Name: Hafsa Riaz

Roll no: 0000478321

Course code: 9306
Course Tittle: Macroeconomics Analysis
Program: BS Economics 2.5 year

Assignment no.1
Q.1 Discuss why labor supply curve is backed bending?
Provide an example of a backed bending supply curve.
Ans:

 Introduction:
The labor supply curve depicts the relationship between the wage rate and the
quantity of labor supplied. It illustrates how individuals respond to changes in
wages by adjusting the amount of labor they are willing to provide. A unique
characteristic of the labor supply curve is that it can be backward bending at
higher wage rates. This phenomenon occurs when an increase in wages leads to a
decrease in the quantity of labor supplied. The backward-bending shape is rooted
in the trade-off between work and leisure and reflects the income and substitution
effects.

 Understanding the Labor Supply Curve:

The labor supply curve generally has an upward slope, indicating that higher
wages attract more labor. Initially, as wages increase, individuals are motivated
to work more hours because the opportunity cost of leisure (the income forgone
by not working) rises. This is known as the substitution effect, where individuals
substitute leisure with labor to take advantage of higher earnings.

 The Substitution Effect:

At lower wage levels, the substitution effect dominates. As wages rise, individuals
prefer to work more hours because the financial reward for working increases.
The opportunity cost of leisure becomes too high, leading workers to allocate
more time to labor. This results in the typical upward-sloping portion of the labor
supply curve.

 The Income Effect:

However, as wages continue to rise, another phenomenon comes into play—the
income effect. With higher wages, individuals achieve a higher standard of living
and may reach a point where they feel they have earned "enough." The higher
income allows them to afford more leisure time, as they can maintain the same
standard of living while working fewer hours. The income effect encourages
workers to substitute labor with leisure.

 Why the Labor Supply Curve Bends Backwards:

The backward-bending portion of the labor supply curve occurs when the income
effect outweighs the substitution effect at higher wage levels. When wages reach
a certain threshold, the desire for additional leisure time becomes stronger than
the desire to earn more money. At this point, an increase in wages leads to a
decrease in the quantity of labor supplied, causing the labor supply curve to bend
backward.

 Example of a Backward-Bending Labor Supply Curve:

Consider a highly skilled professional, such as a consultant or a doctor, who
initially works 40 hours a week at a wage of $100 per hour. If the wage increases
to $150 per hour, the consultant might choose to work more hours (say, 50 hours
a week) to take advantage of the higher earnings. This reflects the substitution
effect, where the individual works more because the opportunity cost of leisure
has increased.
However, if the wage continues to rise to $300 per hour, the consultant may feel
that they are earning sufficient income to meet their financial goals and might
prefer to enjoy more leisure time. As a result, the consultant may reduce their
working hours to 30 per week, even though the wage has increased. This
reduction in labor supply despite higher wages is a manifestation of the income
effect and leads to the backward-bending portion of the labor supply curve.

 Graphical Representation
In a graph depicting the labor supply curve, the x-axis represents the quantity of
labor supplied (e.g., hours worked), and the y-axis represents the wage rate.
Initially, the curve slopes upward as wages rise, indicating that more labor is
supplied. However, after reaching a certain wage level, the curve bends backward,
showing a decrease in labor supply as wages continue to rise.
This backward-bending supply curve can be divided into two segments:
1. Upward-Sloping Segment: Where the substitution effect dominates,
leading to an increase in labor supply as wages rise.
2. Backward-Bending Segment: Where the income effect dominates, leading
to a decrease in labor supply as wages continue to rise.

Implications of the Backward-Bending Labor Supply Curve:

The backward-bending labor supply curve has important implications for
employers, policymakers, and economists:
1. Wage Policies: Understanding the backward-bending nature of the labor
supply curve can help policymakers design wage policies that consider the
trade-off between income and leisure. For instance, increasing wages
beyond a certain point may not lead to higher labor participation and could
potentially result in reduced labor supply.
2. Taxation: High-income earners who are on the backward-bending portion
of the labor supply curve may reduce their working hours if taxes on labor
 income increase, as they may prefer to enjoy more leisure time rather than
working more for diminishing returns after taxes.
3. Labor Market Dynamics: The backward-bending labor supply curve
explains why some highly paid professionals choose to work fewer hours
despite higher wages, contributing to variations in labor market
participation rates across different income levels.

 Conclusion
The backward-bending labor supply curve is a fascinating concept that highlights
the complex relationship between wages and labor supply. It shows that at higher
wage levels, the desire for leisure can outweigh the financial incentives to work
more, leading to a reduction in the quantity of labor supplied. This phenomenon is
crucial for understanding labor market behavior and has significant implications
for wage policies, taxation, and labor market dynamics.

Q.2 Explain the Keynesian theory of internet rate with

reference to the liquidity preference theory.
Ans:
 Introduction:
The Keynesian theory of interest rate, also known as the liquidity preference
theory, is a cornerstone of John Maynard Keynes' economic thought. It addresses
the determination of interest rates in an economy and plays a vital role in his
broader theories of employment, income, and money. According to Keynes, the
interest rate is not determined by the supply and demand for savings, as classical
economists suggested, but by the supply of money and the demand for liquidity.
This theory has had a profound impact on modern economics, particularly in
understanding the role of monetary policy in managing economic activity.
“Keynes defines the rate of interest as the reward for parting with liquidity for a
specified period of time. According to him, the rate of interest is determined by
the demand for and supply of money.”

 Understanding Liquidity Preference Theory:

Liquidity preference theory is Keynes' explanation of the demand for money. He
argued that people prefer to hold their wealth in liquid form (cash or easily
convertible assets) rather than in less liquid forms such as bonds or long-term
investments. The preference for liquidity arises because money is the most liquid
asset, providing individuals with the flexibility to meet unexpected needs and take
advantage of unforeseen opportunities.
Keynes identified three motives for holding money:
1. The Transaction Motive: The need to hold money for everyday
transactions.
2. The Precautionary Motive: The desire to hold money for unexpected
contingencies.
3. The Speculative Motive: The decision to hold money in anticipation of
changes in interest rates or bond prices.

 Interest Rate Determination: The Role of Liquidity Preference:

According to Keynes, the interest rate is determined by the interaction between
the supply of money (controlled by the central bank) and the demand for money
(liquidity preference). The interest rate adjusts to equate the quantity of money
supplied with the quantity of money demanded.
1. The Transaction Motive
The transaction motive is driven by the need for money to conduct everyday
activities. Individuals and businesses require money to buy goods and services and
to pay wages and salaries. The demand for money for transactions is primarily
influenced by the level of income. As income increases, the demand for
transaction money increases as well.
2. The Precautionary Motive
The precautionary motive reflects the desire to hold money as a safeguard against
unforeseen events. People and businesses hold a certain amount of money to
cover unexpected expenses or emergencies. The demand for precautionary money
is also influenced by income, as well as by the level of uncertainty in the economy.
In times of economic instability, the precautionary demand for money tends to
rise.
3. The Speculative Motive
The speculative motive is based on the expectation of changes in interest rates
and bond prices. Keynes argued that people hold money to take advantage of
potential future changes in interest rates. If people expect interest rates to rise,
they may prefer to hold money rather than bonds,
According to Keynes, the higher the rate of interest, the lower the speculative
demand for money, and lower the rate of interest, the higher the speculative
demand for money. Algebraically, Keynes expressed the speculative demand for
money as
M2 = L2 (r)
Where, L2 is the speculative demand for money, and
r is the rate of interest.
Geometrically, it is a smooth curve which slopes downward from left to right.
Now, if the total liquid money is denoted by M, the transactions plus
precautionary motives by M1 and the speculative motive by M2, then
M = M1 + M2. Since M1 = L1 (Y) and M2 = L2 (r), the total liquidity preference
function is expressed as M = L (Y, r).

since bond prices fall

when interest rates rise. Conversely, if interest rates are expected to fall, people
may convert money into bonds to profit from rising bond prices.

 The Money Market and Interest Rate Determination:

In Keynesian economics, the interest rate is determined in the money market,
where the supply of money intersects with the demand for money. The supply of
money is typically controlled by the central bank and is assumed to be fixed in the
short run. The demand for money, however, varies based on the transaction,
precautionary, and speculative motives.
1. The Liquidity Preference Curve
The demand for money can be represented by a liquidity preference curve, which
shows the relationship between the interest rate and the quantity of money
demanded. The curve is downward sloping, indicating that as interest rates fall,
the quantity of money demanded increases. This is because lower interest rates
reduce the opportunity cost of holding money (rather than earning interest on
bonds), leading individuals to prefer liquidity.
2. Equilibrium in the Money Market
The equilibrium interest rate is determined at the point where the supply of
money equals the demand for money. At this point, the liquidity preference curve
intersects with the vertical money supply curve. If the interest rate is above the
equilibrium level, the quantity of money demanded will be less than the supply,
leading to an excess supply of money. People will then buy bonds with their excess
money, driving up bond prices and lowering interest rates until equilibrium is
restored. Conversely, if the interest rate is below the equilibrium level, the
demand for money will exceed the supply, leading to an excess demand for
money. People will sell bonds to obtain money, driving down bond prices and
raising interest rates until the market reaches equilibrium.

 Implications of Liquidity Preference Theory:

Keynes' liquidity preference theory has several important implications for
economic policy:
1. Monetary Policy: Central banks can influence interest rates by altering the
supply of money. For example, by increasing the money supply, a central
bank can lower interest rates, encouraging investment and spending, which
can stimulate economic activity. Conversely, by reducing the money supply,
the central bank can raise interest rates, cooling down an overheated
economy.
2. Liquidity Traps: Keynes warned that in certain situations, particularly
during periods of very low interest rates, monetary policy might become
ineffective. In a liquidity trap, the demand for money becomes highly
elastic, meaning that changes in the money supply have little or no effect on
interest rates or economic activity. People prefer to hold cash rather than
bonds, anticipating that interest rates cannot go any lower and that bond
prices are unlikely to rise.
3. Interest Rates and Investment: Keynes emphasized the role of interest
rates in determining the level of investment in the economy. Lower interest
rates reduce the cost of borrowing, making investments more attractive to
businesses. Higher investment levels can then lead to increased production,
employment, and overall economic growth.

 Criticisms of Liquidity Preference Theory:

While Keynes' liquidity preference theory was revolutionary, it has faced criticism
over time:
1. Overemphasis on Money Demand: Some critics argue that Keynes placed
too much emphasis on the demand for money in determining interest rates,
neglecting other factors such as the role of time preferences and
productivity in influencing interest rates.
2. Limited Applicability: The concept of a liquidity trap, while theoretically
sound, has been questioned in terms of its real-world applicability. Critics
argue that even in situations of low interest rates, other policy tools, such
as fiscal policy, can still be effective.
3. Inflation and Expectations: Later developments in economic theory,
particularly the expectations-augmented Phillips curve and rational
expectations theory, have highlighted the importance of inflation
expectations in determining interest rates, something that Keynes' original
theory did not fully account for.

 Conclusion:
The Keynesian theory of interest rate, as expressed through the liquidity
preference theory, remains a fundamental concept in macroeconomics. It shifted
the focus of interest rate determination from the classical supply and demand for
savings to the interaction between money supply and liquidity preference. This
theory underscores the importance of money demand in influencing interest rates
and provides a framework for understanding how monetary policy can be used to
manage economic activity. Despite criticisms and the evolution of economic
thought, Keynes' liquidity preference theory continues to be a critical tool for
analyzing monetary policy and its effects on the economy.
Q.3 Differentiate between the Keynesian and Classical aggregate supply curve
with the help of diagrams.
Ans:

 Introduction:
The concept of the aggregate supply curve is crucial in understanding
macroeconomic theories. It represents the relationship between the total quantity
of goods and services that firms in an economy are willing to produce and sell at a
given price level. The Keynesian and Classical schools of thought differ
significantly in their views on the shape and behavior of the aggregate supply
curve, reflecting their broader economic philosophies. Understanding these
differences is essential for analyzing how economies respond to changes in
demand, policy interventions, and external shocks.

 The Classical Aggregate Supply Curve

1. Assumptions of Classical Economics
Classical economics, which dominated economic thought before the Great
Depression, assumes of full employment and the flexibility of prices and wages.
Classical economists believe that the economy is always at or near its full
employment level, where all available resources are being utilized efficiently. They
assume that markets, including labor markets, are perfectly competitive, and any
deviations from full employment are temporary.
2. Shape of the Classical Aggregate Supply Curve
The Classical aggregate supply curve is vertical at the full employment level of
output (potential output). This vertical shape indicates that the total output in the
economy is fixed in the long run, regardless of the price level. In other words,
changes in the price level do not affect the quantity of goods and services
produced in the economy. The vertical nature of the curve reflects the Classical
belief that output is determined by factors of production such as labor, capital,
and technology, rather than by the price level.

 Diagram of the Classical Aggregate Supply Curve:

In this diagram, the Classical aggregate supply curve (AS) is vertical at the full
employment level of output (Yf). The price level does not influence the level of
output.

 Implications of the Classical Aggregate Supply Curve

 Full Employment: The Classical model assumes that the economy always
operates at full employment, meaning that all resources, including labor,
 are fully utilized. Any unemployment that exists is considered voluntary or
frictional.
 Price Flexibility: Classical economists believe that prices and wages are
flexible and adjust quickly to clear markets. This ensures that any excess
supply or demand in the economy is temporary.
 Role of Aggregate Demand: In the Classical view, aggregate demand
influences only the price level, not output. An increase in aggregate demand
leads to a rise in the price level, but output remains unchanged. Similarly, a
decrease in aggregate demand results in a lower price level without
affecting output.

 The Keynesian Aggregate Supply Curve:

1. Assumptions of Keynesian Economics
Keynesian economics, developed by John Maynard Keynes during the Great
Depression, challenges the Classical view of full employment and price flexibility.
Keynesians argue that economies can operate below full employment for
extended periods due to rigidities in prices and wages. These rigidities prevent the
economy from automatically adjusting to achieve full employment.
2. Shape of the Keynesian Aggregate Supply Curve
The Keynesian aggregate supply curve is characterized by three distinct segments,
reflecting different economic conditions:
 Horizontal (Flat) Segment: At low levels of output, the Keynesian aggregate
supply curve is horizontal. In this range, the economy is operating below full
employment, and there is excess capacity. Firms can increase production
without raising prices because unemployed resources (e.g., labor and
capital) are readily available. This segment reflects Keynes' belief that
increases in aggregate demand can lead to higher output without
triggering inflation.
 Upward-Sloping Segment: As the economy approaches full employment,
the Keynesian aggregate supply curve begins to slope upward. In this range,
some resources are becoming scarce, leading firms to raise prices to attract
 additional inputs. Output increases, but at a diminishing rate as the
economy gets closer to full employment.
 Vertical Segment: At the full employment level of output, the Keynesian
aggregate supply curve becomes vertical, similar to the Classical curve. In
this range, the economy has reached its capacity, and any further increase
in aggregate demand only leads to higher prices without increasing output.

 Diagram of the Keynesian Aggregate Supply Curve:

In this diagram, the Keynesian aggregate supply curve (AS) has a flat segment at
low levels of output (Y1), an upward-sloping segment as the economy approaches
full employment, and a vertical segment at full employment (Yf).

 Implications of the Keynesian Aggregate Supply Curve:

 Underemployment and Rigidities: The Keynesian model recognizes that the
economy can experience periods of underemployment, where resources are
not fully utilized due to price and wage rigidities. These rigidities prevent
the economy from automatically adjusting to full employment.
 Role of Aggregate Demand: In the Keynesian view, aggregate demand
plays a crucial role in determining output, especially when the economy is
operating below full employment. Increases in aggregate demand can lead
to higher output and employment without necessarily causing inflation.
 Policy Interventions: Keynesians advocate for active government
intervention to manage aggregate demand. During periods of recession or
underemployment, Keynesians support fiscal and monetary policies to
 stimulate demand and boost output. Conversely, during periods of inflation,
they support policies to reduce demand and stabilize prices.

 Comparison of Keynesian and Classical Aggregate Supply Curves:

1. Shape and Slope
 Classical Aggregate Supply Curve: The Classical aggregate supply curve is
vertical, indicating that output is independent of the price level in the long
run.
 Keynesian Aggregate Supply Curve: The Keynesian aggregate supply curve
has three segments: a horizontal segment at low levels of output, an
upward-sloping segment as the economy approaches full employment, and
a vertical segment at full employment.
2. Price and Wage Flexibility
 Classical: Classical economists assume that prices and wages are fully
flexible, allowing the economy to adjust quickly to full employment.
 Keynesian: Keynesians argue that prices and wages are often sticky,
leading to periods of underemployment and requiring active policy
intervention to restore full employment.
3. Role of Aggregate Demand
 Classical: In the Classical model, aggregate demand influences only the
price level, not output.
 Keynesian: In the Keynesian model, aggregate demand plays a critical role
in determining output, especially when the economy is operating below full
employment.
4. Policy Implications
 Classical: Classical economists generally oppose government intervention,
believing that the economy will naturally adjust to full employment through
flexible prices and wages.
  Keynesian: Keynesians advocate for active government intervention to
manage aggregate demand and stabilize the economy, particularly during
periods of recession or inflation.

 Conclusion
The Keynesian and Classical aggregate supply curves represent fundamentally
different views of how economies operate. The Classical curve, with its vertical
shape, reflects the belief in full employment and flexible prices, where output is
determined by supply-side factors. In contrast, the Keynesian curve, with its
distinct segments, recognizes the potential for underemployment and the
importance of aggregate demand in determining output, especially in the short
run. These differences have profound implications for economic policy, influencing
debates on the role of government intervention and the effectiveness of monetary
and fiscal policy in stabilizing the economy.

Q.4 (a) Discuss the factors which can influence the velocity
of money.
(b) Explain the policy implications of the quantity theory
of money.
Ans:

(a) Factors That Influence the Velocity of Money:

The velocity of money refers to the rate at which money circulates in the economy,
or how frequently one unit of currency is used to purchase goods and services
within a given time period. Several factors can influence the velocity of money:

1. Interest Rates:
o When interest rates are high, people are more likely to save less and
spend more, as holding onto money is less attractive. This can increase
the velocity of money. Conversely, when interest rates are low, people
might hold onto their money longer, decreasing its velocity.
2. Inflation Expectations:
o If people expect prices to rise (inflation), they may spend their money
quickly before it loses value, increasing the velocity. On the other hand,
if they expect prices to fall (deflation), they might hold off on spending,
decreasing the velocity.

3. Economic Confidence:
o In a stable and growing economy, people are more confident in spending
money, which increases its velocity. However, during economic
uncertainty or recessions, people tend to save more and spend less,
reducing the velocity of money.

4. Financial Innovations:
o Advances in financial technologies, such as credit cards, mobile
payments, and online banking, can make it easier and quicker to spend
money. This convenience can lead to an increase in the velocity of
money.

5. Money Supply Changes:

o If the mohabits, apply increases rapidly and people do not adjust their
spending habits accordingly, the velocity of money might decrease.
Conversely, if the money supply is tight, people might spend their money
faster, increasing its velocity.

6. Income Levels:
o Higher income levels can lead to higher spending, which increases the
velocity of money. However, if a significant portion of income is saved or
invested, the velocity may decrease.

7. Tax Policies:
o Tax policies that encourage consumption (like lower income taxes or
consumption taxes) can increase the velocity of money. Conversely,
higher taxes on income or consumption might lead people to spend less,
decreasing the velocity.
(b) Policy Implications of the Quantity Theory of Money:
The Quantity Theory of Money (QTM) is a theory that links the money supply in an
economy to the level of prices and the amount of economic output. The basic idea
is that, if all else is constant, an increase in the money supply will lead to a
proportional increase in the price level (inflation). This theory is often expressed
using the equation:
MV=PQMV = PQMV=PQ
Where:
 MMM is the money supply.
 VVV is the velocity of money.
 PPP is the price level.
 QQQ is the real output or quantity of goods and services produced in the
economy.

 Policy Implications:
1. Control of Inflation:
o If the money supply grows too quickly and the velocity of money is
stable, the quantity theory suggests that prices will rise (inflation).
Therefore, central banks might use this theory to justify controlling
the growth of the money supply to prevent inflation.
2. Monetary Policy:
o The theory implies that controlling the money supply is a key tool for
managing economic stability. Central banks may adjust interest rates
or use other tools to influence the money supply, aiming to keep
inflation in check while supporting economic growth.
3. Limitations in Economic Slowdowns:
o During economic recessions, even if the money supply increases,
people might not spend more, meaning the velocity of money
decreases. This situation can lead to a lack of demand and deflation,
 despite an increased money supply. In such cases, the quantity theory
might not fully explain economic outcomes, leading policymakers to
consider additional factors like consumer confidence and fiscal policy.
4. Expectations Management:
o The theory suggests that if people expect higher inflation in the
future, they might spend more now, which could indeed lead to
higher inflation. Therefore, managing public expectations is crucial
for policymakers.
5. Debate on the Velocity of Money:
o Since the velocity of money can change due to various factors, the
assumption that it is stable (as implied in some versions of the
theory) can be misleading. Policymakers must consider how changes
in velocity might affect the economy when designing monetary
policies.
In summary, the Quantity Theory of Money provides a framework for
understanding the relationship between money supply and inflation, but
policymakers need to consider the broader context, including the factors
influencing the velocity of money, to make informed decisions.

Q.5 Explain the rational and adaptive expectations in the

light of Monetarism theory.
Ans:

 Monetarism Theory Overview:

Monetarism, primarily associated with economist Milton Friedman, emphasizes
the role of the money supply in influencing economic activity. Monetarists believe
that changes in the money supply have significant effects on overall economic
performance, particularly on inflation and output.
  Expectations: Rational vs. Adaptive:
1. Adaptive Expectations
Adaptive expectations suggest that people form their expectations about future
economic conditions based on past experiences and trends. If inflation has been
increasing steadily over time, people expect it to continue rising at a similar rate in
the future. Their expectations are adjusted slowly as they observe new
information.

 In the Context of Monetarism:

o Short-Term Impact: Adaptive expectations can lead to a lag in the
response of individuals and businesses to changes in monetary policy.
For example, if the central bank increases the money supply, people
may not immediately adjust their expectations about future inflation.
As a result, the initial impact of the policy might be more
pronounced.
o Long-Term Effects: Over time, as people notice the new inflationary
trends, their expectations will adjust. This means that any short-term
benefits of increasing the money supply might be offset as
expectations catch up with reality, potentially leading to a self-
fulfilling cycle of inflation.

2. Rational Expectations:
Rational expectations propose that individuals use all available information,
including knowledge of economic policies and market conditions, to make
informed predictions about the future. People are assumed to be forward-looking
and incorporate expected policy changes into their decision-making.
 In the Context of Monetarism:
o Policy Effectiveness: Monetarists argue that if people have rational
expectations, they will anticipate the effects of monetary policy
changes, such as adjustments to the money supply. As a result, the
effectiveness of such policies can be limited. For example, if the
central bank increases the money supply, people will expect future
 inflation and adjust their behavior accordingly, such as demanding
higher wages or increasing prices.
o Neutralizing Policy Effects: Since people anticipate the effects of
monetary policies, they might counteract these policies in their own
economic decisions. This can reduce the intended impact of policy
measures, such as stimulus efforts, and lead to outcomes like
inflationary pressures.

Monetarism and Expectations:

 Policy Implications: Monetarists believe that because individuals use
rational expectations, monetary policy must be managed carefully. They
emphasize that frequent changes in the money supply can lead to
unpredictable outcomes as people adjust their expectations and behavior.
 Long-Term Focus: Monetarists suggest focusing on a stable growth rate of
the money supply rather than attempting to fine-tune the economy through
active monetary policy. This is because trying to manage the economy
through policy adjustments might be less effective if people are already
anticipating and countering these changes.

Summary:
In summary, adaptive expectations involve adjusting future predictions based on
past trends, which can lead to delays in response to monetary policy changes.
Rational expectations involve using all available information to make predictions,
leading to more immediate adjustments in behavior in response to policy changes.
Monetarism theory suggests that because people have rational expectations, the
effectiveness of monetary policy is limited, and a stable approach to managing
the money supply is preferred to avoid creating predictable inflationary or
deflationary cycles.
The End