North South University, Department of Economics, ECO104

Spring 2021 FINAL EXAMINATION, Marks: 45 Time: 48 hours (2 days)

Please follow the guidelines at the end very carefully. Total Marks: 55

Faculty: Humaira Husain

Name: _ Sec:_15__________

Answer all following questions: Identify (by highlighting with yellow color) the correct
answer for following questions. (2 times 10 = 20 Marks)

Q1. In the Keynesian model of national income, In case of G multiplier if △G = 3.55 Million
BDT,

MPC = 0.75

△Y = 14.2 Million BDT

a) 12 Million BDT

b) 10 Million BDT

c) 14.2 Million BDT

d) 2 Million BDT

Q2. In the Keynesian model of national income, The smaller the value of MPC

Answer: The smaller the value of G multiplier

a) The smaller the value of G multiplier c) The larger the value of G multiplier

b) The value of G multiplier is unaffected d) Value of G multiplier may increase or

decrease

Q3. In the Keynesian model of national income, the sign of ‘tax’ multiplier is negative because

Answer: a) Increase in equilibrium income is related to decrease in tax collection

a) Increase in equilibrium income is related to decrease in tax collection

b) Increase in equilibrium income is related to increase in tax collection

c) Increase in equilibrium income is not related to reduction in tax collection

d) Increase in equilibrium income is associated with increase in government purchase

Q4. In self-regulating economy if the current output is greater than natural level of output

Answer: Current unemployment rate < natural unemployment rate

a) Current unemployment rate = natural unemployment rate

b) Current unemployment rate > natural unemployment rate

c) Current unemployment rate < natural unemployment rate

d) Current unemployment rate may greater than natural unemployment rate

Q5. In Keynesian model of national income If MPC value falls the planned expenditure line

Becomes

Answer: a) Flatter

a) Flatter

b) Steeper

c) Neither steeper nor flatter

d) None of the above

Q6. In case of fractional reserve banking system

Answer: Commercial Banks contribute to play roles in money creation

a) Commercial Banks are indifferent to play roles in money creation

b) Commercial Banks do not contribute to money creation

c) Commercial Banks contribute to play roles in money creation

d) Commercial Banks do not have ability to play roles in money creation

Q7. In the model of money supply, if the money multiplier is constant, there is

Answer: Directly proportional relationship between money supply and monetary base

a) Directly proportional relationship between money supply and monetary base

b) No relationship between liquidity preference of the public and money supply

c) Relationship between reserve requirement ratio and monetary base

d) Inversely proportional relationship between reserve requirement ratio & liquidity

preference of the public

Q8. In Neoclassical growth theory,

Answer: Capital deepening expedites economic growth

a) Capital deepening expedites economic growth

b) Technological upgradation promotes economic growth

c) Good governance promotes growth

d) Sound property right structure intensifies economic growth

Q9. In new growth theory

Answer: Research and development promote economic growth within economic system

a) Skilled labor enhances economic growth

b) Research and development promote economic growth within economic system

c) Physical capital expedites growth process

d) Property right structure promotes growth within economic system.

Q10. If the base money is constant, greater the value of money multiplier

Answer: Greater the amount of money supply

a) Greater the amount of money supply

b) Smaller the amount of money supply

c) Amount of money supply is unaffected

d) Amount of money supply may be affected

Q11. Answer any five of following questions (Add Picture in your answer if needed) (5
times 7=35 Marks) (Maintain the order please) Do NOT elaborate your answer
unnecessarily. To answer all questions, USE at best 13 sentences.

A) Derive the expression for government purchase multiplier in Keynesian model. If the

value of G multiplier = 2.55 How do you interpret this?

Answer:

Government Purchase Multiplier is also called the government expenditure multiplier.

In this graph, we have actual & planned expenditure on the vertical axis, and on the horizontal
axis, we have income. The original Keynesian cross was A. Here, OY1 is the initial equilibrium
level of income. When the government increased △G purchases, this will affect the original PE.
The economy gets a new Keynesian cross at point B. The economy will experience a new
equilibrium level of income or output at OY2. In the graph, △Y indicated the difference between
new equilibrium output and old equilibrium output, increasing income. Moreover, in this graph
△G also indicate the increase in government purchase.
Derivation of the expression for government purchase multiplier in Keynesian model

Suppose,

Increase in income in 1st round = △G (Increase in purchase or planned G)

Increase in income in 2nd round = MPC × △G [ Multiply by MPC]

Increase in income in 3rd round = MPC (MPC × △G) = MPC2× △G

And the process continues………

In here, △Y = Total change in income. Because △Y is the differences between new equilibrium
income and old equilibrium income. From the graph we can say that, OY2 – OY1 = △Y

Total change in Income = Summation of change in income in all rounds

△Y= △G + MPC × △G + MPC2×△G + MPC3× △G +………[ Increase in income in the

froth round]
(△𝑌)/(△𝐺) = [ 1+ MPC + MPC2+ MPC3+...........] (Factored out △G from the R.H.S. and
divided both side by △G)
(△𝑌)/(△𝐺) = 1/(1−𝑀𝑃𝐶) = 1/𝑀𝑃𝑆

Because, we know that MPC + MPS = 1

So, MPS = 1- MPC

(△𝑌)/(△𝐺) = G multiplier = 1/(1−𝑀𝑃𝐶)

We also know that MPC, lies between 0 and 1. so MPC is a positive function. If we substitute
any value of MPC that lies between 0 and 1; we will be able to calculate (△𝑌)/(△𝐺) is greater
than 1.

To verify the formula, we took 0.6 as the MPC value and found that, = (1/ 1- 0.6) = 2.5
(Which is ˃1).

Interpretation:

If the value of G multiplier = 2.55, that means If Government increases its purchase by 1 $,
equilibrium income rises by 2.55 dollars (MORE than 1 dollar). We can also say that, G=2.55
means when government expenditure increased by 1 unit, the equilibrium level of income
increased by2.55 units.

So we can conclude that, greater the value of MPC the larger the value of G multiplier.

B) Develop the following model of money supply: Money supply = Money multiplier ×
Monetary Base. If Base money = 5 million BDT and reserve requirement ratio = 10% and

currency deposit ratio = 15%, calculate Money supply of the economy.

Develop the model of money supply:

We know that,

Money Supply = money multiplier × monetary base

Developing the money supply model is essential to understand the differences between the
money supply and the monetary base. The money supply is defined as,

M = C + D……. I

Where,

M = Money Supply

C = Currency

D = Demand deposit of Banks

The monetary base is produced or issued by the government and the capital bank, and it is held
in the hands of the public and the bank. Monetary Base is defined as,

B = C + R……………II

Where,

B = Monetary Base

C = Currency held by public

R = Cash reserve held by banks.

After dividing I by II, we found that Currency (C) is common in both the equation; the difference
is due to the presence of D in the equation I and R in equation II. In here D is created by banks
but to create it, bank have to maintain on R. in here, we have

M C+ D
B
= C+ R

Then divide both the top and bottom of the expression on the right by D. We have

𝑀/𝐵 = (𝐶/𝐷 + 1)/ (𝐶/𝐷 + 𝑅/𝐷) here = 𝐶/𝐷 = cr and 𝑅/𝐷 = rr

M / B = (cr + 1) / (cr + rr)

M= (𝑐𝑟+1) / (𝑐𝑟+𝑟𝑟) × B……. III

In here given that, Base Money, B = 5 million BDT

Reserve requirement ratio, rr = 10%

Currency deposit ratio, cr = 15%

 M = (𝑐𝑟+1) / (𝑐𝑟+𝑟𝑟) × B

= (0.15 + 1) / (0.15 + 0.10) × 5

= (1.15 / 0.25) × 5

= 2.3 Million BDT

C) Explain the following two cases of self- regulating economy: Inflationary gap and

recessionary gap. Discuss the Govt policy implication for each case.

Answer:

Inflationary Gap: In inflationary gap the unemployment rate is less than the natural
unemployment rate. In here we observe the shortage of labor market. That means the labor
demand will be high. Due to which the labor cost increase in this situation and in turn the final of
the product cost also higher.

Figure: Inflationary Gap

In this graph, we have P (price) in the vertical line and Y in the horizontal line. Initial
equilibrium is pointed out at 1. which intercepts SRAS1 and AD. The current level of output is
OY1, and the current level of price was OP1. As a result of this, the current level of output
exceeds the natural level of output. Here the labor demand is high. The laborers try to increase
their nominal wages so that the final product also cost high—the SRAS2 shift toward left until it
touches the vertical LARS curve. So in the economy comes back at the natural level of output,
but the price increased at P2. That means. The final equilibrium is achieving at point 2. It is the
intersection of three lines: LRAS, SRAS2, and AD curve. In the inflationary gap, the
unemployment rate is less than the natural unemployment rate; we found that OY1 is greater
than OYN.

Recessionary gap: In here the unemployment rate is greater than the natural unemployment rate.
There will be surplus in the labor market so that many labors will look for job. So the labor cost
low is low in here so that SRAS curve shift towards the right side. The economy moves in to
long run equilibrium.

Figure: Recessionary gap

In this graph, we have P (price) in the vertical line and Y in the horizontal line. Here, 1 is
the initial short-run equilibrium that is the intersection of AD and SRAS1. Here, the current level
of output is OY2, and the price was P1. When the current output level is smaller, the
unemployment rate is higher than the natural level. That indicates that the labor demand is lower
here. That means there is a surplus in the labor market. So the labor will be less costly here due
to that SRAS1 curve shift toward the right side SRAS2. So the economy will be settled finally at
point 2, which is the intersection of AD, LRAS, and SRAS2 curves. The price level will go down
from P1 to P2. So in a Recessionary gap, the economy will be coming back towards the whole
employment level of output or the natural level of output.

Government Policy implication for Inflationary Gap:

Figure of: Monetary policy & Inflationary Gap

At the right side graph, initially, the economy was at point 1. Here the government will
have to take contractionary monetary policy. The government will reduce the money supply. So
the economy ultimately comes back appoint 2 to from point 1. The price level goes down from
P1 to P2, and the output level comes back at the natural level. Here, the current level of out will
be greater than the natural level of output.
 Government Policy implication for Recessionary gap:

Figure: Monetary policy and Recessionary gap

When the government implements exponential monetary policy, the AD curve shift toward
the right side; when the government increases the money supply through the central bank, the
AD curve shift from AD1 to AD2, so the final equilibrium is achieving at point 3. Moreover,
some inflation also recognizes we can see the price level goes up from P1 to P2. So the point 3 is
the intersection of LRAS, SRAS & AD2. So economy very quickly comes back to the natural
level of output.
D) What are basic differences between neoclassical growth theory and New growth theory?

In order to distinguish between Neoclassical Growth Theory and New Growth Theory, we first
understand what these two indicate to us.
Neoclassical Growth Theory: Neoclassical growth theory emphasized two resources: labor and
capital. Here, technology was said to be exogenous; that means technological advancement
comes outside the economic system. This growth theory developed by “Robert Solow”
dominated the literature in the ’60s and ’70s. The basic equation of Neoclassical Growth theory:
𝑌/𝐿 = f (𝐾/𝐿) = f (k). The neoclassical growth approach failed to explain the cross–country
income differences. Because these Economies increased capital intensity in the same way, but
their growth outcomes were different.
New Growth Theory: During the early ’80s, a group of Economists (guided by Paul Romer)
proposed an alternative growth theory which was called New growth /Endogenous growth
theory. According to Roger A. Arnold Book, the New growth theory also proposed that
technological progress is determined within the economic system, and it is driven by Research
and development (R&D) activities. The more resources that go to develop technology, the more
and better technology is developed. For example, in the 1950s, Japan had few natural resources
and capital goods (and still does not have an abundance of natural resources), but it grew
economically. Some economists believe that Japan grew because it had access to ideas or
knowledge to improve.

From the above discussion, we can summarize the following issues:

i. Neoclassical models consider external factors to predict economic growth. However,
New growth theory considers internal factors to predict economic growth.
ii. The neoclassical theory identifies the capital level per worker and the effectiveness of
labor to create permanent growth in the per capita stock per labor of the economy. At the
same time, new growth theory does not introspect this. It only states that the factors of
adequate human capital.
iii. Neoclassical theory predicts only conditional convergence, which states that only two
economies have the same savings rates, same production function, exact rate of
technological progress. In comparison, new growth theory states that there will be no
convergence dynamics towards a steady-state production level.
iv. The key difference between Neoclassical theory and new growth theory is that
neoclassical theory says that economic growth is determined by technological change and
capital. At the same time, the new growth theory says that economic growth is
determined by the accumulation of knowledge capital.
v. In Neoclassical theory, economic growth was achieved by labor, capital, and technology.
If capital and labor are limited, then technology leads the economic growth. If
technological advances reached, economic growth eventually stopped. If technological
progress is achieved, the run out of resources occurred. It makes resources scarce. So
economic growth is stopped.
F) How does Property right structure promote Economic growth?

Answer:

Property rights mainly encouraged individuals to direct their energies to practical

economic projects. Genuinely, Property rights consist of the range of laws, rules, and regulations
that define rights for the use and transfer of resources. The fundamental motivation behind
property rights, and their significant achievement, is that they dispose of fierce rivalry to control
financial assets. If a country has a stable political system, better legal system, and proper
monetary system, we say that the country is under a sound governance system. A stable political
system indicated that the country has a stable democratic system and judicial transparency
method and enjoying its full autonomy. That means the country is free from corruption.

Suppose we consider two property rights structures. At the first structure, people are
allowed to keep the total monetary rewards of their labor. Whereas in the Second, people are
allowed to keep only half the monetary rewards of their labor. Maximum economists would
predict that the first property rights structure would stimulate more economic activity. Most of
the time, certain property rights permit landowners to go from their territory for business and
allow their property to work for them. Property rights formalization is, suitably, frequently
connected with monetary thriving. For example, the eighteenth-century German pioneers were
depicted above by the security of their individual and property. That security thus made it
workable for them to contribute and face challenges. All the more, by and large, the more
grounded the arrangement of property rights, the more grounded the motivation to work, save,
and contribute, and the more exciting the activity of the economy. That means the more viably
an economy works, the more development it will create for any arrangement of assets.

A country needs to have good governance to maintain its Economic growth because
today’s world believes that a sound governance system is a significant resource of economic
growth. Suppose a country has a good property right structure, then the entrepreneur will be
interested in investing and taking more risk to enjoy their full power of autonomy. On the other
hand, if a country has high taxation rules, it demotivated investors to invest. So it is suggested
that to maintain an organized legal system and flexible taxation rate with a minimal infatuation
rate to maintain a healthy economy.

From the above discussion, we can see how property rights structure promotes Economic
growth.