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ECO401 HELPING MATERIALS
Q: What is meant by balance of payment (BOP)? How BOP is used as an indicator of economic and political stability discuss? BOP is an accounting record of a country’s transactions with the rest of the world. To illustrate the related concepts in a non-complicated way, we shall assume a two-country world (Pakistan and the US), and view things from the Pakistani side. The balance of payments (or BOP) measures the payments that flow between any individual country and all other countries. It is used to summarize all international economic transactions for that country during a specific time period, usually a year. The BOP is determined by the country's exports and imports of goods, services, and financial capital, as well as financial transfers. It reflects all payments and liabilities to foreigners (debits) and all payments and obligations received from foreigners (credits). Balance of payments is one of the major indicators of a country's status in international trade, with net capital outflow. Before we can fully grasp the BOPs, it is important to develop an understanding of the market for foreign exchange. Foreign exchange, in the Pakistani context, simply means US dollars (note that foreign exchange from the US’s point of view would be Pak rupees). Q:Define unemployment what is meant by unemployment rate : DEFINITION OF UNEMPLOYMENT While unemployment can be defined in terms of absolute numbers, in most cases, it is the rate of unemployment which is quoted and which enables cross-country comparisons. The unemployment rate is defined as the ratio of the no. of unemployed people divided by the sum of the employed and unemployed people. A rate of 3-4% is usually considered low, 10-15% considered high, and over 20% considered extremely high. It is worth mentioning that unemployment figures, because they are such a sensitive political issue, are often under-stated by government and over-stated by opposition groups. In most LICs, “official” unemployment rates are seriously misleading, and you can find the government quoting a figure of 5% for unemployment, when the actual rate is around 20-25%, if not higher. Unemployment is the state in which a person is without work, available to work, and is currently seeking work. Types of Unemployment: There are several types of unemployment. Frictional unemployment occurs when a worker moves from one job to another. While he searches for a job he is experiencing frictional unemployment. Structural unemployment is caused by a mismatch between the location of jobs and the location of job- seekers. "Location" may be geographical, or in terms of skills. The mismatch comes because unemployed are unwilling or unable to change geography or skills. Cyclical unemployment, also known as demand deficient unemployment, occurs when there is not enough aggregate demand for the labor. This is caused by a business cycle recession. Technological unemployment is caused by the replacement of workers by machines or other advanced technology. Classical or real-wage unemployment occurs when real wages for a job are set above the market-clearing level. This is often as a result of government intervention, as with the minimum wage, or unions. Q: What are the basic functions of Central Banks? FUNCTIONS OF CENTRAL BANK Let us conclude our discussion here with a word about the functions of the central bank. Monetary policy is just one of the functions of the central bank. There are at least three more functions central banks serves: a. As lender of last resort, it must bail (or help) out commercial banks facing temporary liquidity shortfalls; b. As supervisor of the financial system, it must ensure its good health by monitoring commercial banks’ lending (risk-taking), capital adequacy, and liquidity positions. The central bank is also a monitor of the management and governance of financial institutions and of any other threats to the stability of the financial system; c. As the biggest intervener in the foreign exchange market (and/or setter of the exchange rate), it is responsible for exchange rate policy and the balance of payments, per se. Whether the central bank fulfils these functions independently and autonomously or under instruction by the government (Minster of Finance) depends very much on whether the central bank is de facto autonomous or not. In most HICs, central banks enjoy a fair degree of autonomy (and this is cited as one reason for the stability of their monetary and financial sectors) but in LICs, governments often intervene heavily in the functions of the central bank preventing it from achieving its mandated objectives of financial sector health, monetary and BOP stability, and low inflation. Q: What are the difference between Exogenous growth model and endogenous growth model? EXOGENOUS GROWTH THEORY The Exogenous growth model, also known as the Neo-classical growth model or Solow growth model is a term used to sum up the contributions of various authors to a model of long-run economic growth within the framework of neoclassical economics. The most important contribution was probably the work done by Robert Solow; Solow received the 1987 Nobel Prize in Economics for his work on the model. The key assumption of the neoclassical growth model is that capital is subject to diminishing returns. Given a fixed stock of labor, the impact on output of the last unit of capital accumulated will always be less than the one before. Assuming for simplicity no technological progress or labor force growth, diminishing returns implies that at some point the amount of new capital produced is only just enough to make up for the amount of existing capital lost due to depreciation. At this point, because of the assumptions of no technological progress or labor force growth, the economy ceases to grow. ENDOGENOUS GROWTH THEORY In economics, endogenous growth theory or new growth theory was developed in the 1980s as a response to criticism of the neo-classical growth model. In neoclassical growth models, the long-run rate of growth is exogenously determined by assuming a savings rate (the Solow model) or a rate of technical progress. This does not explain the origin of growth, which makes the neo-classical model appear very unrealistic. Endogenous growth theorists see this as an over-simplification. Endogenous growth theory tries to overcome this shortcoming by building macroeconomic models out of microeconomic foundations. Households are assumed to maximize utility subject to budget constraints while firms maximize profits. Crucial importance is usually given to the production of new technologies and human capital. The engine for growth can be as simple as a constant return to scale production function (the AK model) or more complicated set ups with spillover effects, increasing numbers of goods, increasing qualities, etc. Endogenous growth theory demonstrates that policy measures can have an impact on the long-run growth rate of an economy. In contrast, with the Solow model only a change in the savings rate could generate growth. Subsidies on research and development or education increase the growth rate in some endogenous growth theory models by increasing the incentive to innovate. Q: Differentiate b/w actual GDP and potential GDP? ACTUAL & POTENTIAL GDP The GDP gap or the output gap is the difference between actual GDP and potential GDP or potential output. The calculation for the output gap is Y-Y* where Y is actual output and Y* is potential output or the natural level of output. If this calculation yields a positive number it is called an expansionary gap and indicates an economy in expansion; if the calculation yields a negative number it is called a recessionary gap and indicates an economy in recession. The percentage GDP gap is the actual GDP minus the potential GDP divided by the potential GDP. Q: How can a government finance its fiscal deficit? FISCAL POLICY The Govt’s income and expenditures policy is known as fiscal policy. Use of the federal government's powers of spending and taxation to stabilize the business cycle. If the economy is mired in a recession, then the appropriate fiscal policy is to increase spending or reduce taxes--termed expansionary policy. During periods of high inflation, the opposite actions are needed--contractionary policy. The consequences of fiscal policy are typically observed in terms of the federal deficit. Government purchases: Expenditures on final goods and services (that is, gross domestic product) undertaken by the government sector. Government purchases are used to operate the government (administrative salaries, etc.) and to provide public goods (national defense, highways, etc.). Government purchases do not include other government spending for transfer payments. These are expenditures on final goods by all three levels of government: federal, state, and local governments. Government purchases are financed by a mix of taxes and borrowing. Taxes: Any sort of forced or coerced payments to government. The primary reason government collects taxes is to get the revenue needed to finance public goods and pay administrative expenses. However, the more astute leaders of the first estate have recognized over the years that taxes have other effects, including-- (1) redirecting resources from one good to another and (2) altering the total amount of production in the economy. As such, taxes have been used to correct market failures, equalize the income distribution, achieve efficiency, stabilize business cycles, and promote economic growth. Fiscal policy is the government’s program with respect to the amount and composition of (i) expenditure: the purchase of goods and services, and spending in the form of subsidies, interest payments on debt, unemployment benefit, pension and other payments, (ii) revenues, i.e. taxes and non tax fees (such as license fees etc.) and (iii) public debt: borrowing to cover the excess of expenditure over revenues. Borrowing can be done from three sources: domestic banks and the general public, the central bank (e.g. State Bank of Pakistan), and foreign creditors. Budget Deficit, Budget Surplus and Balanced Budget: If i>ii: the government is said to be running a fiscal or budget deficit and so the government must borrow (or raise debt) to cover the deficit; if i<ii: the government is said to be running a fiscal or budget surplus and so the government can pay-off or reduce its debt; if i=ii: the government is said to be running a balanced budget and the government’s net debt may remain constant. Fiscal deficits and debt are often reported as a ratio of GDP. Although, there is no theoretical benchmark for what constitutes a sustainable fiscal deficit or public debt ratio, the Maastricht criteria (for countries in the European Union) is an important practical guide. It stipulates that fiscal deficit to GDP should be less than 3% while public debt to GDP should be less than 60%. Q: Define current account deficit ??? hw to reduce current account defict? CURRENT ACCOUNT DEFICIT Current account is very much important in order to maintain the long term sustainability of the balance of payment. Recall the equilibrium condition of the economy is where withdrawals equal the injections. W=J S+T+M=I+G+X M–X=I–S+G–T Current account deficit = Private sector resource deficit + Government budget deficit Japan and Korean economy remained in high current account deficit due to high private sector resource deficit. This deficit arises when firms want to invest more and debts that are taken to finance the current account deficit go for the investment of the firms. Government spending and household consumption was not being financed. African and Latin American economies were also remained in high current account deficit. But this deficit was due to the higher consumption expenditures by the households and consumers. This caused worsen the debt problems of these countries. HOW TO REDUCE CURRENT ACCOUNT DEFICIT? Devaluation can help in this regard. Devaluation causes an increase in exports and decrease in imports leading to reduction in current account deficit. But this policy also not successful empirically due to several reasons in many countries.
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