MEC 02

MACROECONOMIC ANALYSIS

## IGNOU MEC 02 Solved Free Assignment

MEC 02** Solved Free Assignment July 2023 & January 202**4

**Q. 1. What is meant by endogenous growth? What are its implications? Describe in brief a simple endogenous growth model.**

Ans. The Endogenous Growth Theory gives a great emphasis on accumulation of human capital even more than physical capital. They laid a great stress on knowledge capital.

Secondly, since knowledge capital can be acquired by transfer of technology, developing nations would do well if they open up their economies for developed economies.

It would increase the sharing of technology. Thirdly, the theory also recognizes the role of policies and government in promoting the rate of knowledge capital and thereby human capital formation.

Government need to formulate favourable policies to promote the rate of human capital formation.

And most importantly, the Theory also suggests that automatic convergence in the growth rate does not occur and therefore, a planned effort is required.

Rather it explained logically that in spite of same saving rate, population we can see different countries growing at different rates due to difference in their level of human capital.

And hence, government needs to formulate favourable policies to promote the rate of human capital formation. It is a way to break vicious circle of poverty.

Endogenous theory is called new growth theory because it came into picture later than exogenous growth theory. Endogenous theory is modern as it explains technology as an endogenous variable.

Exogenous theory was outdated with the introduction of endogenous growth models.

The idea of the fact that technology is and must be incorporated as an endogenous variable in growth models was also recognized by the economists like Marx and Schumpeter.

Exogenous theories claimed that economies converge towards equal growth rates but endogenous theory expanded the notion of capital to include human capital ad claimed that different countries diverge from each other depending upon the level of human capital formation.

AK model of endogenous growth was presented by Sergio Rebelo through his article titled ‘Long Run Policy Analysis and Long Run Growth’ which was published in 1991. It is based on the work done by Romer and Lucas. The basic equation of the model is

` Y=AK`

where A is symbolic of factors affecting technology and K includes physical as well as human capital. The model rejects that proposition of diminishing returns.

It claims that externalities or spillovers and increasing quality and variety of intermediate inputs do help to avoid diminishing returns.

Generally speaking lesser importance has been given to technology because endogenous growth theory admits that technology does not explain much of the growth. Initially technology was given a high importance.

But then some economists claimed that there is not much need to understand technology as it is a very small part of the contribution to growth process. They feel that it is so small that it can even be ignored.

But it is not logical. Solow model as well as empirical evidence shows that even if capital formation directly contributes to growth, without technological advancement, growth would stop.

It is so because it is technology that causes investment in the capital and indirectly causes all the growth. It is technological advancement that makes it possible to get increasing returns from all relevant inputs.

Technology connotes the way in which inputs are converted into output. Technology can be taken as a factor which stimulates the productivity of all factors of production. In a Cobb-Douglas production function, technology can be shown as:

Y=K (AL)’ Ō, where A is an index of technology.

Paul Romer’s views on technology and its impact on growth process:

Romer published his two papers in the year 1986 and 1990 in which he presented a way of modeling ideas as an engine of growth. Romer claimed that new ideas are non-rivalrous good and hence produce increasing returns to scale.

He further claimed that increasing returns to scale with explicit presence of research can prevail if and only if there is imperfect competition in the market.

Policy Implications of Endogenous Growth Theory:

The endogenous growth theory has important policy implications for both developed and developing economies:

This theory suggests that convergence of growth rates per capita of developing and developed countries can no longer be expected to occur.

The increasing returns to both physical and human capital imply that the rate of return to investment will not fall in developed countries relative to developing countries.

In fact, the rate of return to capital in developed countries is likely to be higher than that in developing countries. Therefore, capital need not flow from the developed to the developing countries and actually the reverse may happen.

Another implication is that the measured contribution of both physical and human capital to growth may be larger than suggested by the Solow residual model.

Investment on education or research and development of a firm has not only a positive effect on the firm itself but also spillover effects on other firms and hence on the economy as a whole.

This suggests that the residual attributed to technical change in the Solow growth accounting may be actually much smaller.

One of the important implications is that it is not necessary that economies having increasing returns to scale must reach a steady state level of income growth, as suggested by the Solow-Swan model.

When there are large positive externalities from new investment on research and development, it is not necessary for diminishing returns to start.

So the growth rate of income does not slow down and the economy does not reach steady state. But an increase in the saving rate can lead to a permanent increase in the growth rate of the economy.

This further implies that countries having greater stocks of human capital and investing more on research and development will enjoy a faster rate of economic growth.

This may be one of the reasons for the slow growth rate of certain developing countries.

**Q. 2. Bring out the salient features of permanent income hypothesis. Why is this model important? What are the implications of the model?**

Ans. Milton Friedman offered an alternative explanation for the difference between cross-sectional and time series data on consumption through permanent income hypothesis.

The permanent income hypothesis is also based on Fisher’s theory of consumption as an inter-temporal choice.

Unlike the life-cycle hypothesis, Milton Friedman did not assume that there is any regularity or uniformity in the pattern of income over the life-cycle of an individual, he opined that there are random and frequent temporary changes in the income of the household from time to time. Friedman categorized the income of an individual into two parts.

Permanent Income (Y)

→ Transitory Income (YT)

There are certain incomes which are irregular and co-incidental. These are called transitory income by Friedman.

However, permanent income is that part of the income which are expected to prevail over long period of time.

Friedman interprets it as the long-run average income of the individual and transitory income means any deviation from this average.

A positive transitory income would make the current income of the household greater than the permanent income and a negative transitory income would mean that current income of the houshold lower than permanent income.

Since C, = 4+ (Y)=4+Y7

The above equation makes it clear that the current consumption of a household depends only on permanent income and any increase or decrease in transitory part of the income, which does not affect permanent income will not bring about any changes in current consumption.

One of the biggest achievement of Friedman’s permanent hypothesis is that it solves the apparent puzzle in the consumption data Milton Friedman has proved it systematically, that APC (C/Y) is dependent on the ratio of permanent income to current, (Y/y) Hence, when current income rises above the permanent income the average propensity to consume falls and when current income is below the permanent income, the average propensity to consume rises.

He further classified that when we are considering cross-sectional data of different household at any point of time, especially the high income group will have some households with high transitory income and they will have a lower propensity of consume than average.

Similarly, in the group of low income groups these could be some households who have low transitory income and hence, they will have a higher propensity to consume than average.

Consequenty we get a falling average propensity to consume as we move from the lower to the higher income group.

On the other hand, when we are considering long-run time series data, the random fluctuation tend to counter balance each other in such a way that any change in income brings about a permanent change in the average income level.

Hence, in the long-run time series data, APC tends to become constant. The life-cycle hypothesis assumes the income of an individual is expected to be low during the initial years of work life and last years of work life and tend to reach at higher levels during middle years.

It is so because in the initial years, his productivity is low due to lack of experiences and during late years, his productivity is low due to ageing process and hence, it is during the middle years that the productivity of a person is at the peak level.

But he maintains an even level of consumption in all time periods. The life time consumption and income stream over the life time of an individual is presented with the help of diagram given below.

We have taken time period on x-axis. consumption and income on y-axis. During initial years, C>Y i.e. savings are negative, then in middle year C>Y i.e. saving are positive and he uses these savings during late years of his life when again c<>Y and his savings are negative.

Consumption stream over life time.

Consumption and Income

Time period

It is clear and given that consumption and saving behave in such a way, we can explain the inequality between cross- sectional and aggregate time series data on consumption behaviour.

If a person is considering the cross-sectional data for a particular point of time, it is possible that out of randomly selected sample of households, the hight income category will contain a higher than-average proportion of people belonging to middle phase of their life-cycle, and those who have low life time average income during middle phase of their life-cycle, will contain a higher than average proportion of people belonging to either the early or the late phases of their life.

Therefore, people have higher average propensity to save and lower average propensity to consume during middle phase, the cross-sectional data will show a lower propensity to consume for the high income category as compared to the low income category.

Please note that the current consumption of individual is a junction of not only life time income of the individual but also the initial stock of asset, A, (Refer to eqn. viii). In the stort-run, we expect A, to remain constant. The relationship between A, and L, is shown in the figure given below:

It is clear from the figure that C, is an upward sloping straight line curve. But when we consider the time series data in which income is also increasing over a long period of time then the stock of asset is also increasing.

It leads to shift in C, because the intercept A, is increasing. Therefore, if we are aiming to derive the long-run relationship between C, and Y, we can observe points like P, Q, R along successive short-run consumption lines.

And, hence long-run consumption curve will be steeper than the short-run consumption curve.

**Section-B**

**Q. 3. Distinguish between adaptive expectations and rational expectations. What is the impact of adaptive expectations on the Phillips Curve?**

Ans.Adaptive Expectations

. In adaptive expectation, we take decisions on the basis of past data.

. Adaptive expectations will be useful if the present and fu- ture circumstances are similar to past circumstances and if there are some differences, they can be quantifiably accounted for.

. It assumes that we can derive objective probability distribu- tion for future returns on the basis of past data.

**Rational Expectations**

In rational expectations we take decisions on the basis of all information that is available.

Rational expectations are more reliable uncertain and situa- tions that keep changing more frequently. It will consider all pieces of information that are available. But to which infor- mation how much importance will be given, it will vary per- son to person.

It assumes that it is not poss-ible to derive probability distribution for future returns on the basis of past data as the situations keep changing.

In the late 1960s, USA experienced unemployment rates that were much higher than what was expected as per Phillips curve from the past.

On the one hand, there was economic stagnation depicted by a low rate of increase in GDP and on the other hand, there was high rate of inflation.

In economics such a situation was given a term “Stagflation”. Milton Friedman in 1968, gave an explanation as to why the Philips curve might not represent a stable exploitable trade-off between unemployment and inflation rate. His arguments gained a lot of popularity in later years.

He gave an explanation that workers are not interested in an increase in their money wage rates but in an increase in the real wage rate. He also gave a concept of NAIRU (Natural Rate of Unemployment).

He claimed that at natural rate of unemployment,firms as well as workers will be satisfied with the existing real wage rate and equilibrium will get established at a lower real wage rate.

There may be following reasons for it:

(a) Jobs are of heterogeneous nature and firms and workers need appropriate time to search for right jobs and workers.

(b) Unemployed workers may not be able to seek employment by lowering wages due to costs of imperfections.

When unemployment rate is less than natural rate of unemployment, the firms which are employing more labour would be willing to pay a real wage rate lower than what they pay at a higher natural rate of unemployment.

If there is trade union or otherwise a contractual real wage rate then actual rate of unemployment will never be less than natural rate of unemployment.

But in reality, firms and workers enter into stipulated agreements on money wage rates and not real wage rates.

Now, it would depend on the expectations of the workers and the firms regarding future prices whether real wage rate would be lower or higher.

If at the time of accepting a job offer, a worker expects a lower future price level than firms, then rate of unemployment will be lower than natural rate of unemployment.

It is so because the expected real wage rate for workers would be greater for workers than for firms.

On the other hand, if at the time of accepting a job offer, a worker expects a higher future price level than firms, then rate of unemployment will be more than natural rate of unemployment.

It is so because the expected real wage rate for workers would be lower for workers than for firms.

If perception of the firms regarding the state of demand in the economy and the rate of inflation is just correct, then actual real wage rate will be equal to the expected real wage rate by the firms.

Hence, the economy would remain at a fixed rate of unemployment and the rate of increase in money wage rate is just equal to increase in the price level so that

constant.

that real wage rate remains

Symbolically,

w(t)/p(t) = w(t+1)/p(t + 1) = c so that

[w(t+1)-w(t)]/w(t) =[p(t+1)−p(t)]/p(1)

where [w(+1) w(t)]/w(t) is growth in money wage rate in time period 1. where, w() is wage in the time period t; p(t) is the price level in time period t

w(+1) is wage rate in time period + 1; p(+1) is price level in time period / +1;

and is a positive constant.

If present rate of unemployment is lower than natural rate of unemployment, a higher real wage rate will be expected by workers. Therefore, in such a situation

w(t+1)/p(t+1)=&

=p” (t+1) = w(t+1)/ &

i.e. [p(+1)-p(t)]/p(t) = 1/ ¢ [w(t+1)/w(1)]-1

i.e. [p” (1+1)-p(1)]/p(t) = ¢ / ¢ [[p(t+1)= p(1)]-1

i.e. (/) [p” (+1)-p(1)]/p(t) +[/¢-1]

= [p(1+1)-p(1)]/p(1)

Since ċċ 1, rate of increase in nominal demand in the economy must be such that [p(t+1)-p(t)] /p(t) which is a actual rate of inflation must always be greater than expected rate of price inflation given by [p°(t+1)−p(t)] /p(t)

In spite of the fact that actual rate of inflation is greater than expected rate of inflation, Phillips curve will work and give a stable relation between the rate of unemployment and the rate of inflation if the workers expected that the rate of inflation remained same over time.

But if the actual rate of inflation is greater than expected rate of inflation in any given time period, then the expected rate of inflation will also rise on the basis of experience.

Hence, the expectations about the future rate of inflation in time period 1+1 can be given by:

a” (+1)-α)=a[α (1)-a”(1)] where 0 <a λ<1….(1)

This equation shows that rate of inflation adapt to deviations of the actual value from the expected value of rate of inflation in the current period completely if λ = 1 and partially if <1.

This hypothesis about formation of expectations is known as Hypothesis of Adaptive expectations.

**Q. 4. Critically examine the efficiency wage model.**

Ans. In Economics, a model is based on certain assumptions. We give specific relations between the variables involved in a model, give solutions of those equations and bring out all possible implications of the solution.

We are explaining efficiency wage model in this section as given by Romer in 2001.

Specification of the Model: Let us assume that there are M firms in the industry and let us analyse a representative firm. Let us take a simple neo-classical production function assuming that there is only input i.e. labour.

When we say that production function is of neoclassical type, we mean to say that total product increases as efficiency units of labour input increase but at a decreasing rate.

in other words, the marginal product of efficiency units of labour is positive but keeps on decreasing as we increase the units of efficiency labour. Symbolically, it can be expresses as standard assumptions as shown in Chapter 3. F”> 0; F” =0.

The production function of such a representative firm can be expressed as

Y = F (e.L)

Y is the total output produced; L is the number of physical units of labour hired by the firm and e.L is the efficiency units of the labour. e.L can be defined as the total effort (Physical and mental) undertaken by L, the physical units of labour, to produce output Y. greater is the value of e, higher will be labour input in terms of efficiency.

The model makes it very clear that the individual effort of a labour e, depends on wage rate. e is a direct function of wage rate i.e. higher is the wage rate, higher will be individual effort put in by a person. This effort function can be expressed as: e = e(w)

The supply of physical unit of labour is perfectly inelastic in the sense that the total number of workers in an economy is fixed say, N and each worker supplies one unit of labour.

When there is an increase in wage rate, it is efficiency of workers that increases which in turn leads to increase in efficiency units of labour but there is no increase in the physical labour supplied by a worker.

Solution of the Model: To solve the model, we have taken simple behaviourist assumptions like the firms aim at maximizing their profits. The profits of the firms are equal to

II=Y-w.L

Where II is profit; Y is total output of the firm; w is real wage rate and L is number of physical units of labour hired by the firm.

We know that

Y=F (e.L)

e=F (w)

Therefore, Y = F [e (w).L]

On substituting Y in profit maximizing function, we get, maximize

z=F [e (w).L]-w.L

The equation can be solved by using usual calculus techniques by taking the partial derivatives of z respectively with respect to w and L and equating each of these to zero.

This will give us two equations in two unknowns w and L, which can be solved simultaneously to obtain the equilibrium values of w and L. i.e. the values of w and L where profits of the firm are maximum.

Let us equate the partial derivative of z with respect to L to zero in the profit maximizing equation given above. It reduces to w.e'(w)/e(w) = 1

Where e'(w) is the derivative of the effort function with respect to w, given the increase in effort per unit increase in rea wage rate, for infinitely small changes in the wage rate. It is to be noted that we'(w)/e(w) is the elasticity of the effort function e (w) with respect to the real wage rate w.

Hence the equation states that at the profit maximizing level of output, the elasticity of labour effort with respect to wage rate is equal to unity, i.e. the value of real wage rate is determined in such a way that any proportion of change in wage rate brings about equivalent increase in labour effort e(w).

It implies that at the profit maximizing level, the ratio w/e(w) remains same for infinitely small changes in wage rate. It further implies that the ratio w/e(w) is minimum at the profit maximizing level of output.

**Q. 5. Explain why fixed exchange rate is not effective in an open economy**.

Ans. In an open economy, the domestic rate of interest tends to become equal to global rate of interest, if there is free flow of capital across countries.

If there is a difference in the interest rate of domestic economy and global rate of interest, the capital keeps flowing unless it disappears totally.

Mundell- Flemming Model has given an analysis of open economy macro adjustments under perfect capital mobility. This model has extended IS-LM curve to include BP curve which is representative of the external sector.

It is a horizontal line curve. To understand derivation of IS-LM curve, you can refer to chapter 2. Here, in this section, we have included BP curve in IS-LM model. BP curve is a straight horizontal line showing global interest rate to be constant at r*. *

It is assumed that there is perfect competition in international capital market and domestic economy is price taker.

Therefore r is a straight line. When * is equal to r, i.e. global interest rate is equal to the domestic interest rate, there are no capital movements and there is external balance or equilibrium in the economy.

But when there is difference in * and r, an adjustment has to be made through monetary and fiscal policies. Let us explain how monetary and fiscal policies of the government are used to correct a disequilibrium caused by an exogenous shock.

Monetary Policy: Let us assume that the economy is in full employment equilibrium i.e. simultaneous equilibrium in goods market (IS curve), money market (LM Curve) and external market (BP Curve) in which the interest rate and the income corresponding to the equilibrium condition is * and Y*.

If there an expansionary monetary policy such that the supply of money (Ms) in the economy increases, it will shift LM curve downward to the right i.e. from LM to LM,. With the increase in money supply, interest rate in the home country will come down.

it will lead to capital outflow because now *>r and an investor would get higher returns if he invests in foreign market than what he gets in domestic market. It will lead to deterioration of capital account balance of BOP account.

At the same time, fall in interest rate would stimulate domestic investment and income through a process of multiplier.

It will increase the imports and thus would lead to deterioration in current account balance of BOP account. When there is deterioration in capital as well as current account balance of BOP account, it will make it to be in deficit.

Deficit in BOP account will lead to depletion of foreign exchange reserves. It will reduce money supply in the economy and LM curve will once again shift back from LM, to LM.

Hence, if a country is following fixed exchange rate system, monetary policy will become ineffective for it. It is shown with the help of following diagram.

Source: Salvatore Domistic (2008), “Introduction to International Economics” Fiscal Policy: If instead of monetary policy, the government makes use of fiscal policy to address the c then the process of adjustment will be as follows:

ss the cyclical fluctuations,

When the government is using expansionary fiscal policy, it will either increase its expenditure or reduce taxes. Consequently, there will be a shift in IS curve from IS to IS,,.

With this shift in IS curve, there will be an increase in domestic rate of interest which will increase capital inflow in the domestic economy. It will improve balances on capital account.

At the same time, there will be an increase in income which will lead to more of imports and worsening of current account balance. If surplus in capital account of BOP is greater than the deficit in the current account of BOP then there will be BOP surplus.

It means when there is increase in money supply; it will shift LM from LM to LM,. It will shift equilibrium income from y to y,*. Therefore, it is fiscal policy which will work effectively under fixed exchange rate system.

Source: Salvatore Domistic (2005), “Introduction to International Economics”

**Q. 6. Explain how an economy attains equilibrium in the IS-LM model.**

Ans. By integrating IS-LM curves we can get such level of rate of interest and income where there is equilibrium in money market and real market simultaneously. It is shown with the help of figure shown below.

Here both the markets are in equilibrium at point E where IS and LM curve intersect each other. At ri and Yi both the markets are in equilibrium simultaneously.

Government makes use of two policy instruments to intervene in the market: fiscal policy and monetary policy. Fiscal policy is the policy of the government related to tax and expenditure.

Monetary policy is the policy of the government related to money and credit supply. Fiscal policy of the government affects IS curve while changes in monetary policy affects LM curve.

Fiscal policy and IS curve: An increase in government expenditure leads to an increase in investment and thereby an outward shift in IS curve.

Another tool of fiscal policy is tax. When government reduces taxes, it will increase the consumption level and thereby lead to upward shift in IS curve.

Shift in IS curve leads to establishment of equilibrium level of income and rate of interest at a higher level. Opposite will happen when government expenditure is reduced or taxes are increased.

Monetary policy and LM curve: When there is an increase in money supply, an increase in real balances takes place which leads to decrease in rate of interest. When rate of interest decreases, for each level of income, there will be a downward shift in LM curve and accordingly there will be change in new equilibrium level of Y and R opposite will happen when a decrease in real balances take place.

**Q. 7. Write short notes on the following. (i) Lucas Critique.**

Ans. Lucas’ critique has significantly influenced the Macroeconomic theory since 1970s.

Lucas’ critique implies that econometrics using macroeconomic models cannot be applied because it directly assumed certain behavioural relations among macro-economic variables, for checking the impact of alternative policies.

Changes in policies affect the expectations of the economic agents and therefore, the parameters in these behavioural equations can not be assumed to remain unaffected by the changes in the policy environment as a whole.

It is so because the reaction of any individual economic changes does not remain same under different policy regimes.

Micro Foundations: The procedure whereby macro-behaviour of a model is based on micro behaviour is termed as micro foundations.

Rationale behind inclusion of micro foundations:

(a) According to Lucas’ critique, it is necessary to consider how differences in the policy regime influence individual reactions to a particular policy.

It can be done if and only if macro-economic models explicitly make assumptions regarding how individual economic agents take their decisions, how their expectations about the in the economy to determine the values of macro-economic models.

(b) Traditional macro-econometric models contain many behavioural relations between macro economic variables in terms of micro economic behaviour.

For example, William Baumol and James Tobin have used Keynesian demand-for-money functions by building models which explain the demand for transaction balances in the economy.

Similarly, James Tobin used it to explain the demand for speculative balances in the economy.

But it is to be noted that different behavioural equations in a model are not derived explicitly from exactly same set of assumptions.

The consistency between implicit microeconomic assumptions and behavioural relations in the model can be considered only at a superficial level.

Therefore, it is necessary to explicitly derive the behavioural equations in the model from the same set of assumption about the micro-economic foundations.

### (**ii) Real business cycle theory.**

Ans. Real Business Cycle model is technically an explanation of Brock-Mirman Model. They explained, “What happens under uncertainty” and Real Business Cycle explains, “Why does it happen so”. It tried to explain the reasons for fluctuations in economic activity at macro level.

Real Business Cycle model makes two types of propositions:

(a) It says that long-term growth and short-term fluctuations in economic activity are studied separately but for both of them same reasons are responsible.

The theory uses the word fluctuations and not cycles as the latter conveys as if it occurs regularly which might not be true.

(b) The word ‘real’ in the Real Business Cycle Model suggests that this theory like classical economists considers money to be veil and plays down the role of monetary forces.

In their opinion money plays a neutral role and fluctuations are brought about by real factors like investment, demand, supply etc.

A distinction is made between RBC and CBC. In real business cycle models fluctuations are generated by shocks and these may not reflect the rhythms of ebb and flow of classical cycles.

New classical business cycle approach is concentrating on fluctuations generated by the familiar pattern of boom and recession, one following the other in a regular succession.

Therefore, the role of money and finance is different. In the RBC model, the shocks referred to are changes in technology and tastes. Money is a veil. But in CBC model, money and finance are part of the model of expansion and contraction.

IGNOU MEC 106 Solved Free Assignment 2023-24