IGNOU MEC 02 Free Solved Assignment 2022- Helpfirst

MEC 02


MEC 02 Free Solved Assignment

MEC 02 Free Solved Assignment Jan 2022

Q1. What is meant by steady state in the Solow model? Explain how Golden Rule is different from steady state.

Ans. A steady state is a situation in which the economy’s output per worker, consumption per worker, and capital stock per worker are constant that is, in the steady state; output, consumption, and capital do not change over time.

According to the Solow model, investment per unit of effective labour equals saving per unit of effective labour.

i= sy

Since y = f(k) we can write equation (1)


The above shows the relationship between existing capital stock (k) and accumulation of new capital (i) expressed in ‘per effective labour’ term.

As we know, increase in capital stock is due to investment. Thus, the difference between capital stock in two successive years is equal to investment that has taken place during the year. In other words, the rate of /growth capital stock is equal to the rate of investment.

In per effective labour term, we can express (2) as k=sf(k) where k refers to the growth rate in k (In general we put a dot over a variable to represent its growth rate).

The above equilibrium condition is true for an economy where there is no depreciation to capital stock, there is no population growth and technological progress does not take place.

Growth of Capital and Steady State The Solow model assumes that existing capital depreciates at the rate Thus, each year amount of capital is depreciated.

Investment and depreciation act in opposite directions and the growth in capital stock is net of the two quantities. MEC 02 Free Solved Assignment

since i=sf(k(t))

k(t)=sf(k(t)) – sk(t)

MEC 02 Free Solved Assignment

From equation (4) we infer that capital stock rises when remains constant when falls when sfk(t))<8k(t) and sf(k(t)) = 8k(t).

MEC 02 Free Solved Assignment

The two curves, saving and depreciation curves, intersect at point X, where capital stock is ki and depreciation equals investment.

At this point there is no growth in capital stock hence, output also remains steady, k* is therefore known as the steady state level of capital.

There are two unique features of the steady state: (i) economy in steady state will remain, until there is change in any other variable, and (ii) economy will always move towards the steady state.

For example, if the economy starts at level of capital, where k1 <k*, investment exceeds depreciation. As a result, capital stock k1, along with output f(K) rises till k reaches k.

On the other hand, if the economy starts at k2, level of capital, which is greater than k, investment is less than depreciation. MEC 02 Free Solved Assignment

Consequently, there is a decline in capital stock and output in the economy until steady state capital, that is, k is reached.

Once the economy attains the steady state there is no pressure on k to increase or decrease hence, the economy stays there. Thus, the Solow model does not explain sustained economic growth.

An economy with a high saving rate will have higher level of output and capital as compared to a country with low rate of saving.

Thus, saving rate is an important determinant of an economy’s output and capital Saving rate may vary across countries due to plethora of reasons like development of financial markets, tax policy, cultural differences, retirement policies, political stability and political institutions Population Growth and Steady State To analyse the effect of population growth we expand the Solow model.

We now consider the case where population and the labour force grow at a constant rate n. When labour force grows, additional capital is required to maintain the same level of k.

Hence, the economy should have adequate investments to take care depreciation (8k) as well as population growth (nk). In order to introduce n we modify equation (4) as

k (t) =sf(k(t))-(n+8)k(t)

For steady state the amount of investment required must not only cover depreciation (Ok) but also provide new workers with capital (nk).

Break-even investment now would be (n+8)k. The steady sate is achieved at the point of intersection of investment and (n+8)k curves. The line ok in Fig. 2.4 accordingly is adjusted to represent MEC 02 Free Solved Assignment

The steady state is reached in a similar manner. If k1 < k* investment is greater then break even investment so k and y rise. on the other hand k2 > k*, k declines till is reaches k*.

Population growth succeeds in explaining sustained economic growth in an economy. In this framework, however, output per effective labour remains unchanged.

Q2. Explain how the permanent income hypothesis reconciles the difference between short-run and long-run consumption behavior.

Ans. Nobel Prize winner economist Friedman Milton suggested a theory of permanent income hypothesis or theory of consumption.

His theory explains consumer behaviour. Friedman classified the current income Y into two parts Permanent Income Yp and Transitory Income Yt . Thus,

Y = Yp +Yt

Permanent income is that part of income which is certain, i.e. there is no doubt about occurring of this income in future while transitory income is subject to contingency or its occurrence is doubtful.

Friedman says that permanent income is expected but temporary income is not expected by consumers.MEC 02 Free Solved Assignment

For example, if a person is a Chartered Accountant, Advocate, Doctor, Engineer, etc., he or she will earn higher permanent income but think about a farmer whose income depends upon the harvest production, which in turn depends upon weather conditions.

MEC 02 Free Solved Assignment
MEC 02 Free Solved Assignment

If weather conditions go good, then the farmer will get income and in case of opposite weather conditions, he may lose too. Hence, his income is regarded as transitory income.

Friedman argues that consumption depends mainly on permanent income because consumers use saving and borrowing to smooth consumption in response to transitory income.

Mankiw says in this regard, i.e. if a person received a permanent raise of $10000 per year, his consumption would rise by about as much.

Yet if a person won $10000 in a lottery, he would not consume it all in one year. Instead, he would spread the extra consumption over the rest of his life.

Assuming an interest rate of zero and a remaining life span of 50 years, consumption would rise by only $200 per year in response to the $10000 prize.

Thus, consumers spend their permanent income, but they save rather than spend most of their transitory income.MEC 02 Free Solved Assignment

Hence, on the basis of above discussion it can be concluded that Friedman’s consumption mainly depends upon permanent income and this is denoted as follows:


Where, a measures the part of permanent income consumed.

The implication of permanent income hypothesis is that since Keynesian consumption depends upon disposable income while Friedman’s consumption depends upon permanent income, hence, Keynesian consumption function includes a wrong variable.

However, empirical studies show that consumption depends upon current income. Friedman argued that this error in variables problem explains the seemingly contradictory findings.

Average propensity to consume of Friedman consumption function is defined as follows:

APC=C=aYP=aYP MEC 02 Free Solved Assignment

It is clear from the above equation that APC depends upon the ratio of permanent income and current income. When current income increases temporarily above permanent income, then APC falls temporarily or vice versa.

                               Section B 

Q3. Policy makers should stick to rules instead of pursuing discretionary polices. Do you agree with the above statement? Substantiate your answer

Ans. Mankiw says in this regard that there has been a debate among economists is whether economic policy should be conducted by rule or by discretion Policy is said to be conducted by rule if policy-makers announce in advance how policy will respond to various situations and commit themselves to following through on this announcement

Policy is conducted by discretion if policy-makers are free to size up events as they occur and choose whatever policy seems appropriate at the time.

Policy run by rule

Mankiw states that some economists believe that economic policy is too important to be left to the discretion of policymakers.

Although this view is more political than economic, evaluating it is central to how we judge the role of economic policy. MEC 02 Free Solved Assignment

If politicians are incompetent or opportunistic, then we may not want to give them the discretion to use powerful tools of monetary and fiscal policy. Incompetency in economic policy arises for several reasons.

Some economists view the political process as erratic, perhaps because it reflects the shifting power of special interest groups.

In addition, macroeconomics is complicated and politicians often do not have sufficient knowledge of it to make informed judgements.

This ignorance allows charlatans to propose incorrect but superficially appealing solutions to complex problems.

The political process often cannot weed out the advice of charlatans from that of competent economists.

Opportunism in economic policy arises when the objectives of policymakers conflict with the well being of the public.

Some economists fear that politicians use macroeconomic policy to further their own electoral ends. MEC 02 Free Solved Assignment

If citizens vote on the basis of economic conditions prevailing at the time of the election, then politicians have an incentive to pursue policies that will make the economy look good during election years.

A president might cause a recession soon after coming into force to lower inflation and then stimulate the economy as the next election approaches to lower unemployment; this would ensure that both inflation and unemployment are low on election day.

Manipulation of the economy for electoral gain, called the political business cycle, has been the subject of extensive research by economists and political scientists.

Distrust of the political process leads some economists to advocate placing economic policy outside the realm of politics.

Some have proposed constitutional amendments such as a balanced budget amendment that would tie the hands of legislators and insulate the economy from both incompetence and opportunism.

MEC 02 Free Solved Assignment
MEC 02 Free Solved Assignment

Q4. Explain in brief the salient features of real business cycle theory. In what respects is it different from other theories of business cycle?

Ans. Real business cycle theory also known as RBC theory explains macroeconomic instability. The theory states that instability in an economy is a result of real factors affecting aggregate supply instead of monetary or spending factors affecting aggregate demand.

In other words, this theory argues that business cycles arise owing to real factors disturbing aggregate supply not factors disturbing aggregate demand.

According to the theory, changes in technology and resources available are responsible for business cycles or instability. Such changes in technology and resources affect productivity and productivity affects aggregate supply. MEC 02 Free Solved Assignment

Suppose, prices of oil increases significantly due to any reason like creation of cartel such as OPEC, then operating certain types of machinery becomes very expensive, raw materials become much expensive due to hike in transport costs, etc.

Due to increase in the expenses output per worker, i.e. productivity in an economy declines and it causes long-run aggregate supply to fall.

This fall in aggregate supply has been shown in the figure as leftward shift from AS1, to AS2, As real output falls from Y1, to Y2, then people do not demand as much money to buy the reduced goods and services.

So the demand for money falls. In addition to it, decrease in output/slow down in business activity will force producers/firms to decrease business borrowings and it causes deposits to fall.

As a result money supply also falls. Reduction in money supply pushes aggregate demand curve to leftward from AD1, to AD2, with no change in the price level.

On contrary to it, suppose there is an innovation of technology/discovery of new resources resulting increase in productivity, therefore, increase in aggregate supply.

Increase in aggregate supply or output will cause the demand for money to buy increased goods and services. MEC 02 Free Solved Assignment

Apart, business firms would borrow money from banks and therefore increase in deposits from public and it will cause money supply to increase and therefore increase in aggregate demand.

MEC 02 Free Solved Assignment
MEC 02 Free Solved Assignment

The new classical business cycle theory has the following tenets/postulations.

. Economy is affected by aggregate demand and aggregate supply shocks.

The advocates of the new classical business cycle theory argue that fluctuations in an economy are result of demand and supply shocks. Generally, unanticipated changes in monetary and fiscal policies lead aggregate demand shocks.

While unanticipated changes in raw material prices, natural crisis, significant changes in technology, etc. cause aggregate supply shocks.

Such shocks may be positive as well as negative. Positive aggregate demand shocks affects demand favourably or vice-versa. MEC 02 Free Solved Assignment

Similar the case of aggregate supply shocks is. Firms or producers produce more and pay more their workers when they face positive shocks and opposite happens in case of negative shocks.

Q5. Explain why firms may offer a higher wage to workers than the equilibrium wage rate.

Ans. Efficiency Wage Model/Theory of unemployment The efficiency wage model or theory states that if workers are paid keeping in mind their efficiency and such efficiency wage is greater than market wage rate, then there would be no unemployment.

We know that equilibrium wage rate is set when demand for labour (DL) is equal to labour supply (SL). this wage rate is W* and employment level is L.

Suppose, firms like to pay w wage rate instead of w, then you can see easily that there is excess supply of labour and it will result in unemployment equal to Ls to Ld

Now, a natural question arises, i.e. why do firms like to pay W instead of W*? The answer of this question lies in the following reasons.

. When firms feel that effort level of workers cannot be supervised easily or perfectly, then they may like to pay higher wages so that workers do not shirk from the work. Thus, to reduce the quantum of shirking of workers firms would like to pay higher wages.

. It is possible that W* is too low that workers cannot afford nutritional or good quality food due to which their efficiency/productivity will be affected adversely. Thus, to maintain good health of the workers firms may pay higher wages.

. To reduce labour turnover. If firms pay more than W, then it will increase opportunity cost of quitting jobs. Hence, workers would not like to quit jobs if they are getting W in a firm because they know that other will pay W*. MEC 02 Free Solved Assignment

. To insert sense of belonging in the minds of workers, firms pay higher wages.

. To increase motivation of workers for increase in productivity and efficiency.

Q6. Bring out the important issues on which Lucas criticizes Keynesian macroeconomics. To what extent the New-Keynesian economists have accepted these criticisms?

Ans. In an interview Lucas said the following words:

“I think Keynes’s actual influence as a technical economist is pretty close to zero and it has been close to zero for 50 years.

Keynes was not a very good technical economist. He did not contribute much to the development of the field.

Keynes’ influence was more political, is more an image of what sort of things an economist should be doing and what kind of life an economist should live.”

Lucas argued that Keynesian economics required remarkably foolish and short-sighted behaviour from people, which totally contradicted the economic understanding of their behaviour at a micro-level. MEC 02 Free Solved Assignment

In the view of Lucas Keynesian orthodoxy has turned redundant not only from economic policy point of view but also from theoretical and methodological points of view. Here are the following criticisms of Keynesian theory brought by Lucas:

. Ignorance of equilibrium discipline: Lucas criticised Keynesian economics by saying that Keynes discarded equilibrium discipline.

Lucas had opinion that every economist should abide by this equilibrium disciple while structuring a theory. In fact, equilibrium disciple has two postulations i) that agents act in their own self interest and ii) that markets clear.

According to Lucas by betraying this equilibrium discipline, Keynes gave an example of bad social science: an attempt to explain important aspects of human behaviour without reference either to what people like or what they are capable of doing.

. Phillips curve controversy: Keynesians defended the stable Phillips curve allowing for a trade-off between inflation and unemployment.

Lucas criticised this. He said there is no trade-off between inflation and unemployment even in short-run if rational expectation hypothesis is assumed. Keynesians believed on adaptive hypothesis.

. Lucas critique: Nobel Prize winner economist Robert Emerson Lucas Jr. states that there are many issues or topics in Economics about which the knowledge of economists is either limited or zero. MEC 02 Free Solved Assignment

Economists cannot be completely confident while assessing the effects of alternative policies. Therefore, economists should exercise a big caution when evaluating or assessing a policy and giving advice.

Lucas’ focus revolves around expectations made by people. He says that expectations play crucial role in economic behaviour of economic agents.

For example: Firms invest keeping in view the expected profitability and consumers spend keeping in view their expected income.

Therefore, policymakers should give a great weightage to the expectation made by people in response to a given policy.

Lucas states that traditional methods of policy evaluation do not adequately consider this impact of policy on expectations. He criticised such traditional methods and his criticism got famous as Lucas critique. MEC 02 Free Solved Assignment

The sacrifice ratio is one of the best examples of Lucas critique. Sacrifice ratio means how many per cent GDP will decline if inflation is to be reduced by one per cent.

Sacrifice ratio measures the cost of reducing inflation. Since, the measures of sacrifice ratio are large, hence, some economists argue that policy-makers should learn to live inflation instead of incurring large cost of reducing it.

However, the supporters of rational expectation hypothesis argue that data of sacrifice ratio are not reliable because they are subject to Lucas critique.

This is so because such data are based upon adaptive expectation approach, i.e. people expect a variable on the basis of its past trend.

Although, adaptive expectation may be suitable in some circumstances, yet if the policymakers make a credible change in a policy, workers and firms setting wages and prices will rationally respond by adjusting their expectations of inflation appropriately.

This change in inflation expectations will quickly alter the short-run trade-off between inflation and unemployment.

As a result, reducing inflation can potentially be much less costly than appears in data in sacrifice ratio.

Lucas writes in his”Econometric policy evaluation: A critique” Carnegie-Rochester Conference Series on Public Policy that”Given that the structure of an econometric model consists of optimal decision rules of economic agents, and that optimal decision rules vary systematically with changes in the structure of series relevant to the decision-maker,

it follows that any change in policy will systematically alter the structure of econometric models.” MEC 02 Free Solved Assignment

Expectations played a major role in Keynes’ theory of the determination of aggregate output and employment in market economies in the short-run. Expectations about future yields on investment projects underlie ‘the marginal efficiency of capital’ schedule.

However, the volatile nature of these expectations plays a major role in explaining why investment expenditure and therefore output and employment in market economies are subject to fluctuations.

Q7. Write short notes on the following.

i) Rational expectations and adaptive expectations

Ans:- Differences between Rational expectation and Adaptive expectation

Adaptive Expectations Rational Expectation
. Adaptive expectation means the prediction made on the basis of past trend of the variable concemed..Rational expectations mean the best or optimal prediction made by economic agents on the basis of all the information with them at the time of doing prediction.
. Adaptive expectations are not free of systematic errors..Rational expectations mean the best or optimal prediction made by economic agents on the basis of all the information with them at the time of doing prediction
. Adaptive expectations are not free of systematic errors.. Rational expectations are free of systematic errors. However,random errors may arise.
. Adaptive expectation causes inertia in the one or happened to stop/remove such inertia. Thus,if the unemployment rate is at its natural rate and if there are no supply shocks, the price level will continue to increase at the rate it has been increasing. Rational expectations are free of systematic errors. However,random errors may arise.

ii) Non-accelerating Inflation Rate of Unemployment

Ans. Nobel Prize winner Milton Friedman laid down the concept of vertical Phillips curve in long-run. MEC 02 Free Solved Assignment

According to Milton in long-run Phillips is not downward sloping reflecting inverse/negative relationship between inflation and unemployment rather it is a vertical reflecting no trade-off between inflation and unemployment.

Thus, in the eyes of Milton downward sloping Phillips curve is a short-term phenomenon. Milton reconcile between the downward sloping and short-run Phillips curve as follows.

Natural rate of unemployment/NAIRU :

Milton states that in long-run there is a single rate of unemployment irrespective of rate of inflation. This rate of unemployment is termed by him as natural rate of unemployment.

This natural rate of unemployment is also known as non-accelerating inflation rate of unemployment (NAIRU) because in long-run, according to Milton, inflation rate does not affect or accelerate unemployment, i.e. for every level of inflation there is a constant unemployment

Derivation of Long-run Phillips Curve :

we have three short-run Phillips curve labelled as PC1, PC2, and PC3, showing negative relationship between inflation (i) and unemployment rate (u).

Suppose natural rate of unemployment is u and at this level of unemployment the economy is producing potential output level. Further suppose that, in longrun an economy is in equilibrium at the point E as shown in the figure.

At E, inflation rate is i2, Now, if the government thinks that is very higher and decides to decrease the same, then any expansionary policy (rise in money supply or government expenditure or decrease in tax rate) will increase in inflation only because economy is producing its potential output.

Suppose, due to increase in inflation rate the economy moves from E to F along PC1. You can see that at F unemployment is u which is lower than .

In this way, government’s expansionary policy caused to increase inflation but lower unemployment.

But why unemployment has decreased! This is because in increase in inflation causes real wages to fall and this boosts producers to demand more labour.

However, as soon as this fact of decline in real wages is realised by workers, then they react over it and start to demand higher money wages or real wages causing cost of production to increase. MEC 02 Free Solved Assignment

Consequently, labour demand falls and unemployment increases again. So, then the economy would not be stable at point F and it will move towards point G on PC2, where the unemployment rate is again.

One point should be noted that at G inflation rate has increased to i2


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