Here are detailed answers to all the questions:
. Equilibrium Level of Income and Output:
*"The intersection of the aggregate supply and aggregate demand function determines
the equilibrium level of income and output." Explain.*
The aggregate supply (AS) curve shows the quantity of total planned output that firms will
produce at each price level. The aggregate demand (AD) curve shows the quantity of total
planned expenditure on output at each price level. The intersection of the AS and AD curves
determines the equilibrium price level and equilibrium level of real GDP. At this point, the
quantity of goods and services demanded equals the quantity of goods and services supplied.
There are no pressures for prices to rise or fall, so the economy is in equilibrium. Any deviation
from this equilibrium will trigger automatic adjustments in price and quantity to restore
equilibrium.
2"Discuss the concept of ASF and ADF. Explain the determination of real income with the
help of ASF and ADF."*
The aggregate supply function (ASF) shows the relationship between the price level and real
GDP or national output, holding other factors constant. It slopes upwards from left to right
because higher price levels induce firms to supply more output. The aggregate demand function
(ADF) shows the relationship between the price level and total planned expenditure on real
GDP. It slopes downwards from left to right because higher prices lower the purchasing power
of money, reducing consumer demand and planned expenditure.
The intersection of the ASF and ADF curves determines the equilibrium level of real national
income and the price level. At the equilibrium point, the quantity of goods and services
demanded equals the quantity supplied, with no pressures for price changes. An increase in AD
will shift the ADF curve right, raising both income and prices. A decrease in AD will shift the
curve left, lowering income and prices. Therefore, real income is determined by the intersection
of aggregate supply and aggregate demand in an economy.
#### 2. IS-LM Model:
*"Explain goods market equilibrium with the help of IS curve."*
The IS curve shows the equilibrium points between investment (I) and savings (S) in the market
for goods and services. It shows the combinations of interest rates and levels of real GDP
where total planned expenditure on goods and services equals real output.
The downward slope of the IS curve indicates that lower interest rates stimulate more
investment spending and higher GDP, while higher rates discourage spending and lower GDP.
A shift of the IS curve represents a change in non-interest determinants of expenditure, such as
taxes, government spending, and consumer confidence.
The IS curve crosses the x-axis where GDP is such that planned investment equals planned
saving at that output level. Thus, the IS curve represents equilibrium points in the market for
goods and services.
*"Derive IS curve and discuss the factors determining its slope."*
The IS curve is derived from the equilibrium condition in the market for goods and services,
where planned total expenditure (AE) equals output or real GDP (Y):
AE = C + I + G = Y
Where, C = Consumption expenditure
I = Investment expenditure
G = Government spending
The slope of the IS curve depends on how responsive investment and net exports are to interest
rate changes. More responsive components lead to flatter curves.
The main determinants are:
1. Responsiveness of investment to interest rates: More responsive investment makes a flatter
IS curve.
2. Foreign trade sector responsiveness: More responsive net exports make a flatter curve.
3. Alternatives to money assets: More alternatives like bonds lead to flatter curves.
Thus, the slope of the IS curve depends on the sensitivity of investment and net export
components to interest rates in an economy. Flatter curves imply more responsive components.
*"Discuss the equilibrium in money market and factors affecting the LM curve."*
The money market is in equilibrium when money demand equals money supply. The LM curve
represents combinations of income and interest rates that maintain equilibrium in the money
market.
At points to the right of the LM curve, money demand exceeds money supply, causing interest
rates to rise to restore equilibrium. At points left of the curve, excess money supply pushes rates
down.
The position and slope of the LM curve depends on factors affecting money demand and
supply:
1. Liquidity preference: Higher money demand for speculation makes a steeper LM curve.
2. Income: Higher income raises transactions demand, making the LM curve steeper.
3. Money supply: An increase in money supply shifts LM curve to the right as rates fall at every
income level.
4. Price level: Higher prices lower real money balances, shifting the LM curve left.
Thus, the LM curve represents equilibrium points in the money market based on money demand
and supply conditions. Its position and slope are influenced by liquidity preference, income,
money supply and prices.
#### 3. Inflation and Unemployment:
*"Examine Keynes’ concept of inflationary gap and its causes."*
According to Keynes, the inflationary gap is the amount by which aggregate expenditure in an
economy exceeds the economy's aggregate production at full employment level. It represents
excess demand over available supplies in the economy, causing inflationary pressures.
The main causes of an inflationary gap are:
1. Expansionary fiscal policy: Higher government spending and lower taxes boost aggregate
expenditure without matching supply response.
2. Expansionary monetary policy: Higher money supply and lower interest rates boost
investment and consumption without matching output response.
3. Rising exports: Higher external demand for domestic goods boosts aggregate expenditure
without matching growth in production.
4. Positive consumer and business sentiment: Higher confidence and income expectations
boost spending beyond available output.
The wider the gap between spending and potential output, the greater the upward pressure on
prices due to excess demand in the economy.
*"Explain the trade-off between inflation and unemployment in the short and long run,
referring to the Phillips curve."*
In the short run, there is an inverse trade-off between inflation and unemployment represented
by the Phillips curve. Lower unemployment is associated with higher inflation, and vice-versa.
This is because with falling unemployment, aggregated demand rises faster than aggregate
supply, putting upward pressure on prices.
However, in the long run, the Phillips curve becomes vertical at the natural rate of
unemployment. At this equilibrium rate, inflation becomes independent of unemployment.
Attempts to keep unemployment below the natural rate only result in accelerating inflation
without lasting impact on joblessness. This is the natural rate hypothesis.
Thus, while policymakers can exploit the short run Phillips curve trade-off, in the long run they
face a choice between higher inflation or the natural unemployment rate consistent with stable
prices. The Phillips curve itself shifts with changes in inflation expectations and productivity.
*"Discuss the policy trade-off between inflation and unemployment in the short run."*
In the short run, policymakers face a trade-off between higher inflation and lower unemployment
based on the downward sloping Phillips curve. Expansionary policies that boost aggregate
demand can lower unemployment but will accelerate inflation.
Contractionary policies that reduce demand and output can reduce inflation but will raise
joblessness. Increasing money supply, government spending and reducing taxes can stimulate
employment in the short run but carries the cost of more rapidly rising prices.
So policymakers have to decide what combination of inflation and unemployment best satisfies
the economy's priorities at that point. However, these inflation-joblessness trade-offs are only
temporary, disappearing once unemployment hits the natural rate in the long run. Policymakers
hence have to balance the short term gains against long run sustainability. The trade-off also
shifts due to inflation expectations and supply-side factors beyond direct control of policies.
#### 4. Balance of Payments and Policies:
*"Discuss expenditure changing policies to correct disequilibrium in the balance of
payments."*
Expenditure changing policies alter the level of aggregate demand in the economy to influence
imports and correct balance of payments disequilibria:
1. Monetary Policy: Contractionary policy raising interest rates reduces domestic expenditure on
foreign imports while stimulating inflow of foreign capital.
2. Fiscal Policy: Contractionary measures like higher taxes and reduced government
expenditure lowers disposable incomes and demand including for imports.
3. Quotas and Tariffs: Import quotas and higher import duties restrict import volumes directly
while reducing disposable income indirectly.
4. Export Subsidies: Export subsidies allow domestic producers to lower export prices
stimulating foreign demand and improving the current account balance.
On the exchange rate front, currency depreciation also directly makes imports more expensive
while stimulating export competitiveness. The combination of policies to manage AD and
exchange rates help correct balance of payments deficits or surpluses.
*"Explain adjustments in BOP with the help of monetary policy in the IS-LM framework."*
Contractionary monetary policy reduces money supply, raises domestic interest rates, and
appreciates the exchange rate. In the IS-LM framework, higher interest rates shift the IS curve
left, reducing income and the demand for imports, improving the current account balance.
The higher rates also stimulate greater capital inflows into the economy seen as a rightward
shift of the BP curve improving the capital account.
The exchange rate appreciation makes exports less competitive so seen as a leftward shift of
the IS curve, worsening the current account balance. However, this is more than offset by the
larger positive impact on the current account from reduced domestic income and demand.
Thus, contractionary monetary policy helps correct balance of payments deficits by reducing
total expenditure and import demand while attracting foreign capital inflows. This adjustment
mechanism is depicted in the IS-LM framework.
*"Explain the J-curve phenomenon following devaluation or depreciation of the
currency."*
The J-curve phenomenon refers to the initial worsening of the current account deficit followed by
subsequent improvement after a currency devaluation.
In the short-run, a weaker currency fails to increase exports significantly due to contracts and
inelastic foreign demand. But imports become more costly immediately, raising the current
account deficit. Over time, higher exports and lower imports due to the enhanced
competitiveness leads to growing current account surpluses.
This pattern tracing steadily worsening deficits in the early months followed by rising surpluses
later resembles the shape of the letter J, hence the name J-curve effect. The length of the J-
curve depends on trade elasticities, market constraints and consumer preferences that
determine the timing and magnitude of expenditure switching effects after depreciation.
