Macroeconomics and Macroeconomic Policies by pharmphresh31

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									     Masters in International and Development Economics (MIDE)

Macroeconomics and Macroeconomic Policies

        (FAQ for Exercise Given by Prof. Dr. Jan Priewe, April 2005)

                               Prepared by
                         Muhammad Jami Husain
                             (April-July, 2005)


                                 July 2005
In some cases, the explanations/answers to the questions may not be correct/may be incomplete/
may be found with redundant contents. Redundancies are accommodated to clarify the concepts.
The answers are mostly the extracts from several books (mainly Snowdon 1994, Bofinger 2001,
Priewe 2005, Sloman 2000, and website documents). In several cases they may be found poorly
organized in terms of articulation.
The user is recommended not to rely entirely to the contents until he/she is fully convinced of the
answers after going through/consulting the reference books by himself/herself.

                                                                        Muhammad Jami Husain
                                                                        Matrikel Nr. 76900513414
Macroeconomics and Macroeconomic Policies
                                         ---FAQ for Exercise Given by Prof. Dr. Jan Priewe, April 2005

1. Explain some “fallacies of aggregation” (i.e. drawing macroeconomic conclusions from
microeconomic analysis)!

Fallacies of aggregation:

Fallacy of aggregation refers to the tendency to draw macroeconomic conclusions from
microeconomic analysis. In other words, when someone is trapped in the misleading notion
that ‘what is true at the micro level analysis would always be true at aggregate level’ is
referred to as fallacy of aggregation.
The fallacy of aggregation may be explained with few economic and non-economic examples.

         For instance, suppose one person who stands up in a cinema hall full of spectators
         would be able to see the screen much better than in a sitting position. However, if
         everyone stands up following the observed conclusion at the individual level then the
         situation would become worse.

         A firm that lowers the price of its product is expected to increase its market share
         from a perspective of a micro-level analysis. However if everyone is trapped with this
         fallacy and thereby reduce the price then the market share may remain unchanged and
         everyone is worse off.

         Micro-level demand-supply equilibrium analysis entails that in situations of excess
         demand or excess supply only price adjustment (upward or downward) would ensure
         equilibrium. However, it would be a fallacy to think accordingly that deflation or
         inflation is required to reach equilibrium at macro-level. Such conclusion warrants
         much more analysis.

2. (a) Define the GDP! (b) What is the difference between GDP and GNI!

GDP (Gross Domestic Product) is defined as the market value of all final goods and services
produced during a given time period within a country. Three points are emphasized in this

       GDP includes only final goods and services, and not intermediate product.
       GDP measures only currently produced goods and services; it excludes the purchases
       or sale of goods that already exist.
       GDP measures only goods and services that are exchanged in a market transaction.
GNP or GNI is the total value, in current prices, of all final goods and services produced by the
Muhammad Jami Husain                                                         MIDE 2005/06, FHTW-Berlin

factors of production that are supplied (owned) by the residents of a country during a specific
period of time. GNP (or GNI) represents the total income of all residents of a nation including
income earned by participating in production taking place in foreign countries (mostly interest
and dividends earned by resident owners of capital that is used in a foreign country and the
payments sent home by its nationals living abroad).The difference between the two measures
corresponds to the net income earned by foreigners – national factors working abroad net of
foreign factors working within a country.
An illustrative Example:

Suppose that Mr. A lives in Bangladesh but works for the Siemens Company in Germany. The
product that Mr. A produces is part of the total output of the German economy. Since Mr. A
takes his pay check home to Bangladesh (where he uses this income to pay taxes, buy goods
and services, and save), Mr. A’s income is part of the GNP of Bangladesh.

Similarly, If Mr. B is a resident (citizen) of German but works for XYZ company in
Bangladesh, the output produced by him will be part of Bangladesh GDP and Mr. B’s income
is part of the national income of Germany.
German GDP:            excludes Mr. B’s Output

                       Includes Mr. A’s output
German GNP:            includes Mr. B’s output

                       Excludes Mr. A’s output
Bangladesh GDP:        includes Mr. B’s output

                       Excludes Mr. A’s output
Bangladesh GNP:        excludes Mr. B’s Output

                       Includes Mr. A’s output
While the conceptual distinction behind the two measures are straightforward (geography vs.
nationality), measuring overseas activity by a country’s national is extremely difficult. In 1992,
GDP in Zambia and Haiti was larger than GNP (by 18% and 16% respectively), while it was
smaller in Kuwait and Luxembourg (by 21% and 27%).

3. What are the components of aggregate demand in an open economy with government?

The components of aggregate demand in an open economy are:

    a) Personal or Private consumption (C)
             o Durable goods; Non-durable goods; and Services.

    b) Gross Private Domestic Investment (I)

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Muhammad Jami Husain                                                        MIDE 2005/06, FHTW-Berlin

             o It represents expenditures made to increase future output of final products
             o Fixed Investment: Non-residential structures (new plant and equipments),
               producers’ durable equipment, and new residential structures.
             o Changes in business inventories
             o This item does not include purchases of existing plants or buildings, or of
               financial assets such as stocks and bonds, both of which represent transfer of
               existing assets.
    c) Government Purchases of goods and services (G)

             o Federal: national defence and non-defence; State and Local
             o Combines governmental consumption expenditure with public investment
             o Excludes government transfers (such as social security and welfare payments)
    d) Net exports (exports less imports, or X-M).

             o Exports and imports of goods and services.
Therefore the expenditure components of GDP and can be shown in the following way:

                              GDP = C + I + G + (X-M)

4. (a) Define “investment” as a term of SNA! (b) Discuss whether (i) constructing a new house
(ii) buying an old house (iii) expenditures for research & development (iv) buying shares of a
company, should be regarded and understood as “investment” and thus be conceived as
contributing to aggregate demand and GDP!

The term ‘Investment’ refers to gross private domestic investment, which represents
expenditures made to increase future output of final products. It includes business purchases of
capital goods (new plant and equipment), changes in business inventory (a form of business
investment), and residential construction of new homes (which produce future services in the
form of shelter). Investment does not include purchases of existing plants or buildings, or
financial assets such as stocks and bonds, both of which represent transfer of existing assets.

Item 1. Constructing a new house: Construction of a new house produces future services in the
form of shelter and thereby regarded as an ‘investment item’ and part of aggregate demand and
Item 2. Buying an old house: Transfers of existing assets are not considered as ‘investment’
and thereby buying an old house does not contribute to aggregate demand and GDP.
Item 3. Expenditures for research and development: Both advertising and research and
development expenditures are not considered as ‘investment’. These items are classified as
intermediate consumption, because they constitute part of the total output.

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Muhammad Jami Husain                                                        MIDE 2005/06, FHTW-Berlin

Item 4. Buying Shares of a Company (Portfolio Investment; <10% share): Purchase of
existing shares is not included as ‘investment’ component. However, if company issues
primary or new shares then it would contribute to GDP; because in this case revenue by farm is
used to buy capital goods.

Item. FDI: Purchase of parts of foreign company bigger than 10% share is defined as FDI.
Mergers, exchange of ownership etc are not considered as investment in national account, but
fresh FDI may contribute to GDP.

5. What is the difference between net and gross investment?

The investment term (I) measures gross investment. It does not adjust for the fact that capital
wear out. Net investment is therefore the amount of investment that is derived from gross
investment after deducting depreciation.
The part of the current production of capital goods that replaces capital worn out in production
is not net addition to total output. Nevertheless, it is included in the investment total and is
balanced by the inclusion of the depreciation expense item on the other side of he account. The
word ‘gross’ is applied to the description of investment to denote the fact that not all
investment represents a net addition to the capital stock. Later, when we tailor these concepts
for use in macroeconomics analysis, we will subtract depreciation from gross investment and
then speak of the resulting figure as ‘net’ investment, meaning by that the net addition to the
stock of capital.

6. Why is in a closed economy without government S = I ex post?

In a closed economy where it is assumed to exist neither a government nor foreign trade the
value of output is, say, Y. Consumption is denoted by C and investment spending by I. The
first key identity is that output produced equals output sold. Output sold can be expressed in
terms of the components of demand as the sum of consumption and investment spending.
Accordingly we can write,
Y ≡ C+I

The unsold outputs, i.e. accumulation of inventories are counted as part of investment, and
therefore, all output is either consumed or invested.

The next step is to establish a relation among savings, consumption, and GDP. Part of the total
income will be spent on consumption, and part will be saved. Thus we can write,

Y ≡ C+S
Combining the two identities, we get: C + I ≡ Y ≡ C + S

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Muhammad Jami Husain                                                       MIDE 2005/06, FHTW-Berlin

The left hand side of the identity shows the components of demand, and the write-hand side
shows the allocation of income. The identity emphasizes that output produced is equal to
output sold. The value of output produced is equal to income received, and income received, in
turn, is spent on goods or saved.

With slight reformulation we find,
I ≡ Y- C ≡ S

The above identity shows that in a closed economy without state investment is identically
equal to saving.

7. How does the ex post identy I=S change in an open economy with government?

Reintroducing government and e<<,,.,.,al secto< <.<<<    x    <he ex-post identity of I ≡ S in a
closed economy will bear some modification in the following way:
Taking into account all components of demand we can state the fundamental identity:

GDP ≡ C + Igr + G + (X – M)……………………………………(1)e, GDP = Gross domestic
product, or total output.
Igr = Gross investment

G = Government purchases of goods and services
X = Export of goods and services

M = Import of goods and services
The Government enters the picture in two ways. It taxes earned income and it provides transfer
payments. This leaves the household sector with two sources – earned income (Y) and
transfers (TR) – and three possible uses – savings (S), consumption, and income taxes (Dtax).
Because total sources of income must equal expenditures,
Y + TR ≡ S + C + Dtax……………..………………….(1a)

Again, total earned income is equal to GDP less depreciation (Depr) and indirect taxes

Y ≡ GDP – Depr – IndTax …… ……………………….(1b)
Combining 1a and 1b, we get

         (GDP – Depr – IndTax) + TR ≡ S + C + Dtax ………………………………………..2
Let, TA = IndTax + dtax;      then

GDP – Depr – TA + TR ≡ S + C (i.e. Households’ income = households’ spending).............3
Savings and consumption must be equal to all household inflows (earned income and transfers)

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Muhammad Jami Husain                                                              MIDE 2005/06, FHTW-Berlin

less depreciation and taxes.
Combining 1 and 3 we get,

C + Igr + G + X – M – Depr – TA + TR ≡ S + C…………………………………………….4
   Inet ≡ S + (TA – G –TR) + (M-X) ………………………………………………………..5

(net investment is equal to the sum of three sources of savings: personal savings, government
savings and borrowing from abroad – alternatively net imports.)

   Sdom ≡ Inet + Budget Deficit + Current Account Balance…………………………………….6
   Sdom - Inet ≡ Budget Deficit + Current Account Balance…………………………………….7

Identity 7 states that the excess of saving over investment in the private sector is equal to the
government budget deficit plus the trade surplus. For instance, if, saving equals investment,
then the government’s budget deficit (surplus) is reflected in an equal external deficit (surplus).
Several important relationships emerge:
             A fiscal deficit must be financed through decreased investment, higher personal
             savings, or foreign borrowing.
             An increase in personal savings is offset by increased investment, an increase in
             fiscal deficit, or a decrease in external deficit (or increase in net exports).
             A decline in net exports is associated with lower domestic savings, a larger fiscal
             deficit, or increased investment.

8. Consider a closed economy without government spending, so I=S ex post. How about the
causal direction: does I lead to S or S to I? What is a Keynesian, what is a (neo)classical
understanding of the I-S-link?

In a closed economy without government, I ≡ Y- C ≡ S ex-post. One can think of what lies
behind this relationship in a variety of ways.
         The individual can save only by undertaking an act of investment
         Or, one could think of investors financing their investing by borrowing from
         individuals who save.
The ‘neoclassical’ understanding is that it is savings which determine investment. Neo-classics
stipulate that all S (i.e non-concumption) is automatically and immediately transformed into I,
as S=f(r) and I is I =f(r). So it is the interest rate mechanism (guided by flows, i.e. S and I) that
always guarantees sufficient aggregate demand, tied to the assumption that M (money) is
exogenously given.

         If ex ante S>I, r (interest rate) drops, thus equilibrating S and I, and vice versa.

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Muhammad Jami Husain                                                       MIDE 2005/06, FHTW-Berlin

On the other hand, ‘Keynesian’ investment is independent of the full-employment saving; it is
savings which adjust to independently given investment.

         For Keynes, ex ante S>I (i.e. planned saving exceeds planned investment) reflects a
         lack of aggregate demand, leading to lower Y leading to lower S (constant marginal
         propensity to save assumed).
Hence, ex post S = I, but below full employment. It is not the interest rate that adjusts S
and I ex-post, but output Y. The interest rate is not determined by S and I (flows), but by
stocks of money demand and supply, so L and M. L (or liquidity preference consists of
transaction, precautionary and speculative demand).

9. “Capitalists earn what they spend, workers spend what they earn.” (Kaldor and Kalecki)
Explain, using the simplifying assumptions that capitalists do not consume and workers do not

In order to explain the adage that Capitalists earn what they spend, workers spend what they
earn (Kaldor and Kalecki), we need to consider the national income identities from the point of
view of Income Distribution.
We can write,

 GDP – Depr = Y = Prof + W + TA = C + Inet + G + X – M (Taxes and government transfers
are ignored).

Kaldor employed classical considerations of income distribution with two classes: capitalists
(who save a portion of their profits) and workers (who save from wages).
W = C w + Sw
Prof = Cprof + Sprof
Y = Prof + W + TA

   Y = Cprof + Sprof + Cw + Sw +TA
Prof + W + TA = C + Inet + G + X – M

   Prof = C + Inet + G – TA + X – M – W
   Prof = Cprof + Cw + Inet + G – TA + X – M – Cw - Sw

   Prof = Cprof + Inet + G – TA + X – M - Sw ……………………………………………..(1)
In a closed economy without state the identity becomes:

Prof = Inet + Cprof - Sw ……………………………………………………………………..(2)
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Muhammad Jami Husain                                                            MIDE 2005/06, FHTW-Berlin

In an open economy with state, and assuming workers do not save and capitalists do not
consume, i.e. Sw = 0 and Cprof = 0, the identity becomes:

Prof = Inet + G – TA + X – M……………. ……………………………………………..(3)
The Identity 3 shows that profit depends on the investment behaviour. ‘Keynesian’ essence
entails that investment is independent of the full-employment savings; it is savings which
adjust to independently given investment. The profit share and the rate of profit are affected by
investment behaviour: if sw = 0, then they are determined solely by investment behaviour. In
other words capitalists earn what they spend.

10. Explain how the classical theory determines aggregate output and full employment! Explain
“voluntary” employment in the classical theory!

Employment and Output Determination under Classical Model:

To explain the determination of output and employment we need to consider three important
components of classical model; short run production function, supply and demand of labour.
The Short-Run Production Function: The classical short run aggregate production function can
be written in the following form:
Y = A F(K , L)
Where,            Y = real output per period
                  K = the quantity of capital inputs used per period
                  L = the quantity of labour inputs used per period
                  A = an index of total factor productivity
                  F = a function which relates real output to the inputs of K and L.
In the short run, it is assumed that aggregate output will depend on the amount of labour
employed, given the existing capital stock, technology and organization of inputs. This
relationship is expressed graphically in panel (a) of the figure. The short run production
function displays certain properties. First, for given values of A and K there is a positive
relationship between employment (L) and output (Y). Second, the production function exhibits
diminishing returns to the variable input, labour. Third, the production function will shift
upwards if the capital input is increased and/or there is an increase in the productivity of inputs
represented by an increase in the value of A.
Employment Determination (Microeconomic Analysis):

Firms want to maximize profits. To do so, a firm should set its marginal revenue (MRi) that
equals marginal cost of production (MCi). For a perfectly competitive firm, MR I = P i. The
additional cost of hiring an extra unit of labour will be, wiBL, and return is equal to extra
output produced multiplied by price, BQi.Pi. It pays for a profit maximizing firms to hire
labour as long as wiBL is less than BQi .Pi.
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          Muhammad Jami Husain                                                                    MIDE 2005/06, FHTW-Berlin

          Demand Function of Labour:
          The aggregate demand for labour is an inverse function of the real wage. The function can be
          expressed as follows: DL = DL (W/P).W represents the economy wide average money wage and
          P represents the general price level. In panel (b) of the figure this relationship is shown as DL.

          Supply Function of Labour:
          The market supply of labour is therefore a positive function of the real wage rate and is given
          by equation below and is shown in the panel (b) of figure as SL. SL = SL (W/P).
                                                              How much labour is supplied for a given population
                                                              depends on household preferences for consumption
                                                              and leisure, both of which yield positive utility. A rise
                                       Y = A F(K,L)           in real wage makes leisure more expensive in terms
                                                              of forgone income and will tend to increase the
    Ye                                                        supply of labour. This is known as substitution effect.
                                                              However, a rise in real wage also makes workers
                                                              better off, so they can afford to choose more leisure.
                                                              This is known as income effect. The classical model
                                                              assumes that the substitution effect dominates the
                                                  LT          income effect so that the labour supply responds
                             (b)                              positively to an increase in the real wage.
(W/P)1          G                      H
                                                              Determination of Output and Employment:
(W/P)e                   E
                                                              The classical labour market is illustrated in panel (b)
(W/P) 2
                         (a)                                  of the figure, where the forces of demand and supply
                X                  Z
                                                 DL           establish an equilibrium market clearing real wage
                                                              (W/P)e and an equilibrium level of employment (L e).
                                                            If the real wage was lower than (W/P)e, such
                    as (W/P)2, then there would be excess demand for labour of ZX and money wage
                    would rise in response to the competitive bidding of the firms, restoring the real wage
                    to its equilibrium value.

                    If the real wage was above the equilibrium, such as (W/P)1, then there would be an
                    excess supply of labour equal to HG. In this case money wages would fall until the real
                    wage returned to (W/P)e.
          This result is guaranteed in the classical model as the classical economists assumed perfectly
          competitive markets, flexible prices and full information.
          The level of employment in equilibrium (Le) represents ‘full employment’, in that all those
          members of the labour force who desire to work at the equilibrium real wage can do so.

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Muhammad Jami Husain                                                         MIDE 2005/06, FHTW-Berlin

Whereas the schedule SL shows how many people are prepared to accept job offers at each real
wage, the schedule LT indicates the total number of people who wish to be in the labour force
at each real wage rate. LT has a positive slope, indicating that at higher real wages more people
wish to enter the labour force. In the classical model labour market equilibrium is associated
with unemployment equal to distance EN in panel (b) of the figure.
Classical full employment equilibrium is perfectly compatible with the existence of frictional
and voluntary unemployment, but does not admit the possibility of involuntary unemployment.
Friedman later introduced the concept of natural rate of unemployment when discussing
equilibrium unemployment in the labour market.
Once the equilibrium level of employment is determined in the labour market, the level of
output is determined by the position of the aggregate production function. By referring to panel
(a) of the figure, we can see that Le amount of employment will produce Ye level of output.

11. Explain Say´s Law! What determines the interest rate in the classical theory?

Say’s law states that: supply creates its own demand. What this means is that the production of
goods and services will generate expenditures sufficient to ensure that they are sold. There will
be no deficiency of demand and no need to lay off workers. There will be full employment.
The justification for the law is as follows:

When firms produce goods, they pay out money either directly to other firms, or as factor
payments to households. Then all the income generated by firms’ supply will be transformed
into demand for their products, either directly in the form of consumption, or indirectly via
withdrawals and then injections. There will be no deficiency of demand.

There exist two versions of Say’s law; weak version and strong version.. According Trevithic
(1992) the weak version is taken to imply that each act of production and supply necessarily
involves the creation of an equivalent demand for output in general. But this version of Say’s
law does not guarantee that the output will be consistent with full employment. The strong
version of Say’s law states that in a competitive market economy there will be an automatic
tendency for full employment to be established.

12. Use the quantity equation of money (=Fisher equation) and explain the quantity theory of
money! What is meant by “neutrality of money” or “the classical dichotomy”!

The Classical Dichotomy: In the classical model there is a dichotomy; the real and monetary
sectors are separated. As a result, changes in the quantity of money will not affect the
equilibrium values of the real variables (i.e. output, employment) in the model. With the real
variables invariant to changes in the quantity of money, the classical economists argue that the
quantity of money was neutral. The classical neutrality proposition, thereby, implies that the
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Muhammad Jami Husain                                                       MIDE 2005/06, FHTW-Berlin

level of real output will be independent of the quantity of money in the economy.
Fisher’s Quantity equation of Money:

In its simplest form the classical economics states that the general level of price (P) in the
economy depend on the supply of Money (M) and in order to understand this proposition we
may resort to the income version of Fisher’s equation of exchange. This relationship is given
by the following equation.

MV = PY.
V is the income velocity of circulation of money and represents the average number of times a
unit of money is used in the course of conducting final transactions which constitute GDP.
Suppose that each euro’s worth of money is typically spent 5 times per year on goods and
services, and that money supply was 20 billion euro. This would mean that total expenditure on
GDP (M*V) was 100 billion euro.

The classical economists argued that both V and Y were determined independently of the
money supply; that is a change in the money supply would not be expected to lead to a change
in V or Y. the velocity of circulation (V), they claimed, was determined by the frequency with
which people were paid (e.g. weekly or monthly), the nature of the banking system and other
institutional arrangements for holding money. As far as Y was concerned, Say’s law would
ensure that the real value of output (Y) was maintained at the full employment level.

With V and Y as constants with respect to M, therefore, the quantity theory must hold:
P = f(M).

Increases in money supply simply lead to inflation.

13. What determines the interest rate in the classical theory?

To see how the classical economists justified their belief that aggregate spending in the
economy will always be sufficient to purchase the full employment level of output, we need to
examine their ideas relating to investment, saving and the rate of interest.

The classical theory of interest rate determination plays a crucial role in ensuring that a
deficiency of aggregate demand does not occur. The following equation tells us that in
equilibrium aggregate expenditure (E) must equal aggregate output (Y).
E = C(r) + I(r) = Y …………………………………………………………………………(1)

Aggregate expenditure consists of two components: investment expenditure (I) which arises
from firms and consumption expenditure (C) which arises form households. In the classical
model the demand for both types of goods is the function of the interest rate (r). Since
households do not automatically spend all of their income, we can also write down equation 2.

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Muhammad Jami Husain                                                          MIDE 2005/06, FHTW-Berlin

Y – C(r) = S(r) ………………………………………………………………………………(2)
Combining 1 and 2 yields the equilibrium conditions given by equation 3:

S(r) = I(r) …………………………………………………………………………………….(3)
         Supply of Loanable Funds: Savings (S) is also a function of the interest rate. The higher
         the rate of interest the more willing the savers be to replace present consumption with
         future consumption. Hence the classical economists viewed the interest rate as a real
         reward for abstinence or thrift. The flow of savings therefore represents a supply of
         loanable funds in the capital market.

         Demand for Loanable Funds: Investment expenditure on capital goods is negatively
         related to the rate of interest in the classical model and represents a demand for
         loanable funds in the capital market. The higher the rate of interest the higher the
         explicit (and implicit) cost of funds used to purchase the capital goods. We can
         therefore represent business expenditure (I) as a declining function of the interest rate.
The relationship between investment, savings and the interest rate in the classical model is
shown in panel (a) of the figure. The twin forces of productivity and thrift determine the real
rate of interest and variations in the interest act as an equilibrating force which maintains
                                                      equality between the demand for and
                                                      supply of loanable funds, ensuring that
     r                              S1
                                                      aggregate demand is never deficient.
(a)                                                      By referring to the figure we can see
                                                         how important flexibility in the interest
                                                         rate was to the classical equilibration
                                                         process. In panel (a) we represent the
                                                         classical theory of interest rate
                     I0    I1   E0                       determination, with the interest rate on
        450                                    S, I
(b)                                                      the vertical axis and the flows of savings
                 C                                       and investment measured on the
                       B                                 horizontal axis. In panel (b) real output
     Ye                                                  is measured on the vertical axis with the
                                                         overall demand for commodities (C + I)
     Y                              E=Y
                                                         measured on the horizontal axis. As we
know that competition in the labour market will yield an equilibrium real wage and level of
employment which when combined with the production function give a level of full
employment output of Ye. panel (b) of the figure indicates that aggregate expenditures of an
amount equal to Eo are necessary to purchase the output of Ye. Since output and demand are
identical at all points along the 45 degree line, any point such as B and C is consistent with the
weak version of Say’s law. Point A in panel b corresponds to the strong version of Say’s law.

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Muhammad Jami Husain                                                            MIDE 2005/06, FHTW-Berlin

Not only are aggregate expenditure and output in equality, Ye corresponds to the level of
output associated with full employment labour market equilibrium.

We can best see the importance of interest rate flexibility in this model by asking what would
happen if households suddenly decide to save more (consume less). This is represented in
panel (a) of the figure by a rightward shift of the savings function from So to S1. the initial
access supply of loanable funds would lead to a fall in the rate of interest from ro to r1. This
would encourage increase in investment expenditure from (Io) to (I1). Since Eo – Io equals
consumption expenditure, it is clear that the rising investment expenditure, I1 – Io, exactly
offsets the fall in consumption expenditure equal to – ãC in the diagram. Aggregate
expenditure would remain at Eo, although its composition would change.

14. (a) Explain the following terms implicit in the (neo)classical theory of production: marginal
productivity of labour, marginal productivity of capital, diminishing returns to labour (or capital),
constant returns to scale! (b) Explain why the labour demand curve in these theories is
downward sloping with respect to real wages!

Marginal Productivity of Labour: It refers to the increment of output obtained by adding one
unit of labour, with other factor inputs held constant.
Marginal productivity of capital: It refers to the increment of output obtained by adding one
unit of capital, with other factor inputs held constant.
Diminishing returns to labour (or capital): This is a characteristic of a production function
whereby the marginal product of a factor (say labour or capital) falls as the amount of the
factor increases while all other factors are held constant.

Constant returns to scale: This is a characteristic of a production function whereby
proportionate increase in the factors of production leads to equal proportionate increase in
Downward Sloping Labour Demand Curve:

Firms want to maximize profits. To do so, a firm should set its marginal revenue (MRi) that
equals marginal cost of production (MCi). For a perfectly competitive firm, MR I = P i. The
additional cost of hiring an extra unit of labour will be, wiBL, and return is equal to extra
output produced multiplied by price, i.e. BQi .Pi. It pays for a profit maximizing firms to hire
labour as long as wiBL is less than BQi .Pi. To maximize profits requires satisfaction of the
following condition:

BQi .Pi = , wiBL. ; Or, BQi/BLi = wi/ Pi.

BQi/BLi is the marginal product of labour (MPL). Because MPL is a diminishing function of

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Muhammad Jami Husain                                                          MIDE 2005/06, FHTW-Berlin

the amount of labour employed, owing to the influence of diminishing returns, the MPL curve
is downward sloping. Since we have shown that profits will be maximized when a firm equates
MPL with wi/ Pi (real wage), the marginal product curve is equivalent to the firm demand curve
for labour (DLi). DLi=DLi (wi/Pi). This relationship tells us that a firm’s demand for labour
will be an inverse function of real wage; the lower the real wage the more labour will be
profitably employed.

15. Will perfect price and (nominal) wage flexibility lead to and then secure full employment and
general equilibrium?

To see how the price level is determined in the classical model and how real output, real wages
and employment are invariant to the quantity of money, we consider the following figure:

                       (d)                      P                             (c)


   W1                                                                                AD1 (M1)
         W0                                                                      AD0 (M0)

                       W0/P0   W0/P1                              Y0


      SL                                   DL                          Y = AF(K,L)

                 (a)                                                            (b)

           Quadrant (a) shows that a competitive labour market generates equilibrium
           employment of Lo and an equilibrium real wage of Wo/Po.

           Quadrant (b) shows the production function and the full employment level of output Yo.
           Quadrant (c) shows the classical aggregate demand (AD) and aggregate supply (AS)
           functions. With a constant supply of money and stable velocity, a higher price level
           must be associated with a lower level of real output. Ado(Mo) shows how, for a given
           money supply, MV can be split up among an infinite number of combinations of P and
           Y. Since we have assumed V is fixed, the nominal value of all transactions in the
           economy is determined by the supply of money. With higher prices each transaction

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Muhammad Jami Husain                                                        MIDE 2005/06, FHTW-Berlin

         requires more units of currency and therefore the quantity of goods and services that
         can be bought must fall. Since AD curve is drawn for a given quantity of money, an
         increase in the money supply will shift the AD curve to the right, as shown by

         Quadrant (d) shows the relationship between the real wage and the price level for a
         given nominal wage. If the nominal wage is Wo then a higher price level will reduce the
         real wage.
    Let us assume that the initial equilibrium values in the model associated with the quantity
    of money Mo are Yo, Wo/Po and Lo. Suppose the monetary authorities increase the supply of
    money to M1 in an attempt to increase real output and employment. Such a policy will be
    completely ineffective in the classical model. The increase in the quantity of money, by
    creating disequilibrium in the money market (Md < M), will lead to an increase in demand
    for goods and services. Since Y is constrained at Yo by labour market equilibrium
    employment (Lo), prices rise to P1. For a given nominal wage of W0, an increase in the
    price level lowers the real wage and creates disequilibrium in the labour market. An excess
    demand for labour of ZX emerges at a real wage of (Wo/P1). Competitive bidding by
    employers will drive the nominal wage up until it reaches a value of W1, which restores the
    real wage to its equilibrium value (that is Wo/Po = W1/P1).

16. Keynes argued that equilibrium is compatible with permanent unemployment. Explain!

Keynes rejected the classical assumption that market would clear. He asserted that
disequilibrium could persist and mass unemployment could continue. In the labour market,
workers would resist wage cuts. Wages are thus ‘sticky’ downwards. In a recession, when the
demand for labour is low, wages might not fall far or fast enough to clear the labour market. In
other words, a fall in aggregate demand would not simply lead to a fall in wages and prices and
a restoration of the full employment equilibrium. Instead there would be demand deficient
unemployment; as demand fell there would be less demand for labour.
Keynes argued, even under perfect flexibility of wages and prices (which does not exist in
reality) there is no built-in full employment mechanism in capitalism. If the goods market is in
equilibrium and there is still unemployment, competitive markets trigger a drop in nominal
wages. This can induce deflation which does not necessarily lower real wages but has negative
impact on aggregate demand through various channels. If prices remain constant (sticky prices)
real wages drop but the purchasing power of the wage sum is reduced which impacts aggregate
demand negatively, hence also employment. If nominal wages fall faster than prices, so that
real wages become lower, employers may not hire additional workers if there is no additional
aggregate demand. The so-called Keynes-effect might lead to lower interest rates in the case of
deflation, but the effect could be too small and too weak to recover, Keynes thought, so that

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Muhammad Jami Husain                                                                     MIDE 2005/06, FHTW-Berlin

macro policies are preferable. The special cases of sticky wages, liquidity trap (lower floor for
interest rate), and interest inelastic investment only add to the problems. Because of these
various limitations of the price mechanism, Keynes was convinced that the authorities would
need to take positive action in order to eliminate involuntary unemployment. Without
government policies full employment cannot be restored.

17. Explain Keynes` concept of the hierarchy of markets!

(Note: The arguments below should be arranged in a reversed order to reflect the actual
direction of the hierarchy; thereby the order of the flow chart should also be presented in a
reversed way keeping the bottom part at the top.)
The Keynes’ concept of hierarchy of markets can be derived with his theory of effective
demand. The dependence of aggregate output and employment on aggregate expenditure (C+I)
creates the potential instability, since investment expenditure is typically unstable owing to the
influence of business expectations relating to an uncertain future. An uncertain future also
creates the desire for liquidity, so that variations in the demand for money as well as changes
in the money supply can influence output and employment. Therefore in Keynes’s model the
classical proposition that the quantity of money is neutral is rejected. An increase in the money
supply, by reducing the rate of interest, can stimulate aggregate spending via an increase in
investment and the subsequent multiplier effect. The relationship can be depicted as follows:
+del M       - del r    +del I    + del Y, +del L

                             AGGREGATE OUTPUT
                              AND EMPLOYMENT

                            Aggregate Planned Expenditure-
                                  Effective Demand                                Expenditure

            Household Consumer                      Business Investment
               Expenditure                              Expenditure

             Tax Policies

                             Rate of Interest                             Business Expectations and
                                                                           Marginal Efficiency of

             Money Supply                 The Demand for Money                       Uncertainty
                                           – Liquidity Preference

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Muhammad Jami Husain                                                         MIDE 2005/06, FHTW-Berlin

18. What determines aggregate output according to Keynes?

In Keynes’s model output and employment are determined by effective demand. The principle
of effective demand states that in a closed economy with spare capacity the level of output (and
hence employment) are determined by aggregate planned expenditure, which consists of two
components, consumption expenditure from household sector (C) and investment expenditure
from firms. In Keynes model, consumption expenditure is endogenous and essentially passive,
depending as it does on income rather than the interest rate. Investment expenditure depends
on the expected profitability of investment and the interest rate which represents the cost of
borrowing funds. Thereby, the role of expectation plays a crucial role in determining the
investment. Given an exogenous injection in the economiy (say in terms if investment) the
output is generated through a multiplier process. Keynes introduced the concept of marginal
propensity to consume, which plays a crucial role in determining he size of multiplier.
19. How did Keynes explain inflation, and why did he reject the quantity theory of money as a
tool to explain inflation?

Keynes argued that V is unstable. Increased money supply can lower the interest rate and
induce higher investment that then could contribute to higher aggregate demand. If aggregate
demand however increases, it will not necessarily cause inflation as it depends on the degree of
utilisation of capacities and the employment level. If the aggregate supply curve is perfectly
elastic then a change in effective demand brought about by an increase in the quantity of
money will cause output and employment to increase with no effect on the price level until full
employment is reached.
Keynes’ rejection of the quantity theory of money depended mainly on the notion that V is
unstable and depends on interest rates and that money is not neutral. Money demand depends
on interest rates (among other factors). Money affects the real economy. Keynes with his
liquidity preference theory postulated that Md can shift about unpredictably, causing velocity to
vary, implies that changes in M may be offset by changes in V in the opposite direction. With
Y and V no longer assumed constant in the equation MV = PY, it is clear that changes in the
quantity of money may cause V, P, or Y to vary. The neutrality of money is no longer
Keynesian articulation of inflation entails that inflation mainly depends on real economy. Core
element of inflation is costs.
Yn = Yr .P = (1+a) W.
   P = (1+a) W/ Yr = (1+a) wh/ Yr = w/πL, Where, πL = Yr/h = Labour productivity.
So, P = w/πL

If, W increases but π is fixed, then P also increases (given constant mark-ups). If both W and π
increases then P is stable.

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Muhammad Jami Husain                                                          MIDE 2005/06, FHTW-Berlin

20. Explain Keynes´ idea of the multiplier assuming that aggregate investment increases!

From his analysis of consumption function Keynes developed the concept of the marginal
propensity to consume which plays a crucial role in determining the size of the multiplier.
Because of the multiplier any disturbance to investment expenditure will have a magnified
impact on aggregate output. This can be shown quite easily as follows. Letting c equal the
marginal propensity to consume (ãC/ãY) we can write the behavioural equation for
consumption as:
C = cY                        …………………….. (1)

In Keynes’s Model the amount of aggregate consumption is (mainly) dependent on the amount
of aggregate income. Substituting equation 1 into the equation E = C + I we get the
equilibrium condition given by:
Y = cY + I.

Since Y-cY = I and Y – cY = Y (1 – c) we obtain the familiar reduced form equation
Y = I (1 / 1 – c)

Where, (1 / 1 – c) represents the multiplier. It follows that ãY = ãi (1 / 1 – c).

This equation tells us that income (output) changes by a multiple of the change in investment
expenditure. The size of the multiplier will depend on the value of c, and 1 > c > 0. The
multiplier effect shows that for an autonomous demand shift (ãI) income will initially rise by
an equivalent amount. But this rise in income in turn raises consumption by cãI. The second
round increase in income again raises expenditure by c(cãI) which further raises expenditure
and income. So what we have here is an infinite geometric series such that the full effect of an
autonomous change in demand n output is given by:

ã Y = ã I + cãI + c2ãI + ………. = ãI (1+c+c2+c3+…………………)

(1+c+c2+c3+…………………) = (1 / 1 – c).

Throughout the above analysis it is assumed that an economy with spare capacity where firms
are prepared to respond to extra demand by producing more output. Since more output requires
more labour input, the output multiplier implies and employment multiplier. Hence an increase
in autonomous spending raises output and employment.

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Muhammad Jami Husain                                                         MIDE 2005/06, FHTW-Berlin

21. How does Keynes explain the interest rate? Use and explain the term “liquidity preference”!

Keynes’s explanation of interest rate determination marked a break with his classical
predecessors. Keynes rejected the idea that the interest rate was determined by the real forces
of thrift and the marginal productivity of capital. In the General Theory the interest is a purely
monetary phenomenon determined by the liquidity preference (demand for money) of the
public in conjunction with the supply of money determined by the monetary authorities. To the
transactions motive for holding money, Keynes added the precautionary and speculative
motives, the later being sensitive to the rate of interest. Keynes rejected the classical notion
that interest was the reward for postponed current consumption. For him the rate of interest is
the reward for parting with liquidity or not hoarding for a specified period. In a world
characterized by uncertainty there will always be a speculative motive to hold cash in
preference to other financial assets (such as bonds) and in Keynes’s view liquidity preference
will always exert a more powerful influence on the rate of interest than saving decisions. By
introducing the speculative motive into the money demand function, Keynes made the rate of
interest dependent on the state of confidence as will as the money supply. If liquidity
preference can vary, this undermines the classical postulate relating to the stability of the
money demand function. This in turn implies that the velocity of circulation of money is liable
to vary.

22. Keynes underlines the role of expectations in a decentral market economy when analysing
aggregate demand and aggregate output. Explain what he means!

In Keynes’s model output and employment are determined by effective demand. The principle
of effective demand states that in a closed economy with spare capacity the level of output (and
hence employment) are determined by aggregate planned expenditure, which consists of two
components, consumption expenditure from household sector (C) and investment expenditure
from firms.

Investment expenditure depends on the expected profitability of investment and the interest
rate. Given the volatility of expectations, often driven by ‘animal spirits’, the expected
profitability of capital must also be highly unstable. Thus in Keynes model employment
becomes dependent on an unstable factor, investment expenditure, which is liable to wide and
sudden fluctuations. That investment decisions could be influenced by tides of irrational
optimism and pessimism, causing large swings in the state of business confidence, led Keynes
to question the efficacy of interest rate adjustments as a way of influencing the volume of
investment. Expectations of the future profitability of investment are far more important than
the rate of interest in linking the future with the present because: ‘given the psychology of the
public, the level of output and employment as a whole depends on the amount of investment’
and ‘it is those factors which determine the rate of investment which are most unreliable, since

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Muhammad Jami Husain                                                            MIDE 2005/06, FHTW-Berlin

it is they which are influenced by our views of the future about which we know so little.’
(Keynes, 1973).

The ‘extreme precariousness’ of a firm’s knowledge concerning the prospective yield of an
investment decision lies at the heart of Keynes’s explanation of he business cycle. In his
analysis of instability, ‘violent fluctuations’ in the marginal efficiency of capital form the
shocks which shift real aggregate demand, that is, the main source of economic fluctuations
comes from the real side of the economy.

23. Please derive the IS-curve and LM-curve, put them together and explain the intersection.

The IS curve

           The IS curve is the schedule of combinations of the interest rate and level of income
           such that the goods market is in equilibrium.

The IS part of the subject comes from goods market equilibrium. In the most elementary
version the demand for output comprises investment, I, and consumption, C. In equilibrium the
sum of the two must equal the supply of output, which is also the same as income earned from
that supply, Y, that is,

I+C=Y             …………………………………………………1
Investment is postulated to be determined by the rate of interest, r:
I = I(r)          ………………………………………………….2

Consumption is determined by income:
C = C(Y)          …………………………………………………..3

It follows that
I(r) + C(Y) = Y          …………………………………………..4
Saving is defined as income minus consumption:
S=Y–C             …………………………………………………..5

In equilibrium, investment equals savings:
I(r) = S(Y)       …………………………………………………..6

Hence IS.
Two further postulates are that investment varies inversely with the rate of interest and saving
increases as income increases. It follows that, if income is higher, making S higher, r must be
lower so that I rises by the same amount. This implies an inverse relationship between r and Y
if there is to be goods market equilibrium. This is the IS curve, which is illustrated in figure 1.

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Muhammad Jami Husain                                                           MIDE 2005/06, FHTW-Berlin

                                                    The IS curve is negatively sloped because
                                                    an increase in the interest rate reduces
                                                    planned investment spending and therefore
                                                    reduces aggregate demand, thus reducing
                                                    the equilibrium level of income.
                                                    The smaller the multiplier and the less
                                                    sensitive investment spending is to changes
                                                    in the interest rate, the steeper the IS curve.

         The curve is shifted by changes in autonomous spending. An increase in autonomous
         spending, including an increase in government purchases, shifts the IS curve out to the
The LM Curve:

         The LM curve is the schedule of combinations of interest rates and levels of income
         such that the money market is in equilibrium.

The Lm part of the subject comes from money market equilibrium, and so-called ‘liquidity
preference’. Assets may be held in the form of bonds which yield interest; or money which
pays no interest but yields liquidity. Money will be demanded for a variety of motives, which
may be connected with, and be captured within the theory by, the level of income. The higher
the level of income, the more the demand for money. Holding money means forgoing the
interest on bonds; that is, interest is the opportunity cost of holding a stock of money. The
higher the rate of interest, therefore, the lower the demand for money. In sum, the demand for
money, Md, is determined by the level of income and the rate of interest:

Md = L (Y, r) ………………………………………………………………...7
The L is there to remind us of liquidity preference. If the supply of money, M, is given, money
market equilibrium implies:
L (Y,r) = M       …………………………………………………………………8
An increase in Y leads to an increase in the demand for money. This must be offset by an
increase in r if total demand is to equal supply. In other words, if there is to be money market
equilibrium, there must be positive relationship between r and Y. For obvious reason, this is
                                       called LM curve. It is depicted in the following figure:
                                              The LM curve is positively sloped. Given the
                                              fixed money supply, an increase in the level of
                                              income, which increases the quantity of money
                                              demanded, has to be accompanied by an increase
                                              in interest rated. This reduces the quantity of

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Muhammad Jami Husain                                                           MIDE 2005/06, FHTW-Berlin

         money demanded and thereby maintains money market equilibrium.
         The LM curve is steeper when the demand for money responds strongly to income and
         weakly to interest rate.
         The Lm curve is shifted by changes in the money supply. An increase in the money
         supply shifts tha LM curve to the right.
Intersection of IS-LM

Since full equilibrium requires both goods and money market equilibrium, the levels of r and Y
must be the same on each curve. Obviously, equilibrium will occur where the curves intersects.
This is shown in the figure below: The equilibrium rate of interest r* and the equilibrium level
                                                  of income Y* and their intersection is the
                                                  point where simultaneous equilibrium in the
                                                  goods and money market.

                                                     Two points are worth mentioning:
                                                            a) The intersection of the two
                                                                curves represents the only value
                                                                of the rate of interest and income
                                                                which      is    consistent    with
                                                                equilibrium in both markets.

         b) If the level of income is below that of full employment then both fiscal and
            monetary policy have a potentially important role to play in stabilizing the

24. Explain expansionary fiscal (monetary) policy to increase GDP and employment in the IS-
LM-framework. For simplicity, use only the IS and the LM-curve.

Two points are worth mentioning:
         a) The intersection of the two curves represents the only value of the rate of interest
             and income which is consistent with equilibrium in both markets.
         b) If the level of income is below that of full employment then both fiscal and
            monetary policy have a potentially important role to play in stabilizing the
Expansionary Fiscal policy:

In the figure, the economy is initially in equilibrium at roYo (the intersection of ISo and LM)
at less than full employment. Expansionary fiscal policy shifts the IS curve upwards to the
right, from ISo to IS1 and results in an increase in both the equilibrium rate of interest (from ro
to r1) and the equilibrium level of income (from Yo to Y1). As spending and income increases,
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Muhammad Jami Husain                                                             MIDE 2005/06, FHTW-Berlin

the transactions and precautionary demand for money increase, which, with an fixed money
supply, results in an increase in the rate of interest. The rise in the rate of interest in turn leads
to a reduction in private sector investment spending, the extent of which depends on the
interest elasticity of investment.

                                      The fiscal policy will be more effective in influencing
                                      aggregate demand and therefore the level of output and
                                              the more interest elastic is the demand for money;
                                              that is the flatter is the LM curve, and
                                              The less interest-elastic is investment; that is the
                                              steeper is the IS curve.

In the limiting cases
         A vertical LM curve (classical range) fiscal expansion will have no effect on income.
         As the rise in rate of interest will reduce private investment by an amount identical to
         the rise in government expenditure; that is , complete (100%) crowding out or the so
         called ‘treasury View’;
         A horizontal LM curve, liquidity trap fiscal expansion will result in the full multiplier
Expansionary Monetary policy:

In the figure, the economy is again initially in equilibrium at roYo (the intersection of Lmo and
IS) at less than full employment. Expansionary monetary policy shifts the LM curve
downwards to the right, from LMo to LM1 and results in a fall in the equilibrium rate of interest
(from ro to r1) and an increase in the equilibrium level of income (from Yo to Y1). Within the
                                      orthodox Keynesian transmission mechanism the strength
                                      of monetary policy depends on:

                                                The degree to which the rate of interest falls
                                                following an increase in the money supply;

                                                The degree to which investment responds to a fall
                                                in the rate of interest; and

                                                The size of the multiplier.
                                        The monetary policy will be more effective in
                                        influencing aggregate demand and therefore the level of
                                        output and employment:

         The more interest inelastic the demand for money; that is, the steeper is the LM curve

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Muhammad Jami Husain                                                               MIDE 2005/06, FHTW-Berlin

          The more interest elastic is investment; that is, the flatter is the IS curve.
In the limiting (extreme Keynesian) cases of either (1) a horizontal LM curve (liquidity trap) or
(2) a vertical IS curve (that is, where investment is completely interest inelastic) the
transmission mechanism breaks down and monetary policy will have no effect on the level of

25. Explain how full employment can be impeded by the following cases in the IS-LM-model: (a)
rigid nominal wages (b) interest-inelastic investment (c) liquidity trap.

Underemployment Equilibrium with Rigid Nominal Wages

Within the IS-LM model the existence of underemployment equilibrium can be attributed to
the existence of ‘rigidities’ in the system, especially two key prices, the money wage and
interest rate. Let us begin with ‘Keynesian’ assumption of downward rigidity in money wage.
This can be illustrated using the four quadrant diagram.
          (a)                                                                 (d)
                                            LM1                                       SL


                       Y0    YF                 Y               L0    LF
             (b)                                          Y                                 (c)


                        Y0    YF            Y                    L0    LF                         L

Quadrant (a) depicts the standard IS-LM model. Quadrant (c) shows the short run production
function where, with the capital stock and technology taken as given, the level of
output/income (Y) depends on the level of employment (L). Quadrant (d) depicts the labour
market in which it is assumed that the demand for/supply of labour is negatively / positively
related to real wages. Finally quadrant (b) shows, via a 45 degree line, equality between the
two axis, both of which depict income. It facilitates to link good and money market with labour

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Muhammad Jami Husain                                                         MIDE 2005/06, FHTW-Berlin

Suppose the economy is initially at point Eo; that is, the intersection of LMo and IS in
quadrant (a). While both the goods and money markets are in equilibrium, the income level of
Yo is below the full employment income level Yf. Reference to quadrant (d) reveals that with a
fixed money wage (set exogenously) and a price level consistent with equilibrium in the
money market (that is, the curve LMo) the resultant level of real wages (W/P)o is inconsistent
with the labour market clearing. In other words there is no guarantee that the demand-
determined level of employment (Lo) will be at full employment (Lf). The excess supply of
labour has no effect on the money wage, so that it is possible for the economy to remain at less
than full employment equilibrium with persistent unemployment.
liquidity trap

It happens when people demand money and interest remain constant. People absorb the mney
into idle or speculative balance. The money balances will not be channelled into bond market
and this prevent the reduction of interest rate, which is needed to stimulate aggregate demand
and investment. With non-increase in aggregate demand to moderate the rate of fall in prices,
prices fall proportionately to the fall in money wages (a balanced deflation) and real wages
remain constant above their market clearing level. Aggregate demand is insufficient to achieve
full employment and the economy remains at less than full employment equilibrium with
persistent ‘involuntary’ unemployment. Finally, in case of liquidity trap, monetary policy
becomes impotent, while fiscal policy becomes all powerful, as a means of increasing
aggregate demand and therefore the level of output and employment.

(For graphical explanation, see Snowdon book).

Interest-inelastic investment

In the interest-inelastic investment case, the economy will also fail to self-equilibrate at full
employment. The Keynes effect (or expansionary monetary policy) is not sufficient to re-
establish full employment. There is a reduction of wages what leads to a reduction of prices
and nominal wages. Thus the real money-supply increases which induces lower interest rate.
This fall in inerest rate cannot acheive full unemployment. For that a negative interest would
be needed.
(For graphical explanation, see Snowdon book).

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Muhammad Jami Husain                                                             MIDE 2005/06, FHTW-Berlin

26. Explain the (a) so-called Keynes effect and the (b) Pigou-effect as two mechanisms to
guarantee full employment. Why did Keynes argue not to rely on these mechanisms?

Keynes effect

Causation: In case of Unemployment

 u             w         p             (Ms/p)          r         I       Y          AD               L

The ‘indirect’ effect of falling money wages and prices which stimulates spending via the
interest rate is referred to as the ‘Keynse Effect’. The increase in aggregate demand moderates
the rate of fall in prices so that as money wages fall at a faster rate than prices (an unbalanced
deflation) the real wage falls towards its (full employment) market-clearing level. It is
important to stress that it is the increase in aggregate demand, via the Keynes effect, which
ensures that the economy returns to full employment. In the upper causation chain, Keynes was
in favour of intervention at “r” level but not reduction of “w” or “p”.

Due to existence of liquidity trap, which prevents interest rates to fall; or interest inelastic
investment, which prevents falling prices……Keynes effect would not work.
(For graphical explanation, see Snowdon book).


Pigou argued that, providing money wages and prices are flexible, the orthodox Keynesian
model would not come to rest at least than full employment equilibrium. The Pigou effect
concerns the effect that falling prices have on increasing real wealth, which in turn increases
consumption expenditure.

     u             w         p            (Ms/p)           C                 Y         AD                L

If individuals expect a further fall of prices, they would postpone consumption and firms will
delay their investment, causing a rise in unemployment.
(For graphical explanation, see Snowdon book).

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    Muhammad Jami Husain                                                         MIDE 2005/06, FHTW-Berlin

    27. Why did Keynes propose not to follow a policy of lowering nominal wages in case of

    Keynes rejected the policy of wage cutting as a method of stimulating employment on both
    practical and theoretical grounds. The practical reason was that in a democracy characterized
    by decentralized wage bargaining wage reductions are only likely to occur after ‘wasteful and
    disastrous struggles’ producing an end result which is not justifiable on any criterion of social
    justice on economic expediency. Keynes also argued that workers will not resist real wage
    reductions brought about by an increase in the general price level, since this will leave relative
    real wages unchanged and this is a major concern of workers.

    He rejected wage and price flexibility as a reliable method of restoring equilibrium on
    theoretical grounds also. Indeed in many circumstances extreme flexibility of the nominal
    wage in a monetary economy would in all probability make the situation worse. A severe
    deflation of prices would also be likely to adverse repercussions on business expectations,
    which could lead to further declines of aggregate demand. The impact of severe deflation on
    the propensity to consume via distributional effect was also likely to be adverse.

    28. Explain the (traditional) Philipps-curve!

    Phillips curve is a curve that shows inverse relationship between inflation (price) and
    unemployment. A.W. Phillips in 1958 showed the statistical relationship between wage
    inflation and unemployment in the UK from 1861 to 1957. With wage inflation (W) on the
    vertical axis and unemployment rate (U) on the horizontal axis. The curve that best fitted the
    scatter has become known as the ‘phillips curve’.

                                                    The curve has been often used to illustrate the
W                                                   effects of changes in aggregate demand. When
                                                    AD rose (relative to potential output), inflation
                                                    rose and unemployment fell. When AD fell
                      The Phillips curve            there was a downward movement along the
                                                  There is also second reason given for the
                                                  inverse relationship. If wages rose, the
                                                  unemployed may have believed that the higher
                                                  wages they were offered represent a real wage
    increase. That is they did not realize that the higher wages would be eaten up by price
    increases: they suffered from money illusion. They would thus accept jobs more readily. The
    average duration of unemployment therefore fell. This is a reduction in frictional

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Muhammad Jami Husain                                                         MIDE 2005/06, FHTW-Berlin

29. Explain why the monetarists believe in the inherent stability of a market economy!

The monetarists belief entail that a market is inherently stable and can adjust flexibly to
exogenous shock. This can be best explained with Friedman’s quantity theory of money.

Friedman postulated that the demand for money (like the demand for any asset) yields a flow
of services to the holder and depends on three main factors; (1) the wealth constraints, which
determines the maximum amount of money that can be held; (2) the return or yield on money
in relation to the return on other financial and real assets in which wealth can be held; and (3)
the asset holders’ tastes and preferences. The way total wealth is allocated between various
forms depends on the relative rates of return on the various assets. Three important differences
are highlighting. First, Friedman’s analysis of demand for money can be regarded as an
application of his permanent income theory of consumption to the demand for a particular
asset. Second, he introduced the expected rate of inflation as a potentially important variable
into the demand for money function. Third, he asserted that the demand for money was a stable
function of a limited number of variables.

A simplified version of Friedman’s demand function for real money balances can be written in
the following form.

Md                 •e
   = f (Y p ; r , P; u )
Where Yp = permanent income which is used as a proxy for wealth, the budget constraint;
r = return on financial assets,
Pe = expected rate of inflation, and
u = individual’s taste and preferences.
This analysis predicts that, ceteris Paribas, the demand for money will be greater, (1) the
higher the level of wealth; (2) the lower the yield on other assets; (3) the lower the expected
rate of inflation, and vice versa. Utility maximizing individuals will reallocate wealth between
different assets whenever marginal rates of return are not equal. The portfolio adjustment
process is central to the monetarist specification of the transmission mechanism whereby
changes in the stock of money affect the real sector. This can be illustrated by examining the
effects of an increase in the money supply brought about by open market operations by the
monetary authorities. An initial equilibrium is assumed where wealth is allocated between
financial and real assets such that marginal rates of return are equal. Following open market
purchases of bonds by the monetary authorities, the public money holdings will increase.
Given that the marginal return on any asset diminishes as holdings of it increase, the marginal
rate of return on money holdings will in consequence fall. As access money balances afre
exchanged for financial and real assets their prices will be bid up until portfolio equilibrium is
re-established when once again all assets are willingly held and marginal rates of return are
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Muhammad Jami Husain                                                         MIDE 2005/06, FHTW-Berlin

If the demand for money function is stable, then velocity will also be stable, changing in a
predictable manner if any of the limited number of variables in the demand for money function
should change. In the face of stable demand for money, most of the observed instability in the
economy could be attributed to fluctuations in the money supply induced by the monetary

30. What is the “money (or monetary) rule” which Friedman advocated?

The ‘money rule’ advocated by Friedman entails that the money supply should be allowed to
grow at a fixed rate in line with the underlying growth of output (plus tolerated inflation rate)
to ensure long-term price stability.

31. Why did Friedman warn against Keynesian stabilization policy?

In the face of stable demand for money, most of the observed instability in the economy could
be attributed to fluctuations in the money supply induced by the monetary authorities. The
authorities can control the money supply if they choose to do so and when that control is
exercised the path of money income will be different from a situation where the money supply
is endogenous. The lag between changes in the money stock and changes in money income is
long and variable, so that attempts to use discretionary monetary policy to fine-tune the
economy could turn out to be destabilizing.

32. Explain Friedman´s permanent income hypothesis!

Friedman notes that actual income is composed in part of temporary windfall gains and losses
and that the same is true of consumption. The transitory components are wholly unpredictable.
They are therefore completely uncorrelated with any of other variables, and their expected
value is zero. The true consumption income relation is assumed to lie between permanent
consumption and permanent income.

Friedman’s theory is based on the claim that consumers attempt to maximize their utility and
that this implies a consumption plan that does not bounce around with the vagaries of windfall
gains and losses but is based rather on the regular income that the individual can count on
given his or her human and physical resources. Permanent income is viewed as the annual rate
of return that one earns on oneself. Imagine adding together, all your expected future earnings.
Add to this the value of your accumulated assets and then imagine selling the entire bundle for
a lump-sum payment. This sum is then used to buy a perpetual annuity. The perpetual interest
on this lump-sum of wealth is what friedman would call your permanent income.

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Muhammad Jami Husain                                                             MIDE 2005/06, FHTW-Berlin

33. Why is the long-run Philipps-curve vertical according to Friedman?

Friedman argued that there is no trade-off between unemployment and inflation in the long
run; that is the long-run Phillips curve is vertical at the natural rate of unemployment.

Friedman argued that the Phillips curve should be set in terms of the rate of change of real
wages. He therefore augmented the basic Phillips curves with the anticipated or expected rate
of inflation as an additional variable determining the rate of change of money wages. The
expectations-augmented Phillips curve can be expressed mathematically by the equation:

 •               •
W = f (U ) + P e

Equation shows that the rate of money wage increase is equal to a component determined by
the state of excess demand (as proxied by the level of unemployment) plus the expected rate of
inflation. Introducing the expected rate of inflations an additional variable to excess demand
which determines the rate of change of money wages implies that instead of one unique
Phillips curve, there will be a family of Phillips curve each associated with a different expected
rate of inflation. Once the actual rate of inflation is completely anticipated in wage bargains,
there will be no long run trade-off between unemployment and wage inflation. It follows that if
there is no excess demand (that is the economy is operating at the natural rate of
unemployment) then the rate of increase of money wages would equal the expected rate of
inflation and only in the special case where the expected rate of inflation is zero would wage
inflation be zero; a long run vertical Phillips curve is obtained at the natural rate of
employment. At the natural rate the labour market is in a state of equilibrium and the actual
and expected rates of inflation are equal; that is, inflation is fully anticipated.

34. What is “natural unemployment”?

Natural unemployment, according to Friedman, is the level that would be grounded out by the
Walrasian system of general equilibrium equations provided there is embedded in them the
actual structural characteristics of the labour and commodity markets, including market
imperfections, stochastic variability in demands and supplies, the cost of gathering information
about job vacancies and labour availabilities, the cost of mobility and so on.

Other interpretation entails:
         Unemployment that exists permanently, even at the peak up of a business cycle
         Structural    unemployment,     comprising    ‘frictional’   unemployment        (i.e.   search
         unemployment) and unemployment due to mismatch between demand and supply on
         the labour market.

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Muhammad Jami Husain                                                            MIDE 2005/06, FHTW-Berlin

         Structural unemployment due to imperfections on the labour and goods markets,
         namely inflexibilities.

         It is the level of unemployment where actual inflation equals expected inflation. At
         lower unemployment rate, inflation exceeds inflation expected and vice versa.

35. What are the three main parts of the balance of payments?

The balance of payment is the record of the transactions of the residents of a country with the
rest of the world durng some specific period of time. There are three main components in the
balance of payments:
    a) Current Account (Flows): The current account records trade in goods and services, as
         well as transfer payments.
    b) Capital Account (Changes in stocks): The capital account records purchases and sales
         of assets, such as stocks, bonds, and land. It refers to changes in stocks and the
         components include short term and long term loans, securities (bonds and shares), FDI,
         portfolio investments.
    c) Foreign Exchange Reserves (Changes in stocks): This indicates the net change in the
         country’s international reserves, including its holding of gold, foreign currencies, and
         borrowing rights in the IMF.

Statistical discrepancy or Error term: Due to measurement problem the international
payments may not result in exact balance of inflow and outflow. This discrepancy is covered
by the item called statistical discrepancy.
In balance of payments accounting system entails the debit-credit double entry system. A
credit (+) is any transaction that results in a receipt from residents in the rest of the world
(foreign residents), and a debit (-) is any transaction hat requires a payment be made to
residents in the rest of the world.
External Account must Balance:

The central point of international payments is very simple. Individuals and firms have to pay
for what they buy abroad. If a person spends more than her income, her deficit needs to be
financed by selling assets or by borrowing. Similarly, if a country runs a deficit in its current
account, the deficit needs to be financed by selling assets or by borrowing abroad. This selling
or borrowing implies that the country is running capital account surplus. Thus any current
account deficit is of necessity financed by an offsetting capital inflow. In principle:
Balance of Payment
= balance of current account + balance of capital account + balance of reserves
= 0 (identity)
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Muhammad Jami Husain                                                             MIDE 2005/06, FHTW-Berlin

The above identity makes a drastic point: If a country has no assets to sell, if it has no foreign
currency reserves to use up, and if nobody will lend to it, the country has to achieve balance in
its current account, however painful and difficult that may be. If both the current account and
the capital (private) account are in deficit, then the overall balance of payments is in deficit;
that is, the central bank is losing reserves. When one account is in surplus and the other is in
deficit to precisely the same extent, the overall balance of payment is zero – neither in surplus
nor in deficit.

36. What are the main parts of the current account?

Current Account (Flows): The current account records trade in goods and services, as well as
transfer payments. The main components of current account are:
             Export and import of goods

             Export and import of services (income from transportation, banking, and insurance;
             royalty payments, expenditures by tourists etc.)

             Investment income (income in the form of interest and and dividends from various
             financial assets).

             Grants, transfers (unilateral transactions including remittances and private grants).

37. If there is a net inflow of capital, what is the effect on the current account and the foreign
reserves position? If there is an inflow of grants or remittances, what is the effect on BOP?

Capital inflows comprise equity in the form of FDI (shares, Greenfield investment etc),
portfolio investment (short term oriented shares), credit in the form of bonds of different
maturity, commercial bank credit (money or capital markets) and preferential subsidized loans.
Capital inflows entail credits (positive entries) that record transactions that lead to money
payments flowing into the domestic country.
Therefore in turn, a net capital inflow causes a current account deficit and/or an increase in
reserves. Grants or remittance inflows improve the current account and/or the reserves.
Whether the reserves change or not, depends on the exchange rate system and the monetary
policy of the central bank. With perfectly flexible exchange rates reserves do not change.

38. Should developing countries strive for a surplus or deficit or equilibrium in the current
account? Show advantages, risks and problems.

Orthodox economic theory (classical) does not worry about current account imbalances.
However, more realistic economists and particularly policymakers do indeed worry about
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Muhammad Jami Husain                                                          MIDE 2005/06, FHTW-Berlin

current account deficits and concomitant debt increase. Despite extensive theoretical and
empirical research, in modern macroeconomics, a clear cut uniform opinion has not evolved on
the current account.
         The majority of these countries are heavy capital importers with high external
         indebtedness. High external indebtedness and dependence are almost synonymous for

         The current account constellation is of paramount importance to understand the regime
         of growth of stagnation.

         It is proposed to reduce current account deficits, strive for equilibrium or even current
         account surpluses.

         The specific point for developing countries- in contrast to developed – is the fact that
         current account deficits have to be paid- in almost all cases-with liabilities in hard
         currency. The creditors would not accept interest and redemption in local, not highly
         reputable and reliable currency. Hence, developing countries that want to incur external
         debt to allow for a current account deficit are condemned to an original sin that
         developed countries never face.

         To be a virtuous cycle, five requirements have to be fulfilled.
         a) External capital flows should be used to augment investment rather than
         b) The additional investment has to be efficient

         c) Investment must take place in the production of tradables to improve the trade
            balance (or in infrastructure related to tradables; hence the capital inflows have to
             promote exports or import substitution.
         d) An aggressive hike in domestic saving relative to aggregate income is necessary,
             the mirror image of the trade surplus.
         e) Capital exporters must provide stable and predictable flows of finance-first a long
             period of stable capital inflows and then a long period of stable capital outflow- in
             line with the recipient contry’s factor productivity.

         On the whole financial financial systems in developed countries are more risk oriented,
         have greater hedging opportunities plus other instrument to spread risk, and have better
         institutions to supervise the financial system etc.
         Foreign debt and current account deficit sustainability depend to a large extent on
         foreign investors’ portfolio decisions and their expectations. And the later are volatile
         and not only dependent fundamentals in the debtor country but also on expectations,
         moods, and sentiments of lenders.

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Muhammad Jami Husain                                                             MIDE 2005/06, FHTW-Berlin

         There seems to be evidence that currency crisis not only depend on the current account
         deficit but, in addition, on the stock of external debt. The stock of debt increases
         independently of the current account constellation if some sectors in the economy raise
         foreign credit and other sectors invest their money abroad. The higher the stock of
         external debt, the more critical high current deficits are, and hence the likeliness of a
         financial crisis.

         Whether a current account deficit is regarded as good or bad depends on the
         expectation of the ability for debt service and repayment. This is partly a question of
         how foreign debt is used. However, even if a credit is used for investment in a
         productive way, there is no guarantee that the country is able to fulfil the debt service.
         If capital inflows suddenly cease, it might be impossible for a country to earn sufficient
         export revenues to fulfil all obligation.

         It is important to inderstand that microeconomic efficiency to use foreign credit is not
         at all sufficientr to guarantee that a country-that is all the debtors in the country-can pay
         their debt service. Precipitated depriciations, suddenly increased inflation risk, rising
         country risk premium in interest rate, herd behaviour of financial investors etc, all of
         these generate macro problems that cannot be by passed by even the best micro

         Advantages:: In principle, an improvement of the current account-decreasing deficits or
         prowing surplus-has first of all a positive influence on aggregate demand. In many
         developing countries, resources (mainly labour) are not fully utilized over long periods,
         thus, aggregate demand increases stimulate higher real GDP growth, and vice versa. A
         once off improvement of the current account leads to leap in GDP to a higher level, but
         the long term growth rate remain unchanged, albeit with higher absolute annual
         increase in real GDP (everything else being constant).
         As small open economies have rather few opportunities to use independent monitory or
         fiscal expansionary policies to stimulate demand, promoting exports is much more
         feasible and more efficient than practicing deficit spending.

39. Distinguish portfolio “investment” from foreign direct “investments” and from “investment”
in the category of SNA!

Portfolio Investment: When investment involves less than 10% ownership of a company or
physical capital.
Foreign Direct Investment: When investment involves more than 10% ownership of a
company or physical capital.

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Muhammad Jami Husain                                                         MIDE 2005/06, FHTW-Berlin

40. The output equilibrium in a closed economy without government is S = I (ex ante). How
does this equilibrium equation change in an open economy with state?

Output Equilibrium in a Closed Economy:

Given that: Y = C + I and Y = C + S it follows that S = I (expost).
However, if ex ante S>I, then there would be a fall in the real output. On the other hand if ex
ante I>S, there would be an increase in Y which in turn increases S. Therefore the adjustment
of S and I occurs via changes in Y.

Output Equilibrium in an Open Economy:
In an open economy: Aggregate Demand, AD = C + I + G + X

                       Aggregate Supply,     AS = C + S + T + M
Where, C = Consumption (consumption goods including other non-consumption goods)

         I = Investment
         G = Government Expenditure (Consumption)

         X = Export of goods and services
         M = Import of goods and services
         S = Savings

The equilibrium condition is therefore given by:

Or, I + G + X = S + T + M (ex post, i.e. at the end of the period)
Or, S = I + G - T + X – M

Equilibrium exists at each point at which these expenditures (I + G + X) just offset the
leakages from the current income stream (S + T + M).

41. What happens, if ex ante ( I+G+X)>(S+T+M) ?

The equilibrium condition in an open economy is given by:

Or, I + G + X = S + T + M (ex post, i.e. at the end of the period)
However, if Ex ante (I+G+X)>(S+T+M) then aggregate demand will be in excess of aggregate
supply and thereby output (i.e. GDP) would increase and equilibrium would be restored.
On the other hand, at any level of the net national product at which (S + T + M) is greater that
(I + G + X), aggregate supply will be in excess of aggregate demand and output will fall.
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Muhammad Jami Husain                                                         MIDE 2005/06, FHTW-Berlin

42. Explain the “impossible trinity”! Why are the three targets not achievable simultaneously?
What combination would you recommend for developing countries (argue!)?

The notion “Impossible Trinity” refers to the three macroeconomic targets:

             Exchange rate stability,
             Free capital mobility, and

             Independent domestic monetary policy.
The notion “Impossible Trinity” entails that these three targets are not compatible, i.e countries
cannot achieve all the three targets simultaneously. The countries can at best achieve two
options, and many countries are capable of manoeuvre only one target.

                                          Exchange rate

               Free capital                                      Independent domestic
               mobility                                          monetary policy

                                        The Impossible Trinity

For example, a developed country, say USA, would opt for free capital mobility and
independent monetary policy and would not care much about the exchange rate stability. Trade
surplus bigger developing country like China would opt for exchange rate stability and
independent domestic policy. Developing poor countries would opt for exchange rate stability
and free capital mobility and have rather few opportunities to use independent monetary

Developing country should go for exchange rate stability and independent monetary policy.
Stable exchange rate for LDCs is of paramount importance since they are the preconditions for
macro stability and price stability. Again, if monetary policy in LDC were autonomous and
could be made to the specific monetary problems of the respective countries, it would be
extremely helpful. For LDC macro impact of liberalised international market is double edged
or even detrimental. If capital convertibility as well as financial cross border mobility is
restricted the two other targets are much easier to realise.

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Muhammad Jami Husain                                                           MIDE 2005/06, FHTW-Berlin

43. What is the balance-of-payment equilibrium in the IS-LM-BP-model? BP = …? Include the
independent variables for the terms on the right side.

The IS-LM-BP model is a Keynesian type model that is derived partially from the income-
expenditure model. This companion model analyses the relationship between the:
    1. Interest rate
    2. Real GDP
    3. Balance of international payments.
The BP curve:

The BP curve represents an overall equilibrium in the nation’s balance of payments and shows
how this equilibrium is related to income and interest rates. Equilibrium exists when any
imbalance between exports (X) and imports (M) is offset by an appropriate volume of capital
flows. Anywhere along the BP line, the reserve does not change and the sum of the current
account and the private capital account (both short and long run) equal zero.
Equilibrium in the balance of payment can be algebraically defined as:

BPe = X f(FXp) – M f(FXp, Ynp) + Kg F(id) = 0
In the equation:

FXp = the real exchange rate
Ynp = real net national product

Kg = net global capital flows
id = the difference between domestic and global interest rates.

         Exports (X) are positively related to the price of foreign exchange (FXp). If the price of
         foreign exchange increases, the international value of the domestic currency drops.
         Thus, domestic goods become cheaper for foreigners and exports increase.
         Imports (M) are positively related to the level of real net national product (Ynp) and
         inversely related to the price of foreign exchange (FXp). A fall in the price of foreign
         exchange (an appreciation in the international value of domestic currency) will make
         imports cheaper and thus lead to an increase in import. Imports also will increase from
         a rise in the net national product (Ynp).
         A global capital flows (Kg) are positively related to the difference between domestic
         and global interest rates (id).
The above equation reflects the fact that any difference between exports and imports – net
export balance – must be offset by net flows of global capital. For example, if the domestic
economy is running a current account surplus, there must be an outflow of capital to offset the
surplus. If, on the other hand, there is a current account deficit, then an inflow of global capital
is required to counter the deficit.

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Muhammad Jami Husain                                                          MIDE 2005/06, FHTW-Berlin

44. Show in a graph the combination of the IS-, LM- and BP-curve in equilibrium! Explain the
slope of the BP-curve.

The IS-LM-BP model is a Keynesian type model that is derived partially from the income-
expenditure model. This companion model analyses the relationship between the:
1. Interest rate
2. Real GDP
3. Balance of international payments.

The equilibrium position:
In an open economy, general equilibrium requires simultaneous:

                                                1. commodity market equilibrium
                                                2. money market equilibrium
                                                3. balance of payments equilibrium
                                            This occurs at only one combination of i and Y. In the
                                            figure there is general equilibrium at point E with i1
                                            and Y1.

Slope of BP curve under different capital mobility condition:

The imperfect capital mobility (large country) BP line:

                                          The BP line is upward sloping because:

                                                      Higher levels of real GDP generate to higher
                                                      imports and a current account deficit.
                                                      Balanced BoP requires a higher interest rate
                                                      to generate a capital account surplus.
                                                      All point above the BP line are
                                                      combinations of i and Y that generate a
                                                BoP surplus.
             All points below the BP line are combinations of i and Y that generate a BoP
The upward sloping BP line represents a large country, like the US, in whch domestic financial
markets dominate any international capital flows so that the dometic interest rate can be
different from the world interest rate (iw).

             If ius> iw, not enough capital flows in to lower ius to iw
             If ius< iw, not enough capital flows out to raise ius to iw

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Muhammad Jami Husain                                                           MIDE 2005/06, FHTW-Berlin

An upward sloping BP curve could also represent a smaller country in which there is imperfect
capital mobility in the form of legal restrictions on international capital flows.

The perfect capital mobility (small country) BP line:

                                            With perfect capital mobility, the BP line is
                                            horizontal indicating that the BoP is independent of
                                            real GDP and that the only interest rate at which the
                                            country will have a balance of payments
                                            equilibrium is when the domestic interest rate
                                            equals the world interest rate.

The Imperfect capital mobility BP line:

                                             With perfect capital immobility, the BP line is
                                             vertical indicating that a BoP equilibrium is
                                             independent of the interest rate and that there is
                                             only one level of real GDP at which there will be
                                             balance of payments equilibrium.

Mundell-Flemming Open economy model conclusion:

         Under fixed exchange rate expansionary monetary policy does not work, only fiscal
         policy works.

         Under flexible exchange rate monetary policy works, but fiscal policy does not work.
                                                  Message:     The model is in favour of fleible
                                                  exchange rate.

                                                  Assumptions of Mundell-Fleming Model:

                                                         IS-LM assumption; No inflation,
                                                         perfect capital mobility; No negative
                                                         effect of deflation
                                                  Criticism:   Marshall-Lerner condition, if not
                                                  applied….impact on external debt, induce
                                                  dollarization…in case of spiral depreciation.

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Muhammad Jami Husain                                                           MIDE 2005/06, FHTW-Berlin

45. (1) Explain briefly in words or with formulas a) cost-push-inflation, b)demand-pull-inflation
and c) the monetarist explanation of inflation. (2) Sometimes cost-push-inflation is also called
“conflict inflation”. Explain!

Demand Pull Inflation

Inflation that is caused by persistent rise in aggregate demand (i.e. persistent rightward shifts in
the AD curve) is referred to as demand pull inflation. The rises in aggregate demand may be
due to rises in consumer demand, government expenditure, investment by firms, exports or any
combination of these four. When AD rises, firms will respond to a risein demand partly by
raising prices and partly by increasing output. In other words, it will depend on the shape of the
AS curve. Demand pull inflation is typically associated with a booming economy.

Monetary Explanation of Demand Pull Inflation:

A corner stone of demand pull inflation theory is the classical quantity theory of money, which
states that MV’ = PY’, where M is the exogenously determined quantity of money in
circulation, V is the income velocity of circulation of money (stable), P is the general price
level and Y represents the fixed level of output. If V remains constant and Y is determined
independently of other monetary variables in the equation (hence the bars above these
variables), an increase in the money supply will increase aggregate purchasing power in the
presence of a fixed output. This will create an excess demand for goods, bidding up their prices
in equal proportion to the original increase in the money supply.
Cost Push Inflation

Central to cost-push theories of inflation is the idea that workers and firms possess market
power, consequently influencing wages and prices independently of demand. The primary role
of money in these theories is to accommodate rather than cause inflation.

In general, cost-push inflation is associated with leftward (upward) shifts in the AS curve due
to rise in the cost of production independently of aggregate demand. If firms face a rise in

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Muhammad Jami Husain                                                           MIDE 2005/06, FHTW-Berlin

costs, they will respond partly by raising prices and passing the costs on to the consumer, and
partly by cutting back production (!).

The rise in costs may originate from a number of different sources. As a result we can
distinguish between various types of cost push inflation.
         Wage push inflation: This is where trade unions push upwardwages independently of
         the demand for labour.
         Profit push inflation: This is where firms use their monopoly power to make bigger
         profits by pushing up prices independently of consumer demand.
         Import-price push inflation: this is where import prices rise independently of the level
         of aggregate demand.
         Tax-push inflation: This is where increased taxation adds to the cost of living.
         Exhaustion of natural resources.

Mechanism of cost-push inflation:
Yr . P = (1 + m) W . N              (m = mark-up, W = wage rate, N = number of employment)

         P = (1 + m) (WN / Yr)
         P = (1 + m) (w/∏h)               ∏ = Yr/∑h

To keep P constant or stable, w/∏h is the instrument. So unit wage cost is the anchor to
analyse inflation.
Wage Push Inflation:
 ∧              ∧           ∧
W = f (u ) + p e + π

∧         ∧             ∧       ∧
P =≈ U L C = W − π
∧                   ∧
P =≈ f (u ) + Pe + ε

W = Expected Wage
π = Increase in productivity
 f (u ) = Higher the unemployment group more the downward pressure.
U L C = Change in unit labour cost

ε = Shock factor
              Workers’ wage bargain depends on the level of unemployment, purchasing
power (expected price level) and productivity.

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Muhammad Jami Husain                                                           MIDE 2005/06, FHTW-Berlin

Monetarist Explanation of Inflation

A corner stone of demand pull inflation theory is the classical quantity theory of money, which
states that MV’ = PY’, where M is the exogenously determined quantity of money in
circulation, V is the income velocity of circulation of money (stable), P is the general price
level and Y represents the fixed level of output. If V remains constant and Y is determined
independently of other monetary variables in the equation (hence the bars above these
variables), an increase in the money supply will increase aggregate purchasing power in the
presence of a fixed output. This will create an excess demand for goods, bidding up their prices
in equal proportion to the original increase in the money supply.

MV = Yr.P
         P = (M.V)/Yr

          ∧     ∧      ∧   ∧
          P = M s +V−Y r

                                                 ∧    ∧   ∧           ∧
In this case if target inflation is zero, then M s = Y r − V (given P =0); which implies money
supply should rise according to the growth of GDP given velocity is constant. It is the
mismatch of Ms and Yr that creates inflation.
Ms       --     AD>AS - change in price (implicit assumption of full employment and full
utilization of capacity)
The inflation so described may be international rather than domestic and may be interpreted
under fixed and flexible exchange rate:
Case 1: Fixed exchange rate and inflation in RoW

Causal Chain: Export - Dollar flows in- Trade surplus-              local currency claim increase -
  Money availability increase -- Inflation

Case 2: Flexile exchange rate and inflation in RoW
Causal Chain: Inflation RpW- Appreciation of exchange rate until the differences are
levelled --     No trade surplus--    No inflation.

Conflict Inflation

This theory seems to suggest that ‘excessive wage claims – and, by extension, workers and
trade unions- are the root cause of inflation. But closer inspection reveals this to be falls. If
firms accommodate nominal wage increases that exceed productivity gains by lowering the
mark up, it is evident from the equation above that prices need not rise at all. However, this
will change the distribution of income between wages and profits. Inflation in first generation
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Muhammad Jami Husain                                                                MIDE 2005/06, FHTW-Berlin

cost push theory is therefore the result of firm’s unwillingness to accede to workers implicit
claims for a larger share of income. This interpretation highlights the substance of the
conflicting- claims theory of inflation. According to this theory, inflation is caused by both
workers and firms or, more specifically by the irreconcilable claims on total income that result
from their differing conceptions of what constitutes a fait distribution of income. In conflicting
claims theory, inflation can be either wage-led (as in FGCP theory) or profit-led. Hence firms
can initiate inflation by increasing prices relative to nominal wages (which will increase the
profit share of income). But workers may block this attempted redistribution by bidding up
nominal wages (a process called real wage resistance), thereby encouraging firms to further
increase prices in the hope of achieving their preferred profit share, which will again prompt
real wage resistance, and so on. The result is a process of continually rising prices. Conflict
inflation, thereby, is a special form of cost push inflation, where the conflict is embedded in the
structure of capitalism which tends to be inflationary.

46. Explain hyperinflation (or very high inflation) – how can it happen?

In economics, hyperinflation is inflation which is "out of control", a condition in which prices
increase rapidly as a currency loses its value. No precise definition of hyperinflation is
universally accepted. One simple definition requires an monthly inflation rate of 50% or more.
The definition used by most economists is "an inflationary cycle without any tendency toward
equilibrium." A vicious circle is created in which more and more inflation is created with each
iteration of the cycle. Although there is a great deal of debate about the root causes of
hyperinflation, it becomes visible when there is an unchecked increase in the money supply or
drastic debasement of coinage.
In history, there are many evidences of hyperinflation, specially during or immediately after
war. For example, following the chaos of the First World War, the German government
resorted to printing money, not only to finance domestic spending requirement but also to
finance reparations imposed on by the allies in the Treaty of Versailles. The prices then started
to rise very quickly. As prices increases accelerated, people become reluctant to accept money:
before they knew it, the money would be worthless. People thus rushed to spend their money
as quickly as possible. But this in turn further drove up prices.

Devaluation and wage price spiral…………..

47. Remember the difference between disinflation and deflation?

The term ‘Disinflation’ refers to reduction or decrease in inflation, but when the rate of
inflation drops below zero (i.e. negative inflation rate) it is called deflation.

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Muhammad Jami Husain                                                           MIDE 2005/06, FHTW-Berlin

48. In what way is inflation in a typical developing country different from a developed?

Inflation in a Developing Country: Specific Features:

         In developing countries composition of Consumer Price Index (CPI) basket is very
         different than that of the developed countries. Whereas, generally, food components
         dominate in the CPI basket, it is not the case for the CPI basket of developed countries.

         Developing countries are more prone to supply shocks and thereby play a bigger role in
         the process of inflation.

         Import to GDP ratio in developing country is very high. In that case depreciation would
         impact highly in causing inflation.

         Inflation cannot be tackled with lowering wage rates
         Exchange rates in developing countries are highly determined by autonomous financial
         flows and therefore speculative demand plays a significant role.
         The developing countries are prone to the problem of dollarization.

Balassa-Samuelson Effect:

In a developing country inflation are a bit higher than developed countries due to:
         Developing countries are the ‘catching’ countries with high growth in productivity,
         particularly in modern sector. In the so called primitive or traditional sector the
         productivity is much lower.
         If productivity increase in tradables lead to wage increase in trade sectors, it also
         influence the traditional sector to raise its wages. In that case a gap emerges in
         productivity, contributing in increasing unit labour cost in the traditional sector.

49. The saving-gap theory stipulates that developing countries need foreign finance for higher
growth. Explain the arguments of this theory! What does the concept imply for the structure of
the balance of payment? Priewe. 2005 P.72

The saving gap hypothesis is short. In the 1960s, Chenery/Strout (1966) held that in poor
countries growth is hampered as there is a lack of resources. They argued that the low income
in developing countries prevents sufficient domestic savings and thus constraints the
availability of resources for investment. Domestic saving can be augmented by foreign funds –
reflected in current account deficit. Higher saving will translate into higher investment and
growth. According to this approach the country will realise a long period of current account
deficits and consequently a built up of foreign debt. But during this time, investment projects
will mature. Once the country becomes developed, the current account switches from a deficit

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Muhammad Jami Husain                                                           MIDE 2005/06, FHTW-Berlin

to a surplus. The later will enable the debt service and repayment of foreign finance, but only
in the long run.

The saving gap model is also sometimes referred to as debt cycle or current account stages
hypothesis. Developing countries are regarded as borrowers due their low saving and export
capacity, developed countries are the typical lending economies with an excess of saving over
investment. In addition, during the catch up process, industrial countries loose their traditional
comparative advantage, whereas developing countries gain new advantages and need external
finance to exploit them.

As devlin/F.French-Davis and Griffith-Jones (1995) point out to be a virtuous cycle five
requirements have to be fulfilled:

             External capital flows should be used to augment investment rather than

             The additional investment has to be efficient
             The investment must take place in the production of tradables to improve the trade
             balance (or in infrastructure related to tradables); hence the capital inflows have to
             promote exports or import substitution.

             An aggressive hike in domestic saving relative to aggregate income is necessary,
             the mirror image of the trade surplus.

             Capital exporters must provide stable and predictable flows of finance – first a long
             period of stable capital inflows and then a long period of stable capital outflow – in
             line with the recipient county’s factor productivity.

50. Mention some problems of the saving-gap approach!

(The higher the stock of external debt, the more critical high current account deficits are, and
hence the likeliness of a financial crisis.)
The assumption that developing countries lack resources in general and thus need a current
account deficit gives a fundamentally inaccurate orientation as it presumes that additional
resources that is more goods produced abroad, automatically trigger development.
Development in the first place is a problem of how to unfold productive market forces. And
this question has little to do with the problem of resources.

Following the financial gap model and the notion of lack resources, it is usually assumed that
‘official development assistance (ODA)’ would largely translate into investment to support
development. Easterly found that large parts of foreign aid and in turn of current account
deficits were used for consumption and not for investment. This may be necessary for poor
people to survive but it is an emergency case and not one of development strategy. The belief

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Muhammad Jami Husain                                                            MIDE 2005/06, FHTW-Berlin

that current account deficits will spur growth can also be attacked on theoretical grounds. In
the case of an underutilization of resources- the normal case in developing countries-aggregate
demand becomes the dominating factor for growth. The following equation shows the
important demand factors (C and Y represent consumption and income).

Y = I + C + G + (X-M)
If demand is important for production (Y) any improvement in the current account (X-M)
increases, ceteris paribus, the level of production and income. For example, a one time switch
from a deficit in the current account to a surplus leads to a higher level of production and
income in all periods that follow. The surplus will lead to a one time increase of the GDP
growth; after words the growth rate is – ceteris paribus-unchanged.

A higher current account deficit can also increase government spending or even private
consumption. An increased current account t deficit that crowds out domestic production with
an additional negative growth effect, may also transpire. To sum up there is no guarantee that
an increase in the current account deficit will be offset or over-compensated by increases in
other demand component so that higher growth occurs. However, only under the condition that
domestic resources are used to a larger extent, will higher growth occur.

51. Many people contend that fiscal deficits are the main cause for inflation, especially in
developing countries. Explain under what conditions can a fiscal deficit induce inflation.

The notion that fiscal deficits would lead to inflation in developing countries may not hold
always. In certain cases it may lead to inflation. There are possibilities of either cost push or
demand pull inflation.

(1) Cost push inflation caused by fiscal deficit:

Print Money/monetization of debt by central bank ------      Government debt -----        people get
money------ conversion of local currencies into dollar -----       depreciation----      increase in
import price-- cost push inflation.

(2) Demand pull inflation caused by fiscal deficit:

Deficit financing -----   increase in aggregate demand----      aggregate demand exceeds
aggregate supply 8supply bottleneck) --------------    demand pull inflation.

However, it depends on the state of nation’s resource utilization.

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Muhammad Jami Husain                                                           MIDE 2005/06, FHTW-Berlin

52. “Deflation makes consumers richer and is therefore favourable.” (anonymous consumer
without economic background) Convince him that he is wrong, from the viewpoint of the
economy, and that instead deflation is a disaster!

Deflation refers to negative inflation. It is a process in which purchasing power of money
increases. However, this may lead to a recession situation. Deflation is normally associated
with reduction in real GDP. The reason for reduction of GDP can be illustrated with the
following points:

         Decrease in Consumption: In a deflationary situation, consumer will wait (postpone) to
         consume due to the expectation of further reduction of price.
         Increased Saving: Saving in cash will become more attractive due to increase in
         purchasing power.
         Reduction in Investment: Reduced consumption expenditure may induce reduce
         investment. Also in deflation the nominal interest rate may not reduce to less than zero,
         but the price goes below zero; leading to increase in real interest rate. This is not good
         for investment.
         Loss of job
         Increased Stock of Debt: In deflation the real debt burden for the debtors increases. In
         turn, the creditors will also be hard hit, sooner or later; leading to a financial crisis.
         (Note: Mention Pigue effect also)

53. What are the functions of money?

Traditionally, the functions of money are presented in the form of the so-called triad of the
money functions, which comprise:

         The functions of the means of payment:
             o This involves a narrow definition of money. For example, for transactions
                  among banks, the means of payment is the monetary base, i.e. deposits with the
                  central bank. For transaction among non-banks (and among banks and non-
                  banks), only the components of the money stock M1 can be used as a means of
                  payment: with all other components of the money stock, M2 and M3, direct
                  payment either among banks or non-banks are not possible. Thus, this function
                  would clearly exclude broader monetary aggregates from a definition of money.
         The function of the store of value:

             o The function of store of value is of little help if it is used the sole criterion for
               the moneyness of a financial asset, since almost any financial asset (and even

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Muhammad Jami Husain                                                            MIDE 2005/06, FHTW-Berlin

                  many non-financial assets) can be used as a store of value. The result would be
                  extremely broader definition of money. The statistical concept for such a broad
                  definition is the concept of monetary wealth, i.e. the sum of all financial assets
                  that are held in an economy. While such solution would overcome the
                  classification problem, it would still be confronted with a difficult aggregation
                  problem. However, in the academic literature, and also in practical monetary
                  policy, such a broad aggregate plays no decisive role.
         The function of the unit of account

             o The function of the unit of account is provided by an abstract currency unit that
               is the legal currency for certain area. As a numeraire for the exchange of goods
                  and services, money (or, monetary unit) helps to reduce trabsaction and
                  information costs. As a standard of deferred payments, money helps to organize
                  the intertemporal exchange of goods (for instance, using financial markets and

Money may be defined a special commodity which by itself does not have any face value, but
fulfils the three conditions. Historically it may be gold, silver or paper notes. Money involves
no (or negligible) transaction costs.

54. Define M1 and base money!

Base Money

From the perspective of commercial banks, a perfect substitute for currency in circulation are
reserves that these banks hold with the central bank. If a bank is in need of currency, it can
always convert its reserves with the central bank (R) into currency (C) at negligible transaction
cost. And if a bank’s cash balances are too high, it can always exchange them for reserves.
Deposits with other banks are another perfect substitutes but in aggregation over all banks they
add up to zero. This perfect substitutability between reserves and currency leads to a first
important concept of money; The Monetary Base (B). This is defined as follows:
B = C + R.

From the perspective of private non banks, an almost perfect substitute to currency in
circulation are sight deposits. Today, specially with cash dispensers, it is almost always
possible to transfer an overnight deposit (D) into currency at very low transaction costs. This
leads to a second important concept of money, the money stock M1. This is defined as;
M1 = C + D.

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Muhammad Jami Husain                                                            MIDE 2005/06, FHTW-Berlin

55. Should central banks be independent from the government? Explain your opinion.

At the heart of the financial system of a country is the central bank. The key functions includes
issue of bank notes, provision of liquidity (lender of last resort), guarantee the quality of
money in the context of assumed price stability and function as a payment system (i.e. clearing
transaction among banks). In many countries its role is to oversee and regulate the activities of
the different financial institutions. It has the task of ensuring the stability and efficiency of the
financial system.
The independence of central bank calls for personnel independence, goal independence,
instrument independence and financial independence. The advocates of independence
frequently cite the experience of Germany. Germany’s central bank is fiercely independent and
is credited with being instrumental in Germany’s economic successful. The Bundesbank’s
philosophy is simple; monetary and price stability is of overriding importance in the pursuit of
growth. Inflation should be tightly controlled at all times.
The arguments in favour of an independent central bank are strong:

         An independent central bank is free from political manipulation. It can devote itself to
         attaining long run economic goals, rather than to helping politicians achieve short run
         economic success in time for the next election.
         Independence may strengthen the credibility of monetary policy. This may then play an
         important part in shaping expectations: workers may put in moderate wage demand and
         business may be more willing to invest.
         An independent central bank has a clear legal status and set of responsibilities, it is the
         ‘prtector of the currency’ as such it is not subordinate to government. This is important
         given the political nature of economic policy making in both a domestic and
         international contest.
         Theoretically in the context of the assumption of neutrality of money, it is preferable to
         have an independent central bank to stabilize price.
One of the major arguments against having an independent central bank is that:
       It makes it more difficult to integrate monetary management into wider economic
         policy objectives. On some occasions it might be desirable to accept a higher rate pf
         inflation-if these were of the consequence of growth stimulus at reducing
         unemployment. But with an independent central bank committed to monetary stability,
         it may be difficult for the government to achieve such economic policy goals.
         Experience shows that independence often involved less or limited transparency in the
         Many dependent central bank has good record of maintaining price stability
         (i.e. China), vis a vis examples of badly performed independent central banks.

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Muhammad Jami Husain                                                           MIDE 2005/06, FHTW-Berlin

56. What is direct inflation targeting? What are possible intermediate targets of central banks?

Inflation targeting is a framework for monetary policy characterized by the public
announcement of official quantitative targets (or target ranges) for the inflation rate over one or
more time horizons, and by explicit acknowledgement that low, stable inflation is monetary
policy’s primary goal.

Components of Inflation Targeting.
         Quantification of inflation target
         Independence of central bank, with proper accountability and clear assignment.

         Only one target for central bank
         Appropriate instruments (for example inflation forecasting method)

         Well reputation, communication and transparency
         No fiscal dominance

The justification that economists usually give for using intermediate monetary policy targets is
that it is difficult for a central bank to control the ultimate goal of price stability directly.

Other Intermediate Targets of Central bank
         Monetary Targeting: It provides a rule for an intermediate target; it is based on quantity
         theory of money
         Exchange Rate Targeting: It uses the theoretical framework of purchasing power parity
         and uncovered interest rate theory
         Multi-Indicator Approach: The Tailor Rule: It is designed for he level of operating
         targets and relies on the aggregate demand channel and the transmission via changes in
         the interest rate.

57. Is M1 a sensible intermediate target?

If you want intermediate target…it should have stable component……M3 rater than
m1 sensitive to interest rate

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Muhammad Jami Husain                                                            MIDE 2005/06, FHTW-Berlin

58. What is bad about high inflation?

If people could correctly anticipate the rate of inflation and fully adjust prices and incomes to
take account of it, then the costs of inflation would indeed be relatively small. For us as
consumers, they would simply be the relatively minor inconvenience of having to adjust our
notions of what a fair price is for each item when we go shopping. For firms, they would again
be the relatively minor costs of having to change price labels or prices in catalogues or on
menus, or adjust slot machines. These are known as menu cost.
In reality, people frequently make mistakes when predicting the rate of inflation and are not
able to adapt fully to it. This leads to the following problems, which are likely to be more
serious the higher the rate of inflation becomes and the more the rate fluctuates.

              Inflation redistributes income away from those on fixed income and those in a
weak bargaining position, to those who can use their economic power to gain large pay, rent or
profit increase. It redistributes wealth to those with assets (e.g. property) which rise in value
particularly rapidly during periods of inflation and away from those with types of savings
which pay rates of interest below the rate of inflation and hence whose value is eroded by

Uncertainty and Lack of Investment: Inflation tends to cause uncertainty among the business
community, specially when the rate of inflation fluctuates. Generally, the higher the inflation
the more it fluctuates. If it is difficult for firms to predict their costs and revenues, they may be
discouraged from investing. This will reduce the rate of economic growth.

Balance of Payment:   Inflation is likely to worsen the BoP. If a country suffers from relatively
high inflation its exports will become less competitive in world markets. At the same time
imports will become relatively cheaper. Thus exports will fall and imports will rise. As a result
the BoP will deteriorate and/or the exchange rate will fall.

Extra Resources and Wage-Price Spiral:    Extra resources are likely to be to cope with the effects
of inflation. With high inflations 8or hyperinflations) the basis of the whole market economy
will be undermined. Firms constantly raise prices in an attempt to cover their rocketing costs.
Workers demand huge pay increases in an attempt to stay ahead of the rocketing cost of living.
Thus prices and wages chase each other in an ever-rising inflationary spiral. People will no
longer want to save money. Instead they will spend it as quickly as possible before its value
falls any further.
Dollarization:   In a global economy each currency competes with other currency and unstable
currency faces the problem os so called ‘dollarization’. With the existence of hierarchy of
currency- inflation induces dollarization; i.e. outright capital flight, portfolio mix. High
inflation leads to deterioration of local currency which has bearings on portfolio decision.

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Muhammad Jami Husain                                                           MIDE 2005/06, FHTW-Berlin

59. What are the key “direct instruments” of central banks? What are the 3 key “indirect

Direct Instruments (Non-market based Instruments):
    (1) Interest rate controls
    (2) Credit ceilings (bank-by-bank)
    (3) Rediscount quotas (bank-by-bank)
    (4) Statutory liquidity ratios
    (5) Selective credit controls
    (6) Moral suasion
Indirect Instruments (Market based Instruments):
    1. Reserve requirements
    2. Credit Auction
    3. Open market operations
          a. primary market sales of central bank and government securities, and
          b. Secondary market operations (outright purchases and sales or repurchase)
    4. Public sector deposit
    5. Lombard window
    6. Rediscount window
    7. Foreign exchange swaps

60. Explain in general and additionally two (or more) channels how money (cash) comes from
the printing office of the central bank to nonbanks.

         Bonds sold in auctions through the head offices of the central bank
         Through commercial bank
         Intervention in the foreign exchange market….selling them

61. Explain the Taylor-rule of monetary policy!

The Taylor Rule prescribes a concrete value for the short term interest rate that serves as the
operating target for the Central Banks. The Taylor rule was not developed from a
comprehensive theoretical model or an intensive academic debate. It was the result of an
empirical study of the actual monetary policy of the Federal reserve System during the years
1987-92. In a very general form, the rule can be formulated as a rule for the short-term interest

iT = π e + r * + α (π e − π t ) + β Y − Y *    (          )
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Muhammad Jami Husain                                                                  MIDE 2005/06, FHTW-Berlin

α and β are weights reflecting the impact of the output gap and the deviation of the inflation
rate from its target.

         If π* is too high than πt ------     it Increases ---------     Restrictive monetary policy
         If π* is lower than πt ------      it Deceases ---------      Lenient monetary policy
         If negative output gap ------       it Decreases ---------     expansionary policy

62. Fixed exchange rates and free convertibility of the currency are not compatible with the
control of money by the central bank. Why not?

There exists a conflict between the two simultaneous objectives of maintaining stable
exchange rate and price stability (stability of inflation) under the assumption of full
convertibility of currency. With the assumption of full convertibility of currency, inflows of
foreign currency would increase demand for local currency; which in turn violates the money
target of the central bank. The mechanism may be shown as follows:

Stable exchange rate--- increase in currency in circulation or M1---- Inflation (according
to the quantity theory of money, or through demand pull mechanism).

Under such circumstances, sterilization is often thought to be a solution. In that case the central
bank issues bond with high interest rate. This eventually may reinforce capital inflow leading
to the same problem mentioned above. However, the conflict would not arise if sterilization
does not accompany increase in the interest rate.

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Muhammad Jami Husain                                                           MIDE 2005/06, FHTW-Berlin

Monetary Theory and Policy

A8. How do you define “money”? Why is it problematic to choose broad money, e.g. M3, as the
definition of money?

The variety of instruments used on today’s financial markets makes it extremely difficult to
define money. Money is often defined in terms of its functions. Money may be defined a
special commodity which by itself does not have any face value, but fulfils the three
conditions. Historically it may be gold, silver or paper notes. Money involves no (or
negligible) transaction costs. Money acts as a medium of exchange. To be a suitable physical
means of exchange, money must be light enough to carry around, must come in a number of
denominations, large and small, and must not be easy to forge. The narrow definition of money
includes only items that can be spent directly, such as cash and current accounts in banks
(since they can be spent directly by using cheques or debit cards). A somewhat broader
definition of money also includes various items such as deposit accounts in banks that cannot
be spent directly but which can nevertheless be readily converted into cash.
A microeconomic approach to define money entails that currency in circulation must be a
component of any definition of money. If currency in circulation is regarded as money, then all
assets that are perfect substitutes can also be regarded as money. From a microeconomic
perspective, the usage of the broader monetary aggregates is not so easy to justify. It is obvious
that not all assets that are included in M3 and M2 can be regarded as perfect or close
substitutes to currency in circulation. This becomes evident also from the fact that currency
and overnight deposits are normally non-interest bearing, while all other assets included in M2
and M3 bear positive interest rates which can sometimes deviate considerably from zero. For
such broader monetary aggregates, therefore, it becomes to solve the classification and
aggregation problem.
          If some of the components of a specific monetary aggregate are no longer perfect
          substitutes for currency, it is difficult to explain why these assets are regarded as
          ‘money’ while other assets are excluded. The borderline between money and other
          financial assets becomes arbitrary.
          With an imperfect substitutability of assets, it is also not clear which weights should be
          used in order to calculate a monetary aggregate.

A9. In reality the velocity of money is unstable, especially the velocity of M1. Why?

Empirically the main assumption of quantity theory – a stable velocity of money – cannot be
confirmed. In Germany since mid-1970s onwards the note and coin circulation has risen
substantially faster than nominal GDP. This result is surprising at first sight, since it indicates
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Muhammad Jami Husain                                                         MIDE 2005/06, FHTW-Berlin

that in recent decades more money per unit of nominal GDP has been required, in spite of
massive innovation in financial technology. Among the reasons suggested for this, alongside
moonlighting, tax evasion on investment income, rising bank charges, and drug traficcing, is
the increased use of the deutchmark as a parallel currency in Eastern Europe and the CIS
states. This anomaly is also due mainly to the fact that money holdings also depend on the
wealth of the population. Another important aspect that contributes to the instability of velocity
would be the speculative motive of holding money. Applied to the money stock M1, it assumes
that people are willing to hold money exclusively as a store of value. Money demand may also
depend on financial wealth and related innovations.

A10. What is seigniorage and how can it be generated?

Seigniorage is the term referred to the profit earned by the Central Banks. This constitutes the
revenue for central bank. CB earns some profit as long as credit is forwarded. But money
brought as remittance does not lead to profit generation. Another component of profit could be
foreign reserves.
‘Seignorage is the profit made from coining money, named because it was one of the rights of

A11. What are the positions in the balance sheet of the central bank (a) and of the consolidated
banking system (b) in a closed economy (use the simplest form and omit the position “balance
of other assets and liabilities”).

The most simplified version of the central bank balance sheet is given below.
Assets                           Liabilities

Credit to domestic banks         Currency in circulation

                                 Reserves of domestic banks

The assets side consists solely of the loans that the central bank grants to the banks for fundng
purposes. The liabilities side is made up of notes and coins in circulation (C) and the banks’
central bank balances (R). The monetary base is thus defined as:

B = CrCB/B = C + R.
Where, CrCB/B = Credit from CB to banks.

In a similar way, the simplified consolidated balance sheet of the banking system (neglecting
the net foreign position) can be shown as follows:

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Muhammad Jami Husain                                                          MIDE 2005/06, FHTW-Berlin

Assets                              Liabilities

Credit to domestic non-banks        Currency in circulation

                                    Deposits of domestic non-banks

Expressed in the form of equation, the money supply and total lending can then be written as
M = C + D = CrB/NB; Where, CrB/NB = Credit from banks to non-banks.

The equation shows that money supply is equal to total lending. The non banks’ demand for
bank credit is identical with a demand for cash or deposits (=demand for money) which are
used for transactions. Therefore each bank loan supplied implies that money is supplied in the
form of C or D.

A12. The money multiplier is m = M/B = (1+b)/(b+r). Explain in your own words what this means
and why the multiplier is > 1!

In its simplest form, the money multiplier is a coefficient which describes the relationship
between the volume of money stock and the monetary base:

Multiplier = m = M/B                                                 (1)
This can be deduced as a simple tautology from the determining equations for the money stock
M1 and the monetary base (B). the money stock is made up of cash (C) and deposits (D) only.

M=C+D                                                                (2)
The relationship of cash holdings to deposits (C/D) is referred to as the cash holding ration (b).
Equation 2 thus becomes:
M = bD + D = D (b + 1)                                                      (3)

Again, the monetary base is the sum of cash holdings (C) and banks’ balances at the central

B=C+R                                                                (4)
The relation that the bank’s central bank balances bear to deposits (R/D) is represented by the
reserve ratio (r).
B = bD + rD = D (b+r)

The multiplier can then be determined by dividing (3) by (4):
M/B = m = (1 + b) / (b + r)                                          (5)

If we assume realistically that the reserve ratio has a value of less than unity, i.e. that no bank
will hold a 100% reserve, the money creation multiplier will always greater than 1 (one).

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Muhammad Jami Husain                                                            MIDE 2005/06, FHTW-Berlin

A13. Explain the relationship between the short-term interest rate (money market) and the long-
term interest rate on the credit market.

Profit maximizing banks’ revenue components basically include loan forwarded and interest
earned on that; and cost components include refinancing cost, operating cost and cost of credit
default. Therefore, one of the main components of cost is the refinancing rate. Profit comes
when rate of long term credit set by bank is greater than refinancing rate (short term credit

Long term interest rate in the credit market may be thought of as an integral of all short term
refinancing rate. Since lender exactly do not know the future of short term interest rate, they
build some expectations that lead to higher I (i.e. long term interest rate).

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Muhammad Jami Husain                                                                        MIDE 2005/06, FHTW-Berlin

Rational expectations theory (RET)

A1. What are “rational expectations” in the understanding of the (RET)? Explain why this school
rejects adaptive expectations!

The rational expectations theory entails that people base their expectations of the future on the
information they have available. Expectations are assumed to be formed ‘rationally’ in line
with utility-maximizing behaviour on the part of individual economic agents. Peoples’
expectations are based on the current state of economy and the policies being pursued by the
government. Workers and firms look at the information available to them – at the various
forecasts that are published, at various economic indicators and the assessments of them by
various commentators, at government pronouncement etc. While the information at hand may
be imperfect and therefore people will make errors, these errors will be random. With rational
expectations, agents’ expectations on economic variables on average will be correct.
Furthermore, the hypothesis implies that agents will not form expectations which are
systematically wrong (biased) over time. If expectations were systematically wrong, agents
would learn from their mistakes and change the way they formed expectations.

 Algebraic expression of RET
   •         •
  P t = Pt e + ε t
 In other words, the rate f inflation for any time period will be the rate that people expected in that time period
 plus an error term. This error term, be it large, is likely to be positive and negative and would the values would
 cancel leading to a sum of zero.

The rational expectations hypothesis contrasts with the adaptive expectations hypothesis
initially used by orthodox monetarists in their explanation of inflation expectations and Phillips
curve. In the adaptation expectations hypothesis, economic agents base their expectations of
future values of a variable (such as inflation) only on past values of the variables concerned.
One of the main problems with this ‘backward looking’ approach to forming expectations is
that, until the variable being predicted is stable for a considerable period of time, expectations
formed of it will be repeatedly wrong. In contrast ‘the forward looking’ approach, rational
expectations are based on the use of all publicly available information with the crucial
implication that economic agents will not form their expectations which are systematically
wrong over time; that is, such expectations will be unbiased.

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Muhammad Jami Husain                                                         MIDE 2005/06, FHTW-Berlin

A2. RET rejects the traditional negatively sloped Phillips-curve. Why?

If people are correct in their expectations and if the long run aggregate supply and Phillips
curve are vertical, so too will be the short run curves. In the moderate monetarist (adaptive
expectations) model, the short run AS curve is upward sloping (and the short run Phillips curve
downward sloping) only because expectations lag behind any changes in AD. Once
expectations have adapted, the effect is felt purely in terms of price changes. Output and
employment stay at the natural level in the long run.
In the new classical (rational expectations) model, there is no lag in expectations. If their
information is correct people will rationally predict that output and employment will stay at the
natural level. They predict that any change in aggregate monetary demand will be reflected
purely in terms of changes in prices, and that real aggregate demand will remain the same. If
real aggregate demand remains the same, so will the demand for and supply of labour and the
demand for and supply of goods. Thus, even in the short run output and employment will stay
at the natural level; thereby Phillips curve will be vertical at the short run.

A3. What is the policy-ineffectiveness hypothesis of RET? What does this imply with respect to
the controversy on the (non-)neutrality of money?

The rational expectations theory predicts that, as rational economic agents will take into
account any known monetary rule in forming their expectations, the authorities will be unable
to influence output and employment even in the short run by pursuing a systematic monetary
policy. Furthermore, any attempt to affect output and employment by random or non-
systematic monetary policy will only increase the variation of output and employment around
their natural level.
The policy ineffectiveness hypothesis envisages super neutrality of money, i.e. money is
neutral even in the short run. For example, the monetary authorities might adopt a monetary
rule which allow for a given fixed rate of monetary growth of 6% per annum. In forming their
expectations of inflation, rational economic agents would include the anticipated effects of the
6% expansion of the money supply. Consequently the systematic component (i.e. 6%) of the
monetary rule would have no effect on real variables. However, only departures from a known
monetary rule (such as policy errors made by the monetary authorities or unforeseen changes
in policy) which are unanticipated may influence output. If in practice, money supply grew at a
rate of 8% per annum, the non-systemic component of monetary expansion (i.e. 2%) could
cause output and employment to rise temporarily. In this context, the rational expectation
school entails that policy should follow clear and stable rules, i.e. be non-Keynesian and non-

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Muhammad Jami Husain                                                                  MIDE 2005/06, FHTW-Berlin

Labour markets

A4. What is the NAIRU? You may use a graphical exposition.

The term NAIRU is an acronym for Non-Accelerating Inflation Rate of Unemployment. It is a
concept in economic theory significant in the interplay of macroeconomics and
microeconomics. This "full employment" unemployment rate is sometimes termed the "natural
rate of unemployment" or the "inflation-threshold unemployment rate": if actual
unemployment falls below the NAIRU, the inflation rate is likely to rise quickly (accelerate).
In terms of output, the NAIRU corresponds to potential output, the highest level of real gross
domestic product that can be sustained at any one time. This is also called the "natural gross
domestic product."
The concept arose in the wake of the popularity of the Phillips curve which summarized the
observed negative correlation between the rate of unemployment and the rate of inflation
(measured as annual nominal wage growth of employees) for a number of industrialised
countries with more or less mixed economies. This correlation (previously seen for the U.S. by
Irving Fisher) persuaded some analysts that it was impossible for governments simultaneously
to target both arbitrarily low unemployment and price stability, and that, therefore, it was
government's role to seek a point on the trade-off between unemployment and inflation which
matched a domestic social consensus.

The NAIRU theory mainly intended as an argument against active Keynesian demand
management and in favor of free markets (at least on the macroeconomic level). There is for
instance no theoretical basis for predicting the NAIRU. Monetarists instead support the
generalized assertion that the correct approach to unemployment is through microeconomic
measures (to lower the NAIRU whatever its exact level), rather than macroeconomic activity
based on an estimate of the NAIRU in relation to the actual level of unemployment. Monetary
policy should aim instead at stabilizing the inflation rate, perhaps at zero.

Alternative version of explanation about NAIRU:
It is a certain threshold of unemployment rate at which further lowering of unemployment rate
increases inflation rate. It is different from natural rate of unemployment. In Freidman’s
analysis, natural rate of
unemployment refers to                                                 WSC Wage setting curve
structural                                                   Inflation increase
unemployment, which                                                          PSWS
                           W    Direction of                                 (Price stability wage setting,
is a mix of fictional
                                deflation                                     i.e. target inflation rate)
                                                       NAIRU Unemployment
unemployment      and
degrees of competition                         NAIRU      N* (full employment)

in the labour market. NAIRU entails full employment cannot be reached.
                                                                                                       Page 60
Muhammad Jami Husain                                                          MIDE 2005/06, FHTW-Berlin

A5. Explain briefly Okun´s Law!

In economics, Okun's Law, named after economist Arthur Okun, describes a relationship
between the change in the rate of unemployment and the difference between actual and
potential real GDP. In the United States during the period since 1965 or so, Okun's Law can be
stated as saying that for every one percentage point by which the actual unemployment rate
exceeds the "natural" rate of unemployment, there is a 2.5 percent "GDP Gap". That is,
unemployment above the inflation-threshold unemployment rate corresponds to real gross
domestic product below potential output. It is more accurately called "Okun's rule of thumb"
since it is an empirical generalization rather than being clearly based on economic theory. The
relationship varies depending on the country and time-period under consideration.

A6. Explain the differences between unemployment in developed countries and under-
employment in developing countries!

Underemployment usually refers to the situation in which persons are working less than they
would like to work. Underemployment is a typical characteristic of the subsistence
(agriculture) sector in the developing countries where the people are employed with a very low
productivity. Marginal product of labour is close to zero. For example, with the system of
extended families, where the family farm or family trade occupies all the family members,
people may not be out looking for jobs and thus not openly unemployed. There is simply not
enough work to occupy them fully. This is the problem of disguised unemployment.

A7. What determines the share of wages in aggregate income in the neoclassical theory (a) and
in the classical theory (b)?

The determination of income distribution in the neoclassical theory can be shown graphically
in the following way.

                                  The equilibrium level of employment (neo-classical full
                                  employment) is determined at the intersection of labour
       Profit                     supply and demand curve at the real wage of W/P. The wage
         WAGE          Ld         is therefore the rectangle and the profit is the triangle. But in
                                  Marxist classical school, wage is really a mere reproduction
                N*          N     of labour. There is no marginal analysis involved; it is the
                               capacity of the labour that determines the wage. According
to Keynesian thought of school the determination of income distribution is ascribed to the
mark up set by the capitalists and the bargaining power of the labour. Benchmark for mark-up
is interest rate, which is independently determined. Wage depends on bargaining power – on
the one hand some degree of monopoly power by employers vis-à-vis strength of the labour
bargaining. In Keynesian analysis, distribution is therefore variable, but in neo-classical
analysis it is determined purely by market forces and not disturbed by the social factors.

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