivity of real balances relates to the response of real balances
to changes in interest rates. The demand for money as an asset for holding
wealth is influenced by the opportunity cost of holding money instead of
interest-bearing assets. When interest rates are high, the opportunity cost of
holding money increases, and individuals and firms may choose to hold fewer
real balances and invest more in interest-bearing assets. Thus, the demand for
real balances tends to decline as interest rates rise.
Now,
let's explore the relationship between these factors and the slope of the LM
curve:
The LM
curve depicts combinations of interest rates and income levels that ensure the
equilibrium in the money market. A steeper slope indicates a greater
sensitivity of real balances to changes in income and interest rates.
1. Income Sensitivity and LM Curve Slope: When
the income sensitivity of real balances is high, an increase in income leads to
a larger increase in the demand for real balances. As income rises, individuals
and firms require more money to support their transactions. Therefore, the LM
curve becomes steeper, indicating that a larger change in income is required to
induce a given change in the interest rate, in order to maintain equilibrium in
the money market.
2. Interest Sensitivity and LM Curve
Slope: If the interest sensitivity of real balances is high, a
rise in interest rates prompts individuals and firms to reduce their demand for
real balances and opt for interest-bearing assets. Consequently, the demand for
real balances decreases, resulting in a flatter LM curve. A smaller change in
income is needed to bring about a given change in the interest rate, in order
to maintain money market equilibrium.
In
summary, the income and interest sensitivities of real balances have a direct
impact on the slope of the LM curve. A higher income sensitivity or a lower
interest sensitivity leads to a steeper LM curve, indicating that larger
changes in income are necessary to induce a given change in the interest rate
to maintain money market equilibrium. Conversely, a lower income sensitivity or
higher interest sensitivity results in a flatter LM curve, implying that smaller
changes in income can bring about a given change in the interest rate to
maintain equilibrium in the money market.
Q.2 Suppose
the government cuts income that show in the IS-LM model the impact of the tax
cut under two assumptions.
In the
IS-LM model, which stands for Investment-Saving (IS) and Liquidity
Preference-Money Supply (LM), the impact of a tax cut by the government can be
analyzed under two key assumptions: the flexible price assumption and the
sticky price assumption. Let's examine each assumption and discuss the effects
of a tax cut in both scenarios.
1. Flexible Price Assumption:
Under
the flexible price assumption, it is assumed that prices and wages adjust
instantaneously in response to changes in supply and demand. In this case, the
impact of a tax cut can be analyzed through the IS curve and the LM curve.
a. IS Curve: The
IS curve represents the equilibrium in the goods market, showing the
combinations of interest rates and income levels at which aggregate demand (AD)
equals aggregate supply (AS). A tax cut can have two effects on the IS curve:
i.
Increase in Disposable Income: A tax cut effectively increases disposable
income for households and firms. With more income available, consumption and
investment spending are likely to rise. This leads to an upward shift of the IS
curve, as higher levels of income and spending are needed to achieve
equilibrium in the goods market.
ii. Crowding Out Effect: On the other
hand, a tax cut may lead to a decrease in government revenue, potentially
causing a budget deficit. To finance the deficit, the government may need to
increase borrowing, which raises interest rates. Higher interest rates can
reduce private investment, offsetting the positive effects of increased
consumption. This can result in a less pronounced shift or even a downward
shift of the IS curve.
b. LM Curve: The LM
curve represents the equilibrium in the money market, showing combinations of
interest rates and income levels at which the demand for money equals the
supply of money. The impact of a tax cut on the LM curve can be analyzed as
follows:
i. Increased Money Supply: If
the government finances the tax cut by increasing the money supply, the LM
curve will shift to the right. This is because there is more money available in
the economy, which lowers interest rates and stimulates investment and
consumption. The increase in the money supply can lead to a lower equilibrium
interest rate and higher income levels.
ii. Unchanged Money Supply: If
the tax cut is not accompanied by an increase in the money supply, the LM curve
may not shift. However, changes in the IS curve, as discussed earlier, can
still influence interest rates and income levels.
In
summary, under the flexible price assumption, a tax cut can have mixed effects
on the IS-LM model. It can lead to an upward shift of the IS curve due to
increased consumption and investment, but it can also result in higher interest
rates due to potential crowding out effects. The impact on the LM curve depends
on whether the tax cut is accompanied by an increase in the money supply.
2. Sticky Price Assumption:
Under
the sticky price assumption, it is assumed that prices and wages do not adjust
immediately to changes in supply and demand. Instead, they adjust gradually
over time. In this case, the impact of a tax cut can be analyzed through the IS
curve and the aggregate demand (AD) curve.
a. IS Curve: The
IS curve still represents the equilibrium in the goods market, but the
adjustment mechanism is different under the sticky price assumption. A tax cut
can have two effects on the IS curve:
i. Increase in Disposable Income: Similar
to the flexible price assumption, a tax cut increases disposable income,
leading to increased consumption and investment spending. This causes the IS
curve to shift to the right, reflecting the higher level of income and spending
needed to achieve goods market equilibrium.
ii.
Wealth Effect: A tax cut can also have a wealth effect. When individuals or
firms experience a tax cut, their wealth increases. This can lead to
an
increase in consumption spending, as individuals feel wealthier and more
confident in their financial situation. This also results in an upward shift of
the IS curve.
b. Aggregate Demand (AD) Curve: Under
the sticky price assumption, the AD curve represents the relationship between
the price level and aggregate output (income) in the economy. The impact of a
tax cut on the AD curve can be analyzed as follows:
i. Increased Aggregate Demand: A tax
cut increases disposable income and consumption, which in turn increases
aggregate demand. This causes the AD curve to shift to the right, reflecting
the higher level of spending at each price level.
ii. Potential Inflationary Pressures: If the
increase in aggregate demand exceeds the economy's capacity to produce goods
and services in the short run, it can lead to inflationary pressures. This
occurs when the demand for goods and services outpaces the supply, leading to
upward pressure on prices.
In
summary, under the sticky price assumption, a tax cut leads to an upward shift
of both the IS curve and the AD curve. This is due to increased consumption and
investment spending resulting from higher disposable income and the wealth
effect. However, the impact on the AD curve can also introduce potential
inflationary pressures if aggregate demand exceeds the economy's capacity.
It is
important to note that the effects of a tax cut in the IS-LM model depend on
various factors such as the size of the tax cut, the government's financing
mechanisms, the degree of price stickiness, and the overall state of the
economy. Additionally, the model assumes ceteris paribus (all other things
being equal), which may not always hold in real-world situations.`
a) The
government keeps interest rates constant through an accommodating monetary
policy.
b) The
money stock remains unchanged. Explain the difference in results.
Under
the two different scenarios mentioned, where the government keeps interest
rates constant through an accommodating monetary policy and the money stock
remains unchanged, there are distinct differences in the results. Let's examine
each scenario and discuss the implications.
a) The government keeps interest rates
constant through an accommodating monetary policy:
In
this scenario, the government takes measures to ensure that interest rates
remain at a fixed level, regardless of other economic factors. This can be
achieved through an accommodating monetary policy, where the central bank
adjusts its monetary instruments, such as open market operations or reserve
requirements, to maintain the desired interest rate.
When
interest rates are kept constant, it affects the LM curve in the IS-LM model,
while the IS curve remains unchanged. The impact of this policy can be analyzed
as follows:
1. LM Curve: The LM
curve represents the equilibrium in the money market, showing combinations of
interest rates and income levels at which the demand for money equals the
supply of money. When interest rates are held constant, the LM curve becomes
vertical, indicating that changes in income no longer affect the interest rate.
2- Monetary Policy Actions: To
maintain a fixed interest rate, the central bank adjusts the money supply as
needed. If there is an increase in income and the demand for money rises, the
central bank increases the money supply to accommodate the increased demand and
keep the interest rate constant. Conversely, if there is a decrease in income
and the demand for money falls, the central bank reduces the money supply to
maintain the desired interest rate.
3- Impact on Income: With a
vertical LM curve, changes in income no longer lead to changes in the interest
rate. Therefore, the impact of changes in income on equilibrium income levels
becomes more pronounced. An increase in income will no longer be offset by a
rise in interest rates, as the LM curve is fixed at the constant interest rate.
4-
Output and Employment: In this scenario, changes in income have a direct impact
on output and employment levels, as there are no interest rate adjustments to
counteract them. An increase in income leads to higher levels of output and
employment, while a decrease in income results in lower levels of output and
employment.
5- Investment:
Investment spending is influenced by changes in income, as the constant
interest rate does not affect investment decisions. Higher income levels
generally lead to increased investment, as firms have more available funds for
investment projects.
b) The money stock remains unchanged:
In
this scenario, the government does not alter the money stock, meaning that the
supply of money remains constant. This affects the LM curve and the IS curve in
the IS-LM model. The implications of this scenario are as follows:
1. LM Curve: Since
the money stock remains unchanged, the LM curve retains its traditional
upward-sloping shape. Changes in income will affect the equilibrium interest
rate, as the demand for money will vary with income levels.
2- Interest Rate Adjustment: As
income increases, the demand for money rises, putting upward pressure on
interest rates. Conversely, a decrease in income leads to a decrease in the
demand for money, resulting in lower interest rates. The LM curve adjusts to
ensure that the money market remains in equilibrium.
3- Impact on Income:
Changes in income lead to adjustments in the interest rate, which then affects
income levels. Higher income leads to increased interest rates, which can have
a dampening effect on investment and consumption. This can result in a decrease
in income compared to the initial increase.
4- Output and Employment: The
adjustment in the interest rate due to changes in income affects investment and
consumption spending, influencing output and employment levels. Higher interest
rates can discourage investment and borrowing, leading to reduced output and
employment. Conversely, lower interest rates can stimulate investment and
borrowing, boosting output and employment.
4- Investment: Investment
decisions are influenced by changes in the interest rate.
With
an upward-sloping LM curve, changes in the interest rate due to changes in
income levels can impact investment decisions. Higher interest rates can
discourage investment, as the cost of borrowing increases. Conversely, lower
interest rates can incentivize investment, as the cost of borrowing decreases.
In
summary, the key difference between the two scenarios lies in the behavior of
the LM curve and the response of the interest rate to changes in income. In the
first scenario, where the government keeps interest rates constant through an
accommodating monetary policy, the LM curve becomes vertical, and changes in
income have a direct impact on output and employment. In the second scenario,
where the money stock remains unchanged, the LM curve retains its
upward-sloping shape, and changes in income lead to adjustments in the interest
rate, which then influence output, employment, and investment decisions.
It is
important to note that these scenarios assume ceteris paribus (all other things
being equal) and do not consider the potential effects of other factors such as
fiscal policy, inflation expectations, or external shocks. Additionally, the
actual impact of these scenarios can vary depending on the specific
characteristics of the economy and the effectiveness of government policies.
Q.3 In
the friction less neoclassical model assumes that labour becomes less
productive, with the labour demand curve shifting downward and to the left.
a) What is the effect of the change on the
full employment levels of employment and output?
b) What is the effect on the full
employment real ways?
Under
the two different scenarios mentioned, where the government keeps interest
rates constant through an accommodating monetary policy and the money stock
remains unchanged, there are distinct differences in the results. Let's examine
each scenario and discuss the implications.
a) The government keeps interest rates
constant through an accommodating monetary policy:
In
this scenario, the government takes measures to ensure that interest rates
remain at a fixed level, regardless of other economic factors. This can be
achieved through an accommodating monetary policy, where the central bank
adjusts its monetary instruments, such as open market operations or reserve
requirements, to maintain the desired interest rate.
When
interest rates are kept constant, it affects the LM curve in the IS-LM model,
while the IS curve remains unchanged. The impact of this policy can be analyzed
as follows:
1. LM Curve: The
LM curve represents the equilibrium in the money market, showing combinations
of interest rates and income levels at which the demand for money equals the
supply of money. When interest rates are held constant, the LM curve becomes
vertical, indicating that changes in income no longer affect the interest rate.
2- Monetary Policy Actions: To
maintain a fixed interest rate, the central bank adjusts the money supply as
needed. If there is an increase in income and the demand for money rises, the
central bank increases the money supply to accommodate the increased demand and
keep the interest rate constant. Conversely, if there is a decrease in income
and the demand for money falls, the central bank reduces the money supply to
maintain the desired interest rate.
3- Impact on Income: With a
vertical LM curve, changes in income no longer lead to changes in the interest
rate. Therefore, the impact of changes in income on equilibrium income levels
becomes more pronounced. An increase in income will no longer be offset by a
rise in interest rates, as the LM curve is fixed at the constant interest rate.
4- Output and Employment: In
this scenario, changes in income have a direct impact on output and employment
levels, as there are no interest rate adjustments to counteract them. An
increase in income leads to higher levels of output and employment, while a
decrease in income results in lower levels of output and employment.
5- Investment: Investment
spending is influenced by changes in income, as the constant interest rate does
not affect investment decisions. Higher income levels generally lead to
increased investment, as firms have more available funds for investment
projects.
b) The money stock remains unchanged:
In
this scenario, the government does not alter the money stock, meaning that the
supply of money remains constant. This affects the LM curve and the IS curve in
the IS-LM model. The implications of this scenario are as follows:
1. LM Curve: Since
the money stock remains unchanged, the LM curve retains its traditional
upward-sloping shape. Changes in income will affect the equilibrium interest
rate, as the demand for money will vary with income levels.
2- Interest Rate Adjustment: As
income increases, the demand for money rises, putting upward pressure on
interest rates. Conversely, a decrease in income leads to a decrease in the
demand for money, resulting in lower interest rates. The LM curve adjusts to
ensure that the money market remains in equilibrium.
3- Impact on Income:
Changes in income lead to adjustments in the interest rate, which then affects
income levels. Higher income leads to increased interest rates, which can have
a dampening effect on investment and consumption. This can result in a decrease
in income compared to the initial increase.
4- Output and Employment: The
adjustment in the interest rate due to changes in income affects investment and
consumption spending, influencing output and employment levels. Higher interest
rates can discourage investment and borrowing, leading to reduced output and
employment. Conversely, lower interest rates can stimulate investment and
borrowing, boosting output and employment.
5- Investment:
Investment decisions are influenced by changes in the interest rate.
With
an upward-sloping LM curve, changes in the interest rate due to changes in
income levels can impact investment decisions. Higher interest rates can
discourage investment, as the cost of borrowing increases. Conversely, lower
interest rates can incentivize investment, as the cost of borrowing decreases.
In
summary, the key difference between the two scenarios lies in the behavior of
the LM curve and the response of the interest rate to changes in income. In the
first scenario, where the government keeps interest rates constant through an
accommodating monetary policy, the LM curve becomes vertical, and changes in
income have a direct impact on output and employment. In the second scenario,
where the money stock remains unchanged, the LM curve retains its
upward-sloping shape, and changes in income lead to adjustments in the interest
rate, which then influence output, employment, and investment decisions.
It is
important to note that these scenarios assume ceteris paribus (all other things
being equal) and do not consider the potential effects of other factors such as
fiscal policy, inflation expectations, or external shocks. Additionally, the
actual impact of these scenarios can vary depending on the specific
characteristics of the economy and the effectiveness of government policies.
Q.4 in
the classical model how will and increased desire by the public to hold money
balances affect prices, in comes and employment?
In the
classical model, an increased desire by the public to hold money balances, also
known as an increase in the demand for money, can have implications for prices,
income, and employment. Let's explore these effects in detail.
1. Prices:
In the
classical model, prices are primarily determined by the quantity of money in
circulation and the velocity of money (the rate at which money changes hands).
An increased desire to hold money balances implies a higher demand for money
relative to the supply of money. This increased demand for money, without a
corresponding increase in the money supply, can lead to a decrease in the velocity
of money.
As
people hold onto more money, the velocity of money slows down, reducing the
frequency of transactions in the economy. This decrease in the velocity of
money puts downward pressure on aggregate demand, which can lead to a decrease
in prices. In other words, with a higher desire to hold money balances, there
is less spending happening in the economy, resulting in a potential
deflationary effect.
2. Income:
In the
classical model, changes in the demand for money do not directly impact income.
However, the change in the demand for money can have indirect effects on income
through adjustments in the interest rate and investment.
0As
people increase their desire to hold money balances, they may choose to save
more rather than spending or investing. This increased saving can lead to a
decrease in the demand for loanable funds and put downward pressure on interest
rates. Lower interest rates can stimulate investment and borrowing, leading to
increased aggregate demand and potentially higher income levels.
Conversely,
if the increased desire for money balances results in reduced spending and
investment, it can have a contractionary effect on income. Reduced aggregate
demand can lead to lower production levels, decreased employment, and a decline
in income.
3. Employment:
In the
classical model, changes in the demand for money do not have a direct impact on
employment. However, the indirect effects mentioned earlier can influence
employment levels.
If the
increased desire for money balances leads to reduced spending and investment,
firms may respond by reducing production and employment. Lower aggregate demand
can result in a decrease in the demand for goods and services, leading to a
potential decline in employment levels.
On the
other hand, if the decreased spending is accompanied by lower interest rates
and increased investment, it can stimulate aggregate demand and potentially
lead to an increase in employment. Higher investment can create job
opportunities and increase production levels.
It is
important to note that the classical model assumes flexibility in prices and
wages, implying that adjustments in response to changes in the demand for money
are relatively swift. However, in the real world, prices and wages may be
sticky in the short run, which can impact the speed and magnitude of the
effects described above.
Additionally,
the classical model focuses on long-run equilibrium and does not consider other
factors that can influence prices, income, and employment, such as fiscal
policy, technological changes, or expectations. Real-world economies are more
complex and subject to various influences that can modify the relationship
between the demand for money and these macroeconomic variables.
Overall,
while an increased desire to hold money balances in the classical model can
have deflationary effects on prices and potentially impact income and
employment indirectly through adjustments in interest rates and investment, the
actual outcomes depend on the specific circumstances and interactions with
other economic factors.
Q.5 Compare
and contrast the absolute income hypothesis and permanent income hypothesis.
The
absolute income hypothesis and the permanent income hypothesis are two economic
theories that attempt to explain how individuals' consumption patterns are
determined by their income levels. While they both address the relationship
between income and consumption, they differ in their assumptions and implications.
This essay will compare and contrast these two theories, highlighting their key
features and underlying principles.
The
absolute income hypothesis, proposed by economist John Maynard Keynes, posits
that an individual's consumption is primarily determined by their current level
of income. According to this theory, people tend to spend a fixed proportion of
their income on consumption, regardless of the income level. In other words,
individuals have a certain threshold of income below which they cannot sustain
their desired level of consumption. Consequently, any increase in income above
this threshold leads to a corresponding increase in consumption.
The
permanent income hypothesis, developed by economist Milton Friedman, challenges
the notion that current income alone determines consumption. Instead, it argues
that individuals base their consumption decisions on their long-term, or
permanent, income rather than their temporary or transitory income. Permanent
income refers to the average income an individual expects to earn over an
extended period. According to this theory, individuals save or borrow during
periods of income fluctuation to maintain a relatively constant level of
consumption over time.
One
key difference between the two theories lies in their treatment of income
changes. The absolute income hypothesis assumes that individuals react
proportionately to changes in income. For example, if someone's income
increases by 10%, their consumption is expected to rise by a similar
percentage. In contrast, the permanent income hypothesis suggests that
individuals adjust their consumption gradually in response to changes in
permanent income, rather than reacting immediately to transitory income
changes. This implies that a temporary increase in income, such as a bonus or
windfall, might not result in a corresponding increase in consumption, as
individuals may choose to save or invest the extra income rather than spend it.
Another
distinction between the two theories is their view on saving behavior. The
absolute income hypothesis suggests that saving is primarily a function of
income levels. As income increases, saving levels should decrease because
people allocate a larger share of their income to consumption. On the other
hand, the permanent income hypothesis argues that saving is based on the gap
between actual income and permanent income. If individuals perceive a shortfall
between their current and permanent income, they will save to bridge that gap
and maintain their desired level of consumption. Similarly, if they experience
a windfall or an increase in permanent income, they may choose to save less and
increase their consumption.
The
time horizon considered by each theory is also worth noting. The absolute
income hypothesis focuses on short-term consumption decisions and assumes that
individuals adjust their consumption primarily in response to changes in their
current income. In contrast, the permanent income hypothesis takes a
longer-term perspective, considering individuals' expectations of future income
and their effects on consumption decisions. It suggests that individuals have
forward-looking behavior and make consumption choices based on their perceived
long-term income prospects.
In
terms of policy implications, the two theories suggest different approaches to
stimulating economic activity. The absolute income hypothesis suggests that
policies aimed at increasing individuals' disposable income, such as tax cuts
or income redistribution, can boost consumption and stimulate economic growth. This
is because individuals with higher income levels are likely to have a higher
marginal propensity to consume. In contrast, the permanent income hypothesis
implies that policies focused on enhancing individuals' long-term income
prospects, such as education and skills training, might be more effective in
promoting sustained consumption and economic development.
In
conclusion, the absolute income hypothesis and the permanent income hypothesis
offer distinct perspectives on the relationship between income and consumption.
While the absolute income hypothesis emphasizes the immediate impact of current
income on consumption, the permanent income hypothesis considers individuals'
long-term income expectations. Understanding these theories can help economists
and policymakers analyze consumption patterns, predict economic behavior, and
design effective policies to promote economic growth and stability. By
considering both short-term and long-term income dynamics, policymakers can
make informed decisions that align with individuals' consumption behavior and
economic realities.
Dear Student,
Ye sample assignment h. Ye bilkul
copy paste h jo dusre student k pass b available h. Agr ap ne university
assignment send krni h to UNIQUE assignment
hasil krne k lye ham c contact kren:
0313-6483019
0334-6483019
0343-6244948
University c related har news c
update rehne k lye hamra channel subscribe kren: