MACROECONOMICS PREVIOUS YEARS QUESTIONS

Q1. Show that in a Keynesian model, equal expansion in tax and government expenditure does
not always lead to a Balanced Budget Theorem. (10 marks)

Ans: A balanced budget is a budget (i.e., a financial plan) in which revenues are equal to
expenditures, such that there is no budget deficit or surplus. Although the concept of a balanced
budget applies to any organization that generates operating revenues and incurs operating expenses, it
is most commonly applied to government budgets.

𝑌 = 𝐶 + 𝐼 + 𝐺 + 𝑁𝑋 [ Keyne’s equation ]
𝑌=𝐶+𝐼+𝐺 [ NX=0 , Closed Economy ]
𝐶 = 𝐶 + 𝑏(𝑌 − 𝑇)

Putting the value of C in Y equation , we get;

𝑌 = 𝐶 + 𝑏(𝑌 − 𝑇) + 𝐼 + 𝐺
1
⇒ 𝑌 = ⎡ 1−𝑏 ⎤(𝐶 − 𝑏𝑇 + 𝐼 + 𝐺)
⎣ ⎦

Government multiplier : Δ𝑌/Δ𝐺 = 1/(1 − 𝑏)

Tax multiplier : Δ𝑌/Δ𝑇 = (− 𝑏)/(1 − 𝑏)

For equal expansion in tax and government expenditure, let government expenditure increase by 1$
and tax by 1$, then
1 −𝑏
(Δ𝑌/Δ𝐺) + (Δ𝑌/Δ𝑇) =
1−𝑏
+ 1−𝑏
= 1

A 1$ increase in government spending financed by a 1$ increase in taxes increases equilibrium

income by 1$. This result is termed as the balanced budget multiplier, reflecting the fact that tax
changes have a smaller per dollar impact on equilibrium income than do spending changes.

However, Balanced Budget doesn’t hold when Tax is proportional. It is the taxing mechanism in
which the taxing authority charges the same rate of tax from each taxpayer, irrespective of income.
Proportional tax multiplier is affected by:

1. Initial income

By Vibhas Jha
 2. Rate of tax change
3. Initial Tax level

[tT=G] where (t) is the rate of proportional tax to income, making the government-expenditure
multiplier less than 1. The proportional tax reduces the value of Autonomous multiplier by larger
withdrawal or leakage from circular flow, due to taxation of Income at each marginal level.

Thus, Equal expansion in Government expenditure and Taxation doesn’t always lead to a Balanced
Budget Theorem.

Q2. In what sense is Friedman’s quantity theory said to be a ‘re-statement’ of Fisher’s theory ?
(10 M)

Ans: Fisher equation of exchange:

M.VT = P.T
M𝑉 = P.T { 𝑉 is constant }
Where
T is number of transaction of average size
M is defined as quantity money,
V is velocity of circulation of money, and
P is the average price level.

The classical macroeconomic theory relies on the QTM as the theory of demand for money. This
theory says that it is the quantity of money in the hands of the public that determines how high or low
the price level will be. Such a conclusion has been reached since the level of output in the classical
model is always at the full capacity (or full employment) level.

The Cambridge economists, being dissatisfied with Fisher’s analysis, explained this theory in a new
way.
M = k.P.Y
Where, k: the part of real income which people want to keep with them in the form of cash

M = Md = k.P.Y
M.(1/ k)= P.Y

Where, 𝑉, the velocity of money, equals l/k

By Vibhas Jha
 M. 𝑉 = P.Y
Milton Friedman, has made a restatement of the Quantity Theory of Money. His version is referred
to as Monetarism or the New Quantity Theory. It is the modern version of the classical QTM.
Friedman’s money demand theory can be used to restate the Cambridge equation as follows:
Md = k(rB, rE, rD).P.Y

Where,
rB = nominal interest rate on bonds
rE = nominal return on equities
rD = nominal return on durable goods

In this, instead of a constant k we now have k expressed as a function of the rates of return on the
assets that are alternatives to holding money. A rise in the rate of return on any one of these alternative
assets would cause k to fall, reflecting the increased desirability of the alternative asset. In these
terms, we see that Friedman restated the quantity theory, providing a systematic explanation of k that
takes into account the Keynesian analysis of money’s role as an asset.

Both Fisher’s QTM and Friedman’s QTM suggested direct relation between nominal income and
money supply and value of GDP decide money.Even though Fisher’s equation reached the same
conclusion as Friedman's equation, Friedman's equation was much evolved for policy making because
other factors affecting money demand are a function of money demand.

Q3. Automatic stabilizers are supposed to mitigate cyclic fluctuations, but there exist limitations
which dampen the effect of these stabilizers. Analyze. (10 M)

Ans: Automatic stabilizers are counter cyclical tools built into federal budgets that reduce the impact
of the business cycle. They are “automatic” because they happen without requiring anyone to take any
action.There are mainly 2 automatic stabilizers :

a. Proportional Tax:
b. Transfer payment:

When aggregate demand decreases, two actions kick in automatically. First, income taxes will go
down because the amount of income has decreased i.e. tax reduces the value of Autonomous
Multipliers by a larger leakage from circular flow. This results in reducing fluctuation in the economy

By Vibhas Jha
across the business cycle. At the same time, transfer payments like unemployment compensation and
welfare benefits will increase. As a result, consumption will not decrease by as much as it would have.
Factors that dampen the effect of these Automatic Stabilizers are :

1. Supply Side disturbance: Business cycle being a demand side theory thus cannot be mitigated
by multipliers. Automatic Stabilizer can increase cost further but cannot increase the output.

2. People have Rational Expectation: They will not work because Systematic error will not
occur. As people are not in temporary shock, they will adjust the economy immediately.

3. Negative External Shock: The stabilizer will harm the economy growth instead of promoting.

4. If the economy has dominance of Informal Sector: In this situation stabilizers like tax rate will
not control fluctuation much and unemployment allowances will not be available to all
peoples.

5. Dominance of Black Economy: The stabilizers will not work because black economy factors
will affect the government fiscal policy.

Therefore, Macroeconomic policy should be based on contemporary economic situations rather than
on basic standard theory.

Q3. The following data are given for an economy :

Consumption function, C =250+0.5(Y -T)-500r

Investment function, I = 250-500r
Real money demand function, L/P=0.5Y -500r
Nominal money supply, M = 7650
Price level, P=17
Tax = T = Government expenditure = G = 200

Here Y = Real income, r = Real rate of interest, L = Nominal money demand, P = Price level.

(i) Find the equations for IS and LM curves, and solve for Y and r.
(ii) Find out the multiplier formula for money supply change and then calculate the change in
output if money supply changes by 510. (7+8=15 M)

By Vibhas Jha
Ans: IS equation:

Y =C +I +G
Y = 250 + 0.5[Y -200] -500r +250 -500r +200
Y = 600 +0.5Y -1000r
0.5Y = 600 -1000r
Y = 1200 -2000r …………..eq 1

LM equation:

L=M
L/P = M/P
0.5Y -500r = 7650/17
0.5Y =500r +450
Y= 1000r +900 …………….eq 2

From eq 1 & eq 2, we get;

1200 -2000r =1000r +900

3000r = 300
r = 300/3000
r = 0.1 ……………… eq3

Putting the value of r = 0.1 in eq 2, we get;

Y =1000r +900
Y =1000 ×0.1 +900
Y = 100 +900
Y= 1000

Now,
T= Y.t => t= 200/1000 ⇒ 0.2
I = 𝐼 - b.r = 250-500r ⇒ b =500
α𝐺 = 1/ [1 − 𝑐(1 − 𝑡)] ⇒ 1/[1- 0.5(1- 0.2)]

= 1/ [1- 0.4]
=1/0.6 ⇒ 1.67

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k =0.5 ; h =500

Monetary Multiplier β= Fiscal Multiplier γ × (b/h)

= [α𝐺 / {1+ (α𝐺 .b.k /h)}]× (b/h)

=0.91

Money Supply Increase =510

Initial Real Money supply =450

New Real Money Supply = 450 +[510/17]

= 480
Change in real money supply =30

Change in Output = 30×0.91

= 27.3

Q5. Keynesian demand for money is one of the key concepts of Keynesian theory of
unemployment. Illustrate.

Answer: According to Keynes, people prefer to hold liquid money for three purposes: transaction
motive, precautionary motive and speculative motive. The transaction motive and precautionary
motives are interest inelastic whereas speculative motive is interest elastic. Thus the rate of interest is
determined by the demand for liquid money for speculative purposes.

The transaction demand and the precautionary demand vary positively with income and negatively
with the interest rate. The speculative demand for money is negatively related to the interest rate.
Taking those factors together, we can write total money demand as

Md = L(Y, r) {Y= Income and r= interest rate}

Speculative demand for money arises from the expectation about the behavior of prices in financial
assets such as bonds. Money holders keep liquid cash to take advantage of changing prices of
financial assets such as bonds. They speculate about future bond prices and act accordingly. This
increases the demand for idle cash.

By Vibhas Jha
Liquidity Trap Theory (Keynes)

Fig: Keynesian Liquidity Trap

Liquidity trap is a condition in which the interest responsiveness of Md (Money Demand) becomes
infinite. In this case LM curve is horizontal because people don’t transact in the Bond market under
the assumption that bond price is highest and interest rate is lowest. An increase in income will still
keep the interest rate at the same level because people already hold all the money in their hand.
According to Keynesian Theory of Liquidity Trap takes place when an economy has depression or a
very large recession because there is negative sentiment in the market regarding its future
performance.

Fig: Effect of Negative Speculation in the Economy

In the Keynesian model it is possible for equilibrium to happen before Full Employment (Y2) due to
the negative speculation and negative sentiments in the economy. This happens due to the lack of
Aggregate Demand in the economy.

Keynesian Demand of money theory was the explanation of classical theory failure due to Great
Depression i.e. Supply doesn’t create its own demand. Thus Keynes suggested that only fiscal policy

By Vibhas Jha
is effective which can take the economy from low level output equilibrium to full employment
equilibrium.
Q6. What makes monetary policy ineffective even in the short run? Explain. (15 Marks)

Answer: If output (Y) doesn’t change in spite of change in Money Supply, then Monetary Policy is
ineffective. Following are the models where the Monetary policy is ineffective:

1. Pure Classical Model

According to the proponents of classical economics, there is Money Neutrality which means that it
affects monetary variables such as prices, wage rate and exchange rate. It does not affect real variables
such as output and employment. Output is not affected by money supply by assumption, there is
always full employment in the economy. Prices and wage rates are assumed to be flexible.

Fig: Money Neutrality

The classical economists assumed the Supply side theory. The AS curve plays an important
role in the determination of the output. Since monetary policy changes [M0 to M1] only AD [shift of
AD0 to AD1 ] not AS. This shows that there is an increase in price level P0 to P1 but the Output level
remains the same at the Full Employment [YF]. This implies that Monetary Policy change doesn’t
affect Money Supply.

2. Rational Expectation

By Vibhas Jha
As per the rational expectations hypothesis, there is no impact of predictable macroeconomic policy
on output and employment. Unpredictable policy actions have some impact on the real GDP and
employment level. The rational expectation is a cause that negates the change in the AS and AD.
There is an increase in price level but output remains constant.

If people forecast changes in policy correctly, then there will be an increase in the price level. With an
increase in prices, there will be a demand for higher wages and it will lead to a decrease in AS. If
people forecast changes in policy incorrectly, then they cannot forecast change in prices caused by
policy. Consequently, there will be an increase in output and increase in aggregate supply with the
increase in prices. Thus in the short run, monetary policy is fully ineffective.

But it has been observed empirically that money supply change does have an effect on the
short run and changes the expectation in the market, due to which Monetary policy has an impact in
the Contemporary world Business cycle.

Q7. Using the IS-LM model, show how expected deflation may cause equilibrium output to
remain at less than full-employment level. (10 Marks)
Answer: The Fisher equation provides the link between nominal and real interest rates. To convert
from nominal interest rates to real interest rates, we use the following formula:
[ real interest rate = nominal interest rate - expected inflation rate ]
𝑒
[𝑟 = 𝑖 −π ]
𝑒
If there is expected deflation in the economy then π becomes negative in the Fisher’s equation.
𝑒
[𝑟 = 𝑖 +π ]

In the IS-LM model, the equilibrium is determined where the IS curve intersects the LM curve. At the
equilibrium point the goods market and the money market together are in equilibrium.

By Vibhas Jha
 fig 7.1
Real interest rate affects demand for Investment. Any expected deflation will result in reducing
Demand for Investment by increasing the Real Interest rate due to which the IS curve will shift to the
left. As the IS curve shifts to the left the output falls due to which we have less than full employment
level.

Investment demand is a function of Autonomous investment and real interest rate. Any expected
deflation will result in reducing investment demand due to which equilibrium output becomes less.

Fig 7.2

In fig 7.2 the IS curve shifts to left (IS0 to IS1). There is a fall in output from Y0 to Y1. This shift in
the output level is due to the fall in investment.

In the IS LM model, the real interest rate affects variables like investment and any change in price
level will have an impact on it and thus resulting it to this value.

By Vibhas Jha
Q8. Is stagflation a logical outcome of Keynesian orthodoxy? Give reasons for your answer.
[10 Marks]
Answer: Keynesian orthodoxy
1. In simple Keynesian model only AD determined the equilibrium output Y
2. The model was orthodox because of complete rejection of the supply side. This was due to the
assumption that supply side factors do not have any impact on the equilibrium of the
economy.

Stagflation : Stagflation is an economic cycle characterized by slow growth and a high

unemployment rate accompanied by inflation. It is a situation when the rising inflation is
accompanied by a falling or stagnating output. This generally happens in the conditions of some
structural rigidities and mostly due to adverse supply shocks in an economy.

Fig 8.1 Adverse supply shock

In fig.8.1, where AD0 and AS0 are in equilibrium at point E and determine price level OP0 and
aggregate national output OY0. Due to this supply shock aggregate supply curve shifted to the left to
the new position AS1 which intersects the given aggregate demand curve AD0 at point H. At the new
equilibrium point H, price level has risen to P1 and output has fallen to OY1 which will cause
unemployment rate to rise. So, we have a higher price level with a higher unemployment rate.

Keynesian theory didn’t talk about Supply side Inflation and was mostly based on Business cycle
Inflation. So, there was no information and solution for the supply side inflation. Hence Keynesian
orthodoxy is responsible for Adverse Supply shock.

By Vibhas Jha
Q9. In the simple Keynesian model, if consumption and investment are both functions of
income, how would the multiplier be affected? [15 marks]
Answer: Multiplier gives the change in equilibrium output per unit change in autonomous
expenditures (e.g., government spending). In Simple Keynes , the multiplier is [ 1/(1-MPC) ] because
Investment is a function of Animal Spirit.

Let; 𝐶 = 𝐶 + 𝑏(𝑌 − 𝑇) ;
𝐼 = 𝐼 + 𝑑𝑌 ; 𝐺 =𝐺

In Equilibrium;

Y=C+I+G
Y = 𝐶 + 𝑏(𝑌 − 𝑇) + 𝐼 + 𝑑𝑌 + 𝐺
Y. [1 - b - d] = 𝐴 - bT
1
Y= [1 − 𝑏 − 𝑑]
[ 𝐴 - bT ]

1
Autonomous Multiplier ⇒ (∆𝑌/∆𝐴) = [1 − 𝑏 − 𝑑]

When Investment (I) and Consumption (C) are functions of Income (Y), then for every increase of
income comparatively higher level of injection via expenditure mode.

In Emerging market it is seen that investment is based on expected demand which is a function of the
rise in Income. Therefore any rise in income results in an increase in consumption and investment
leading to a larger increase in income compared to a simple Keynesian model with consumption as
only a function of Income.

Q10. What is hysteria? Explain the impact of hysteresis in Gradualist Monetarist and Eclectic
Keynesian frameworks. 15
Answer: Hysteresis is a policy change having continuous cumulative impact over a long period of
time in the same direction creating stronger results.

Gradualist Monetarist approach was based on the Neoclassical model. Neoclassical economists
believe that a consumer's first concern is to maximize personal satisfaction. Therefore, they make
purchasing decisions based on their evaluations of the utility of a product or service. This theory

By Vibhas Jha
coincides with rational behavior theory, which states that people act rationally when making economic
decisions.

Fig 10.1

In fig 10.1,After the Expansionary policy in the economy, the AD curve shifts right from AD1 and
AD2. Then the equilibrium shifts from A to B making expected Price rise from P1 to P2. Since Price
must equal to Expected Price in neoclassical theory, which makes the leftward shift of AS from AS1
to AS2. Now new equilibrium changes with the new expected price. This continues in the long run
till AS intersects AD at Yp (Full Employment). Shift of AS is the Gradualist approach.

Eclectic Keynesian framework : However in pure Keynes expectations are not gradual, they are
adaptive but immediate.

Fig 10.2

By Vibhas Jha
The expenditure-output model, sometimes also called the Keynesian cross diagram, determines the
equilibrium level of real GDP by the point where the total or aggregate expenditures in the economy
are equal to the amount of output produced. The keynesian cross was not affected by any kind of
gradualism.

The Hysteresis effect had an impact on the Gradualist Monetarist approach but had no impact on the
Eclectic Keynesian framework.

Q11. How will you derive the real aggregate demand curve using the New Classical Theory?
Answer: New Classical economics borrowed AD of Neo-Keynesian economics. The AD curve was
derived by IS LM using the relation between price and income, such that both the Goods and Money
market are in equilibrium.

The aggregate demand curve shows the inverse relation between the aggregate price level and the
level of national income. Now we may establish this relation on the basis of the IS-LM model.

Suppose we hold the nominal money supply constant. Now if the price level (P) rises, the supply of
real money balances (M/P) falls. As a result the LM curve shifts upwards to the left. This leads to a
rise in r and a fall in Y as shown in part (a) of Fig. 11.1

The price level rises from P0 to P1 the income level falls to from Y0 to Y1. This inverse relationship
between Y and P is captured by the aggregate demand curve, as shown in part (b) of Fig. 11.1.

By Vibhas Jha
Thus the aggregate demand curve is a locus of points showing alternative combinations of Price (P)
and (Y) Income that are consistent with the general equilibrium of the goods market and money
market, i.e., equilibrium interest rate (r) and Income (Y) — shown by the intersection of the IS and
LM curves.

Macroeconomics is stable with respect to AD after the Neo-Keynesian approach.

Q12. Show that in the complete Keynesian model only fiscal policy is effective during a period of
depression.
Answer: In the complete Keynesian model only fiscal policy is effective due to the presence of
Liquidity Trap , monetary policy didn’t work in the Keynesian model. Keynesian AD is a function of
[C+I+G], which means that it was affected by the level of output and animal spirit. Monetary policy
has no role to play in change in level of output , animal spirit and the government expenditure. In
Keynesian theory any change in output will take place due to fiscal policy.

Fig 11.1

Deflationary gap is the amount by which actual aggregate demand falls short of aggregate supply at
level of full employment’. The equilibrium can be achieved by increasing AD, which can be done by
only fiscal policy. Since Investment is not a function of interest rate making monetary policy
ineffective.

By Vibhas Jha
 Fig 11.2

If the LM curve is horizontal, monetary policy is completely ineffective because the demand for
money is perfectly interest elastic. This is the case of the “liquidity trap” shown in Figure 3, where the
increase in the money supply has no effect on the interest rate and the income level. Thus increase in
income is done by only Fiscal policy.

Q13. Explain the difference between the assumptions of New Classical and the New Keynesian
approaches in managing individuals and markets. [10 marks]
Answer:New Classical assumptions:
1. They stress on rational expectations which assume short term contraction or temporary
changes having a larger impact on the economy.
2. They assumed any anticipated changes in the policy were ineffective whether monetary or
fiscal.

3. They didn’t assume that microeconomics impact has no importance over macroeconomics
structure. The new classical explains the forces at work in terms of rational choices made by
households and firms.

New Keynesian assumptions:

1. They also assumed rational expectations. But it will be affected by the microeconomic
changes and contractual changes in the long period and discontinuity in the short run of the
economy.

2. They assumed that if there is any anticipated change in the economy, policy beyond the period
of contraction will have an impact.

By Vibhas Jha
 3. They assumed that microeconomics has an impact on macroeconomics structure. Keynesians
base their models on the real world imperfectly competitive markets where consumers,
producers and labour market participants operate with imperfect information.

Q14. Show that full employment is the logical conclusion of the Classical macro model.
[10 marks]
Answer: The two key assumptions underlying the classical study of macroeconomics are Full flexible
wage and prices and Say's law (Supply creates its own Demand).

Voluntary unemployment is characterized by a situation when people are either not interested in any
gainful employment, or are willing to work only at a wage rate higher than that prevailing in the
labour market. Involuntary unemployment is characterized by a situation in which people are
prepared to work at prevailing wage rates but they are not able to get employment.

However in the Classical model, with assumption of Supply creates its own demand which meant that
there was no question of any unsold inventory. Also because of Wage price inflation there was no
question of inflation from controlling demand. As soon as prices increase the wages increase and it
results in the same purchasing power of workers.

Therefore, in the classical model; it is impossible for the workers to be involuntarily unemployed.
Thus in the classical model the economy remains at full employment.

Q15. Discuss briefly the circumstances where fiscal expansion leads to full crowding out. [15m]
Answer: Any increase in government expenditure shifts IS upwards, resulting in increase in income
which creates excess demand for money and excess supply of bonds. Due to excess supply of bonds ,
the price of bonds falls and the interest rate increases. This rise in interest rate has 2 impacts:

1. Decrease in private investment

2. Decrease in money demand

By Vibhas Jha
 Fig 15.1

Decrease in private investment due to increase in government expenditure financed by borrowing and
therefore increasing interest rate and reducing liquidity for the private sector in the Asset market is
called Crowding Out.

Cases in which Full Crowding Out takes place:

a. If the LM curve is vertical ( Pure Classical Approach)

Fig 15.2
If the LM curve is vertical, then an increase in government spending has no effect on the equilibrium
level of income. It only increases the interest rate.Thus with a vertical IM curve, an increase in
government spending cannot change the equilibrium level of income, but only raises the equilibrium
interest rate.
The increase in interest rates crowds out private investment spending. Crowding out, as defined
earlier, is the reduction in private spending (and particularly investment) associated with the increase
in interest rates caused by fiscal expansion. There will be full crowding out if the LM curve is vertical.

By Vibhas Jha
 b. NeoClassical Adjustments:

Fig 15.3

After the Expansionary policy in the economy, the AD curve shifts right from AD1 and AD2. Then
the equilibrium shifts from A to B making expected Price rise from P1 to P2. Since Price must equal
to Expected Price in neoclassical theory, which makes the leftward shift of AS from AS1 to AS2.
Now new equilibrium changes with the new expected price. This continues in the long run till AS
intersects AD at Yp (Full Employment). Overall the long run Price keeps rising and will keep shifting
the LM curve till it is crowded out.

c. Perfectly anticipated change by Government (NewClassical Theory)

In this theory, the government will change the expenditure and the people will anticipate quickly. This
anticipation will change all factors in the short run. This will shift both AD and AS curve with rise in
price and no change in output. The Change in price will increase the interest rate. This will create a
complete crowding out in the economy. Even if there is unanticipated change in the economy, after
some time period there will be complete crowding out.

Therefore, under circumstances where the factors affecting Aggregate demand are weak and
when there is a lack of coordination between money market and goods market, then fiscal policy
remains less effective.

By Vibhas Jha
Q16. Transaction demand for money is not always interest rate inelastic." Discuss. [15 M]
Answer: Yes, Transaction demand of money is not always interest rate inelastic. It can be explained
through Baumol’s Money Demand Theory.

Baumol’s Money Demand Theory:

According to Baumol, the cost which people incur when they hold funds in money is the opportunity
cost of these funds, that is, interest income forgone by not putting them in saving deposits.

2.𝑏.𝑌
𝐶 = 𝑟

Here, size of the pay cheque (i.e. salary) be denoted by Y, the average amount of the cash he
withdraws each time the individual goes to the bank by C, the number of times he goes to the bank to
withdraw cash by T, broker’s fee which he has to bear each time he makes a trip to the bank by b.

For this rule, it follows that a higher broker’s fee will raise the money holdings as it will discourage
the individuals to make more trips to the bank. On the other hand, a higher interest rate will induce
them to reduce their money holdings for transaction purposes as they will be induced to keep more
funds in saving deposits to earn higher interest income. That is, at a higher rate of interest transactions
demand for money holdings will decline.

Keynes thought that transactions demand for money was independent of rate of interest. According to
him, transaction demand for money depends on the level of income. However, Baumol has shown that
transaction demand for money is sensitive to rate of interest.

As explained above, interest represents the opportunity cost of holding money instead of bonds,
saving and fixed deposits. The higher the rate of interest, the greater the opportunity cost of holding
money (i.e. the greater the interest income forgone for holding money for transactions).

Therefore, at a higher rate of interest people will try to economize the use of money and will demand
less money for transactions. At a lower interest rate on bonds, savings and fixed deposits, the
opportunity cost of holding money will be less which will prompt people to hold more money for
transactions.

By Vibhas Jha
Q17. Explain the Keynesian and classical extreme monetary assumptions for showing their
effects on the slope of the LM curve. [20 M]
Answer: Classical LM Curve:

Fig 17.1

In Classical model, the Money Demand is a function of only Transaction Demand for money i.e.
[ M = k.P.Y ] making money demand is completely interest-insensitive. This is the classical quantity
theory of money, which argues that the level of nominal income is determined solely by the quantity
of money, not interest.

If h=0, then corresponding to a given real money supply, there is a unique level of money which
implies that the LM is vertical. Therefore, in a classical model due to the assumption of Classical
Dichotomy interest sensitivity of money demand is zero and due to that LM curve becomes Vertical.

Keynesian LM curve:

Fig 17.2
According to Keynes, people prefer to hold liquid money for three purposes: transaction motive,
precautionary motive and speculative motive. Speculative demand for money arises from the
expectation about the behavior of prices in financial assets such as bonds.

By Vibhas Jha
Keynes’s theory of the speculative demand for money showed that as the interest rate becomes very
low, relative to what is considered normal, a consensus develops considering future interest-rate
increases as likely. In this situation, with expected future capital losses outweighing the small interest
earnings on bonds, the public would hold any increase in money balances with only a negligible fall in
the interest rate. In this range of the money demand schedule, the interest elasticity of money demand
becomes extremely high.This case, which Keynes termed the liquidity trap. Since infinite elasticity
attaches to speculative demand, the LM is horizontal.

Q18. What are the fiscal and monetary implications of vertical IS and vertical LM curves?
[10M]
Answer: Policy mix changes its results from standard theory in case of extreme shapes of IS and LM
curves.

Fiscal policy impact on Vertical IS :

Fig 18.1

The case of the Expansionary Fiscal Policy on vertical IS schedule is shown in Figure 18.1. Here
investment is completely interest insensitive. The increase in government spending causes the interest
rate to rise, but this rise does not result in any decline in investment. Income increases by the full
amount of the distance of the horizontal shift in the IS schedule; there is no crowding out of
investment. Fiscal policy is mostly effective, where the IS schedule is vertical.Similarly, under
contractionary policy, Income and interest rate will fall as the IS curve shifts to the left.

Monetary policy impact on Vertical IS :

By Vibhas Jha
 Fig 18.2

The impact of Expansionary Monetary policy is shown in fig 18.2.If the IS schedule is vertical,
increasing the money supply simply shifts the LM schedule down along the IS schedule. The interest
rate falls until money demand increases by enough to restore equilibrium in the money market, but
income is unchanged. Similarly, under Contractionary Monetary policy, the LM curve shifts to the left
resulting in increase in interest rate with no change in Income. Thus making monetary policy fully
in-effective.

Transmission mechanism fails in this case because vertical IS implies that interest sensitivity of
Investment demand is zero. Therefore no 2nd stage of transmission mechanism.

Fiscal policy impact on Vertical LM :

Fig 18.3
The case of the Expansionary Fiscal Policy on vertical LM schedule is shown in Figure 18.3.

By Vibhas Jha
If h=0, then corresponding to a given real money supply, there is a unique level of money which
implies that the LM is vertical. If money demand is completely insensitive to changes in the interest
rate, only one level of income can be an equilibrium level—the level that generates transaction
demand just equal to the fixed money supply. An increase in aggregate demand, caused by an increase
in government spending, creates upward pressure on income at a given interest rate.This will lead to
complete Crowding Out. Similarly, the Contractionary Fiscal Policy will shift the IS curve to the left
reducing the interest rate at the same output level. Thus fiscal policy is ineffective on Vertical LM.

Monetary policy impact on Vertical LM :

Fig 18.4
In Figure 18.4, where money demand is completely interest inelastic, the interest rate again falls after
an increase in the money supply. Here the fall in the interest rate itself does nothing to increase the
demand for money and to restore equilibrium in the money market, because in this case money
demand does not depend on the interest rate. The fall in the interest rate, however, causes investment
and income to rise. Similarly, Contractionary monetary policy, the LM curve shifts to the left resulting
in decrease in output and increase in interest rate.

Therefore; vertical IS makes money neutral while vertical LM makes fiscal policy fully ineffective.

Q19. "The advent of New Classical Macroeconomics has tended to upset the applecart of
Keynesian and to a great extent, that of the Monetarists." Discuss. [20 M]
Answer: Keynesian approach and to a greater extent neoclassical approach was based on Business
Cycle. Keynes' approach was the explanation of the solutions of the Great Depression. Keynesians
believe that, if government spending increases, for example, and all other spending components
remain constant, then output will increase. This will shift the AD curve towards full employment. But
NeoClassical reconciles Keynes with the Classical approach. According to them, in the short run it
actually matters if there are monetary and fiscal policy changes. It does affect the economy i.e. AD

By Vibhas Jha
curve shifts and AS curve responds to it and only in the long run that AS comes back to full
employment level.

New classical economists propose that economic agents will form rational expectations, rational in
that they will not make systematic errors. According to the hypothesis of rational expectations,
expectations are formed on the basis of all available relevant information concerning the variable
being predicted. Therefore, business cycle fluctuation did not need policy interventions because it was
assumed that even due to certain errors in the economy, some kind of deviation from full employment
would occur. The economy will adjust to full employment as soon as people filter that error and make
it as an information set.

New Classical Criticism of Keynes:

● New Classical Theory was critical of theoretical fundamentals of Keynesianism.

● According to them, consumption demand function and money demand function had no
theoretical use and could not explain consistently observed behaviour in economics.
Therefore, they called it based on the "Rule of Thumb".
● They also criticized adaptive experimentation in the Keynesian model and observed that if
information is complete then money demand and money supply can shift to keep the market
in equilibrium.
● They criticized wage rigidity in the Keynesian model by asserting that agents will optimize
their behaviour and keep AS curve vertical.
● They also criticized Keynesian assumption of liquidity trap and asserted that there is no
possibility of liquidity trap as long as the central bank does not create expectations.

New Classical Criticism of Monetarists

New classical economics based on Rational Expectations model criticized monetarists for following
reasons:

● Monetarists followed adaptive expectation which resulted in systemic errors being repeated.
● New classicals stated that only temporary changes in policy could affect the business cycle
while monetarists always assumed viability of only monetary policy.
● New classical economics accepted the role of contracts and adjustments based on changed
expectations, monetarism did not have any theory related to these.

By Vibhas Jha
New Classical economics was developed in the 1970s after Oil Shocks where expectation plays a
major role. Therefore macroeconomic imbalances were explained by NewClassical Economists
contextually better than monetarists or by Keynesians.

Q20. Discuss in brief Friedman's restatement of the quantity theory of money and find its
similarity/difference with the classical quantity theory. [15M]
Answer: Fisher equation of exchange:
M.VT = P.T
M𝑉 = P.T { 𝑉 is constant }
Where
T is number of transaction of average size
M is defined as quantity money,
V is velocity of circulation of money, and
P is the average price level.

The classical macroeconomic theory relies on the QTM as the theory of demand for money. This
theory says that it is the quantity of money in the hands of the public that determines how high or low
the price level will be. Such a conclusion has been reached since the level of output in the classical
model is always at the full capacity (or full employment) level.

Milton Friedman, has made a restatement of the Quantity Theory of Money. His version is referred
to as Monetarism or the New Quantity Theory. It is the modern version of the classical QTM.
Friedman’s money demand theory can be used to restate the Cambridge equation
as follows:
Md = k(rB, rE, rD).P.Y

Where,
rB = nominal interest rate on bonds
rE = nominal return on equities
rD = nominal return on durable goods

In this, instead of a constant k we now have k expressed as a function of the rates of return on the
assets that are alternatives to holding money. A rise in the rate of return on any one of these alternative
assets would cause k to fall, reflecting the increased desirability of the alternative asset. In these
terms, we see that Friedman restated the quantity theory, providing a systematic explanation of k that
takes into account the Keynesian analysis of money’s role as an asset.

By Vibhas Jha
Similarities:

1. Both assumed, money as a function of Transactional purpose

2. Both assumed any change in Nominal GDP definitely required Money supply.
3. Both assumed that its labour market and capital market which dominates more i.e. Supply
side assumptions.

Differences:

1. Unlike Fisher, Friedman explained why a particular proportion of money to be used as

nominal GDP and not entire nominal GDP for money.
2. Friedman identifies money not for transactional purposes but also for storage purposes. But
Fishers doesn’t suggest any such purpose other than transactional
3. Friedman identified the speculation purpose of the money.
4. Friedman understood that in the short run money supply has an impact on real output.
Whereas Fisher had rejected this hypothesis.

Fisher’s theory and Friedman’s theory were given at different time periods, but the policy approach
had broadly similar suggestions on macroeconomic policy.

Q21. Distinguish between Monetarist and Neo-Keynesian approaches expectation-augmented

Phillips curve. [20M]
Answer: Simple Phillips Curve:

Fig 21.1

π𝑡 = − α(𝑢𝑡 − 𝑢𝑛)

Here ; π: Inflation rate

u: Unemployment rate

By Vibhas Jha
The Simple Phillips Curve was designed to show the inverse relation between inflation and
unemployment. It was based on the Keynesian approach of the business cycle model. It showed that
any increase in unemployment will result in reducing price and any decrease in unemployment below
the natural rate will increase price. Therefore, inflation is zero, that is, price remains stable when the
economy is at a natural rate of unemployment

Expectation-Augmented Phillips Curve

The ‘oil crisis’ of 1973 and 1979 i.e. Supply side Shock suggests that only the Business cycle cannot
explain all inflationary tendencies. Therefore, the Phillips Curve was revised and it was suggested
that it should be based on worker's expectations framed from the past experience. It was said that
current period inflation will not only depend on the unemployment rate but also expected inflation. In
simple terms, expected rate of inflation in period t is given by

𝜋t = 𝜋n + πte
𝑒
⇒ [ π𝑡 = π𝑡 − α(𝑢𝑡 − 𝑢𝑛) ]

Fig 21.2

But NeoClassical never insists on the long run Phillips Curve. Their theory was based on the short
run, that Phillips curve will change with change in inflation and unemployment relation. The only
change is that their interception point is not Zero like Simple Phillips Curve rather it is at Expected
inflation (πte). It suggests that if Inflation goes above the (πte) i.e unemployment is falling and
vice-versa.

Monetarists Approach:

[ π𝑡 = π𝑡−1 − α(𝑢𝑡 − 𝑢𝑛) ]

By Vibhas Jha
The expectation of augmented Phillips Curve has an intercepting point at π𝑡−1 , because when

inflation does not change the economy is at a natural rate, i.e, when π𝑡 = 𝑢𝑛, this implies that

π𝑡 = π𝑡−1 .

Natural rate of unemployment 𝑢𝑛is also called Non Accelerating Inflation Rate of Unemployment

(NAIRU) by Milton Friedman.

Fig 21.3
According to Monetarists, in the short run, when money supply is increased, then the fooling model
operates and income increases beyond the natural rate. Therefore, inflation increases and the
unemployment rate falls, but in the long run, the economy goes back to equilibrium at the natural rate
of unemployment because the workers perceive that prices have increased and they adjust
accordingly.

According to the monetarist approach, any increase in money supply will result in an upward
movement on the Phillips curve because the unemployment rate will decrease and inflation will
increase (fooling model operates). The economy moves from point A to point B and remains there in
the short run. But, as the workers observe new levels of inflation, they will shift the Phillips curve
upward such that the new expected inflation. The Phillips curve passes through point C at u. The
economy shifts to point C because inflation has increased sufficiently to cancel all increase in money

By Vibhas Jha
supply. Joining points like A and C we get a long run phillips curve which is vertical showing no
relation between inflation and unemployment.

Broadly the indicators of NeoKeynesian and Monetarists were similar. But the basic assumptions were
different. NeoKeyneians did not assume long run impact but monetarists assumed long run impact
because in long run there will be no change in employment despite change in inflation, Policy will
become ineffective but for NeoKeynesian policy remain effective because they didn’t give any
importance to long run theory.

Q22. State Okun’s law and find out the expectations-augmented Phillips curve. [10M]
Answer: Okun’s Law : It states that a 1% fall in the rate of unemployment will increase the growth
rate of output (𝑔𝑦) by 2.5% above its Natural Rate of Growth (𝑔 𝑦) and vice- versa. The law was given

under the assumption that wage and price are sticky, AS curve is upward sloping, the economy's
natural rate of output growth is known and markets respond to government policy in the short run

𝑔𝑦 − 𝑔 𝑦 = 2. 5% …….. Eq1

(𝑢𝑡 − 𝑢𝑡−1)= -0.4[ 𝑔𝑦 − 3%] .……. Eq2

𝑔 𝑦 = (% Increase in Labour force) + (% Increase in Technical Coefficient of Economy) =3%

Okun calculated all his parameters used in eq1 and eq2 by taking U.S. economy data from 1916-1952.
Okun showed the inverse relationship between output growth and rate of unemployment. Thus, the
generalized equation of Okun’s Law is:
(𝑢𝑡 − 𝑢𝑡−1) = β. [𝑔𝑦 − 𝑔 𝑦]

& Phillips Curve:

[ π𝑡 = π𝑡−1 − α(𝑢𝑡 − 𝑢𝑛) ]

Okun’s law with Phillips curve has been used to show growth inflation Trade Off faced by any given
economy. There is inverse relation between growth and output around 𝑔 𝑦 and rate of unemployment

combined with inverse relation between change in inflation and rate of unemployment, one can show
direct relation between inflation and growth rate of the output. Any increase in ( 𝑔𝑦) above (𝑔 𝑦) from

a steady state can take place only when ut falls below un which imply π𝑡 𝑎𝑏𝑜𝑣𝑒 π𝑡−1 . Therefore (𝑔𝑦)

will necessarily result in an inflation rise. This is also called GRowth Inflation Trade-off.
Okun's law has been used to define the sacrifice ratio for the economy which is the ratio of
point year of excess unemployment to % change in inflation.

By Vibhas Jha
It helps in finding out for policy makers the rate at which inflation control can be planned so that there
is no exogenous impact in the economy with respect to expectations formed.

Expectation-Augmented Phillips Curve

The ‘oil crisis’ of 1973 and 1979 i.e. Supply side Shock suggests that only the Business cycle cannot
explain all inflationary tendencies. Therefore, the Phillips Curve was revised and it was suggested
that it should be based on worker's expectations framed from the past experience. It was said that
current period inflation will not only depend on the unemployment rate but also expected inflation. In

adaptive expectation (πte) is (π𝑡−1). In simple terms, expected rate of inflation in period t is given by

𝜋t = 𝜋n + πte
𝑒
⇒ [ π𝑡 = π𝑡 − α(𝑢𝑡 − 𝑢𝑛) ]

Fig 22

But NeoClassical never insists on the long run Phillips Curve. Their theory was based on the short
run, that Phillips curve will change with change in inflation and unemployment relation. The only
change is that their interception point is not Zero like Simple Phillips Curve rather it is at Expected
inflation (πte). It suggests that if Inflation goes above the (πte) i.e unemployment is falling and
vice-versa.
NeoClassical synthesis of Keynes and Classical model was based on Okun’s Law and Phillips Curve
in finding in the short run policies are relevant and but in the long run period the policies become
neutral.

By Vibhas Jha
Q23. “If the interest elasticity of demand for money is low, the monetarists could predict the real
GNP simply by the -use of money supply.” Explain this statement. [10M]
Answer: Since Money Demand is a function of Income and interest rate;
Md = kY - h.r {Y= Income and r= interest rate}

According to the question, the interest elasticity is low which means that (h) in the above equation
tends to zero. This makes Md Money demand as function of only income i.e. ( Md=kY) . This leads to
the vertical LM curve and Monetarist approach.

Monetarism is a macroeconomic theory which states that governments can foster economic stability
by targeting the growth rate of the money supply. Essentially, it is a set of views based on the belief
that the total amount of money in an economy is the primary determinant of economic growth.
Friedman’s money demand theory equation states the monetarist approach as follows:
Md = k(rB, rE, rD).P.Y

Where,
rB = nominal interest rate on bonds
rE = nominal return on equities
rD = nominal return on durable goods

In this, instead of a constant k we now have k expressed as a function of the rates of return on the
assets that are alternatives to holding money. A rise in the rate of return on any one of these alternative
assets would cause k to fall, reflecting the increased desirability of the alternative asset.

Fig 23

In figure 23, Money demand is used from the monetarist approach. According to them, the line
passing through the origin is the Money demand Md. The vertical line shows the exogenous money

By Vibhas Jha
supply Ms. The equilibrium point E determines the Nominal GNP or Income in the economy. This
Nominal GNP at any price level will provide us with the real GNP.
If the Money Supply becomes more i.e Rightward shifts of MS1 to MS2 ; then Money increases
from M1 to M2 and the equilibrium will shift from E to H. This rises the Nominal GNP again tracing
the rise of price and Real GNP can be calculated.

Once the Monetarist had the proportional relation between price and output , they could easily
predict that with a given change in Money Supply by how much will GNP change and that could
allow us to understand how much Real GNP change. If proportional relation between price and output
is unknown , they could predict Nominal GNP but real GNP cannot be predicted.

Q24."Under rational expectations hypothesis, systematic monetary policy will be ineffective.”

Explain this statement using a suitable model. [20M]
Answer: Rational Expectation Hypothesis (REH) implies that given all information is available in
(t-1) time period, then the information formed by an individual in time period (t) will not have any
systematic error. This theory asserts that any error can be made only if the changes are temporary.
This theory can be explained using the Policy Ineffective Proposition hypothesis given by Rational
expectation theorists that any change in the economy is the anticipated change where it has no impact
on real variables in the market.

Policy Ineffective Proposition:

Fig 24.1

In fig 24.1, After the Expansionary policy in the economy, the AD curve shifts right from AD1 and
AD2. Then the equilibrium shifts from A to B making expected Price rise from P1 to P2. Since Price

By Vibhas Jha
must equal to Expected Price in neoclassical theory, which makes the leftward shift of AS from AS1
to AS2. Now new equilibrium changes with the new expected price. This continues in the long run
till AS intersects AD at Yp (Full Employment).

Equilibrium point A to Equilibrium Point C shows the vertical extent of shift in AD which represents
an Increase in Money Supply. The AS curve will shift vertically by the same extent because of
rational expectation everybody will know that the vertical extent AC will be the change in price even
if the output doesn’t change.

Temporary Change in Money Supply:

Fig 24.2

In Fig 24.2 after the expansionary policy The AD curve shifts to AD’ leading to the shift of AS curve
in the same proportion. Due to the unanticipated change in money supply, there is a shift of Price P1
to P2 in one time period Fig 24.2. Unlike in NeoClassical where adjustments were made over a period
of time. Thus in this case the labour is fooled for one time period and immediately at the end of the
time period the expectation will be revised and again it shifts back to full employment.

Therefore the statement "Under rational expectations hypothesis, systematic monetary policy will be
ineffective.” holds true because any anticipated change with rational expectation theory will have an
impact on output at real variables.

Q25. Show that liquidity preference is neither necessary nor sufficient for the existence of
involuntary unemployment in the Keynesian system. [20M]
Answer: According to Keynes, people prefer to hold liquid money for three purposes: transaction
motive, precautionary motive and speculative motive. The transaction motive and precautionary

By Vibhas Jha
motives are interest inelastic whereas speculative motive is interest elastic. Thus the rate of interest is
determined by the demand for liquid money for speculative purposes.

The transaction demand and the precautionary demand vary positively with income and negatively
with the interest rate. The speculative demand for money is negatively related to the interest rate.

Keynesian Equilibrium:

Fig 25.1

The expenditure-output model, sometimes also called the Keynesian cross diagram, determines the
equilibrium level of real GDP by the point where the total or aggregate expenditures in the economy
are equal to the amount of output produced. The point where the aggregate expenditure line crosses
the 45-degree line will be the equilibrium for the economy. If an economy found itself to the right of
the equilibrium point E, the AD is below the 45-degree line showing that the level of aggregate
expenditure in the economy is less than the level of output. As a result, output is piling up
unsold—not a sustainable state of affairs. The level of aggregate demand in the economy is above the
45-degree line, indicating that the level of aggregate expenditure in the economy is greater than the
level of output. When the level of aggregate demand has emptied the store shelves, it cannot be
sustained either. Firms will respond by increasing their level of production.

Keynesian Liquidity theory resulted in affecting the money market and he also assumed the money
market to be in Liquidity Trap. This implies the money market system could not have any impact on
the goods market. In the money market, if Keynesian liquidity preference changed , it didn’t have any

By Vibhas Jha
impact on the goods market because Keynesian Investment is not a function of Interest rate.
Investment in Keynesian theory was based on the animal Spirit.

Therefore it is not necessary for money market changes to affect goods market changes in Keynesian
theory. Implication is not true the other way around too. Money market changes were not sufficient
for goods market changes. It was possible that in the Money market in Keynesian theory there can be
excess demand and excess supply but in the Goods market was determined by Bulls & Bears
combined with consumptions which was based on Income and Government expenditure as shown in
Keynesian cross above fig 25.1. Therefore the Money market was not even sufficient to explain
changes in the Goods Market.

Q26. Explain the meaning and significance of money illusion on the part of workers in the
Keynesian theory of employment. [10 M]
Answer: Money illusion is an economic theory positing that people have a tendency to view their
wealth and income in nominal dollar terms, rather than in real terms. In other words, it is assumed that
people do not take into account the level of inflation in an economy, wrongly believing that a dollar is
worth the same as it was the prior year.

Significance of Money Illusion in Keynesian approach:

Downward rigidity of Nominal wage after a point i.e. Even in a period of deflation (falling prices)
workers are likely to resist nominal wage cuts because of the psychological cost of seeing a fall in
nominal wages. Thus in a period of deflation, we can end up with real wage unemployment –
unemployment caused by wages above the equilibrium.

Reasons of Money Illusion:

● First reason for the existence of money illusion is that workers of a firm or industry think
that though rise in prices reduces their real wages, but that this rise in prices equally affects
workers in other industries so that their relative wages as compared to those employed in
other industries remain the same. Therefore, workers who are more concerned with their
relative position with other workers will strongly resist the cut in their money wages, while
they will not oppose so strongly their cut in real wages through rise in the general price level.

● The second reason for strong resistance to cut in money wages is that the workers blame
their own employers for this, whereas they think that a cut in real wages through rise in prices
in general is the outcome of the working of general economic forces over which strikes in an
industry would have little effect. However, it does not necessarily mean that trade unions

By Vibhas Jha
 remain silent spectators if they feel that changes in Government policy adversely affect their
economic interests.

Fig 26
Keynesian AS curves become horizontal as shown in Fig 26; as workers are not willing to work extra
at a given Price making Price and Wage both rigid. Thus under the assumption of Money Illusion we
get Wage-Price Rigidity. Due to money illusion the AD will not rise even if full employment is at a
higher level, making workers willing to remain unemployed rather than willing to work at a higher
wage rate.

Q27. Differentiate between the complete, partial and zero crowding out effect of a given increase
in government expenditure in an economy. (10 M)
Answer: Crowding out means decrease in Investment due to increase in interest rate brought by an
expansionary fiscal policy; that is, increase in Government expenditure.

Complete Crowding out: There are 2 possibilities

1. When LM curve is vertical (Classical)

Fig 27.1

By Vibhas Jha
If the LM curve is vertical, then an increase in government spending has no effect on the equilibrium
level of income. It only increases the interest rate.Thus with a vertical IM curve, an increase in
government spending cannot change the equilibrium level of income, but only raises the equilibrium
interest rate. This results in Full Crowding out.

2. Long Run NeoClassical

Fig 27.2

After the Expansionary policy in the economy, the AD curve shifts right from AD1 and AD2.
Then the equilibrium shifts from A to B making expected Price rise from P1 to P2. Since Price must
equal to Expected Price in neoclassical theory, which makes the leftward shift of AS from AS1 to
AS2. Now new equilibrium changes with the new expected price. This results in Full crowding out.

Partial Crowding Out

Fig 27.3

By Vibhas Jha
Any increase in government expenditure shifts IS upwards, resulting in increase in income which
creates excess demand for money and excess supply of bonds. Due to excess supply of bonds , the
price of bonds falls and the interest rate increases. Decrease in private investment due to increase in
government expenditure financed by borrowing and therefore increasing interest rate and reducing
liquidity for the private sector in the Asset market is called Crowding Out.

Zero Crowding Out : There are 2 possibilities

1. Liquidity trap

Fig 27.4
If the LM curve is horizontal, monetary policy is completely ineffective because the demand for
money is perfectly interest elastic. This is the case of the “liquidity trap” shown in Figure 27.4, where
the increase in the money supply has no effect on the interest rate and the income level. Thus zero
Crowding Out

2. Monetization of Deficit

Fig 27.5

By Vibhas Jha
If the increase in Money supply is the same proportion to the government expenditure i.e Shift Of
LMcurve with same proportion to rise in IS curve. In Fig 27.5 The equilibrium point shifts from E to
E1 making no change in interest rate i1and rise in output level from Y to Y1. This situation creates
Zero Crowding Out.

Q.28 Explain the paradox of thrift. (10 M)

Answer: Paradox of thrift was suggested by Keynes to counter the classical idea of savings being a
virtue. This means that under the paradox of thrift, higher savings resulted in reducing output in the
economy instead of increasing it.

Fig 28
In Fig.28, the initial saving curve is S and the investment curve is I. Economy attains equilibrium
(Saving = Investment) at E and equilibrium level of income is OY. Now, suppose the society decides
to become thrifty by reducing consumption expenditure and increasing saving by, say, AE. As a result,
the saving curve shifts upward to S1 intersecting Investment curve I at E1.

Unplanned inventories will increase and firms will cut down production and employment and move to
new equilibrium E1. The figure shows that in the end, planned saving has fallen from AY to E1Y1.
Notice at the new point of equilibrium E1, investment level and also realized saving remain the same
(E1Y1) but level of income has fallen from OY to OY1. The decline in equilibrium level of income
shows the paradox of thrift as the reverse process of multiplier has worked on reducing consumption
expenditure. In fact Increased saving is virtually a withdrawal from circular flow of income.

Criticism :

1. Higher saving increases bank balances and can lead to an increase in bank lending - and hence
investment.

By Vibhas Jha
 2. A fall in demand from higher saving, will cause lower prices, which encourage demand to
increase. This is related to Say's Law which states supply creates its own demand.
3. Higher domestic savings can lead to lower domestic inflation and therefore increase exports.
Higher exports can boost demand.

Q29. "Monetarists are of the view that only money matters and Keynesians believe that money
does not matter at all." What is the reasoning behind these extreme views held by their
protagonists? (20 M)
Answer: Keynes basic Assumption was that it is a Demand Side theory assuming wage - price
rigidity and asserting under-employment equilibrium.

Monetarists assumed only transaction demand for money to be dominant and other factors to be
transitory based on which they concluded that fiscal policy has no role in an economy.

Keynesianism:

1. Keynesian assumption of Liquidity Trap:

Fig 29.1

If the LM curve is horizontal as shown in Fig 29.1, monetary policy is completely ineffective because
the demand for money is perfectly interest elastic. This is the case of the “liquidity trap” shown in
Figure 29, where the increase in the money supply has no effect on the interest rate and the income
level. Thus increase in income is done by only Fiscal policy and monetary policy is ineffective.

By Vibhas Jha
 2. Keynesian Equilibrium:

Fig 29.2

[ Y = C+ I + G ]
The expenditure-output model, sometimes also called the Keynesian cross diagram, determines the
equilibrium level of real GDP by the point where the total or aggregate expenditures in the economy
are equal to the amount of output produced. The point where the aggregate expenditure line crosses
the 45-degree line will be the equilibrium for the economy. Any change in Equilibrium point E is due
to change in Consumption C, Investment I (based on animal spirit) and Government expenditure G
and none of them are functions of (i) Interest rate. Since they are not a function of interest rate making
monetary policy has no impact on Demand

Monetarism :

Monetarism is a macroeconomic theory which states that governments can foster economic stability
by targeting the growth rate of the money supply. Essentially, it is a set of views based on the belief
that the total amount of money in an economy is the primary determinant of economic growth.
Friedman’s money demand theory equation states the monetarist approach as follows:
Md = k(rB, rE, rD).P.Y

Where,
rB = nominal interest rate on bonds
rE = nominal return on equities
rD = nominal return on durable goods

By Vibhas Jha
 Fig 29.3

In figure 29.3, Money demand is used from the monetarist approach. According to them, the line
passing through the origin is the Money demand Md. The vertical line shows the exogenous money
supply Ms. The equilibrium point E determines the Nominal GDP or Income in the economy. This
Nominal GDP at any price level will provide us with the real GDP.

If the Money Supply becomes more i.e Rightward shifts of MS1 to MS2 ; then Money increases
from M1 to M2 and the equilibrium will shift from E to H. This rises the Nominal GDP again tracing
the rise of price and Real GDP can be calculated. It shows that change in Money Supply impact
Nominal GDP

Both extreme versions are contextually true but in the real world both are lacking in explaining
Business Cycle entirely.

Q30. Explain with appropriate assumptions, the determination of equilibrium Income and
Interest rate In a Keynesian model of goods-money market, through diagrams. (20 M)
Answer: Assumptions of IS-LM

1. Goods market and Asset market (Money market) interact to provide Macroeconomic
equilibrium.
2. Labour market is inactive
3. Investment is a function of interest rate and autonomous constitution
4. Consumption is a function of Income and Tax
5. Government expenditure is Autonomous
6. Money demand is a function of both speculative demand for money and transactional demand
for money.

By Vibhas Jha
Adjustment to Equilibrium in the IS–LM Model

Fig 30 Adjustment to Equilibrium in the IS–LM Model

Note:
[ interest rate is affected by money market]
[Output Y is affected by the Goods market]

Assuming the initial point at Zone I, the economy finds itself with excess supply of goods and excess
supply of money i.e above IS & LM curve . In this case, output produced decreases while interest rate
also falls affected by the goods market and money market respectively. Together they push the
economy into the second zone (II)

At Zone (II) where there is excess demand for goods and excess supply for money i.e above LM curve
and below IS curve. This results in reducing interest rate and increasing output production. Together
they make the economy reach zone III

At Zone (III) where there is excess demand for goods and excess demand for money i.e below IS and
LM curve. This results in increasing interest rate and output produced. Together they take the
economy to zone IV

At Zone (IV) with excess supply of goods and excess demand for money i.e. above IS and below LM
curve. This results in increasing output produced, pushing the economy to zone I.

By Vibhas Jha
Over the period, it continues until the economy is able to find combinations of output and interest rate
such that both the markets are together in equilibrium

The adjustment process continues with the economy shifting from one zone to another and if
all parameters are supportive the economy will be able to reach equilibrium at the time when both
goods market and money market are equilibrium. The adjustment in the money market is faster than
the goods market. Therefore the economy can keep shifting between zones from 1 time period to
another. So Macroeconomic adjustments are unlike microeconomics adjustments.

Q31.Discuss the Classical dichotomy that money is neutral. (20 M)

Answer: Classical dichotomy represents a proposition in the classical model that nominal variables
like money supply can affect the nominal variables like price or nominal interest rate but it cannot
affect real variables like output. Real variables are affected only by changes in other real variables like
an increase in output in classical models can take place only if real variables like Technology or
labour supply change in the market.

Money Neutrality means that money supply affects monetary variables such as prices, wage rate and
exchange rate. It does not affect real variables such as output and employment. Output is not affected
by money supply by assumption, there is always full employment in the economy. Prices and wage
rates are assumed to be flexible.

Fig 31.1

The classical economists assumed the Supply side theory. The AS curve plays an important role in the
determination of the output.in fig 30.1 the AS curve is vertical due to wage price flexibility and AS
curve hyperbola due to Fisher’s identity. Since monetary policy changes [M0 to M1] only shifts AD
rightwards [shift of AD0 to AD1] not AS. This implies too much money chasing too few goods. This
shows that there is an increase in price level P0 to P1 but the Output level remains the same at the Full
Employment [YF]. This implies that Monetary Policy change doesn’t affect Money Supply. Thus in
the Classical model Money remains neutral even in the short run due to wage price flexibility.

By Vibhas Jha
 Therefore in the Classical Model, with a vertical AS curve and complete wage price
flexibility, change in money supply has no impact on change in Output even in the short run. This
shows the Classical Dichotomy of complete Money Neutrality.

Q32. Explain the determination of output and employment in a macroeconomy under the
conditions when individuals are subject to: (10 M)
● Money illusion
● No Money illusion
Answer: Money illusion is an economic theory positing that people have a tendency to view their
wealth and income in nominal dollar terms, rather than in real terms.
Money illusion can be seen in Pure Keynes Adjustment:

An increase in aggregate demand affects commodity prices sooner than it affects labor market prices.
Thus, a drop in unemployment is, after all, an outcome of decreasing real wages, and an accurate
judgment of the situation by employees is the only reason for the return to an initial (natural) rate of
unemployment (i.e. the end of the money illusion, when they finally recognize the actual dynamics of
prices and wages).

No Money Illusion phenomenon can be seen in Pure Classical adjustment.

By Vibhas Jha
 In the classical doctrine, equilibrium level of income is determined by the availability of factors of
production. This means that this theory puts emphasis on the supply side for the determination of the
equilibrium level of income and thus neglects the demand side. This supply-oriented classical
approach towards income and employment was based on certain assumptions. These are: (i) there is
always full employment of resources; and (ii) the economy always remains in the state of equilibrium.

Therefore under money illusion only fiscal policy works and under no-money illusion only
supply side policy works.

Q33. If workers supply labour on the basis of an expected real wage, how is the aggregate
supply of output determined in an economy? Suppose aggregate demand and supply are below
the natural rate of employment and output, would the New Classical economists advocate any
particular policy intervention when the economy is in such a situation? (25M)
Answer: NeoClassical AS curve drawn under the assumption of Sticky wage and price which is
based on workers expected real wage.

Derivation of AS curve :

1. Wage - Setting relation

Fig 33.1

[ W = P e. f ( u,z ) ] eq1

Wage has direct relation with Pe i.e Expected Price and a function of Unemployment (u )and other
supports like presence of social securities (z). This means workers will decide how much they will

By Vibhas Jha
charge depending on expected price and rate of unemployment and other factors present in the
economy.

2. Price - Setting Relation : It represents firms desire to pay wages for a given labour.

Let a production function be [ Y = AN ]

Imperfect Competition in market which means firms can charge : [ P = MC + µMC ]. Here µ is the
mark-up.

Now, [ P = (1+ µ) MC ]
[ MC = W/A ]

Therefore;
[ P = (1+ µ) (W/A) ]
[ W/P = A / (1+ µ) ] eq2

Eq2 shows firms willing to pay real wages are directly related to workers productivity and inversely
related to Monopoly power of the firm.

Combining both Wage price relation and Price setting relation, we get;

Fig 33.2
Un: Natural rate of unemployment

By Vibhas Jha
At P=Pe , then µ = Un

Now, [ P = (1+ µ) (W/A) ] and [ W = P e. f ( u,z ) ]

Here, u = ( Unemployed ) / Total workforce

u = ( 𝐿 - L) / 𝐿
u=1-(L/ 𝐿) eq 3

Since, [ Y = AN ] and let N be L

Then, [ L = Y / A ]

Now putting the value of L in equation 3 we get;

u=1-(Y/ 𝑌)

Now putting the value of u in equation 1 , we get;

[ W = P e. f (1 - ( Y / 𝑌 ) , z ) ]
Now,
P = (1+ µ) .Pe. . f (1 - ( Y / 𝑌 ) , z ) eq4
Equation 4 shows the relation between wage setting and price setting such that we find a relation
between P Price and Y Output.

Fig 33.3

● At Point A : P=P e and Y=Yn

By Vibhas Jha
 ● If Y > Yn then µ < Un ( unemployment is less than natural unemployment) will make the
wage rate to rise and also leads to the rise in Price i.e P > P e
● If Y < Yn then µ > Un ( unemployment is more than natural unemployment) will make the
wage rate to fall and also leads to the falls in Price i.e P < P e

NewClassical Approach ( Rational Expectation Hypothesis )

Fig 33.4

Here, Y < Yn implies P < P e .

For the next time period, the information set will be complete and adjustment in AS will take place
such that the AS curve shifts to AS’ and shifting equilibrium from E to E’ and Price decreases from
P2 and making new Expected Price and bringing back the economy at the Full employment Yn.

By Vibhas Jha