Macro Economics

Assignment No. 01 Macro Economics Question No. 1 Explain different methods of measurement of National Income. The national income accounts are an interlocking set of statistics on a national economy’s consumption, production, and asset accumulation. National income accounts have two roles: the measurement of economic activity and the measurement of economic well-being, or progress. In an important sense, these two roles are one, as economic activity derives its rationale from its social benefit. According to A.C. Pigou (1938), whose work set forth the basic framework for welfare analysis in economics, the national income is a measure of the part of national welfare that can be “brought directly or indirectly into relation with a money measure.” Pigou’s definition is limited to those elements of welfare that can be measured by money, but it does not draw a fixed line between what can and cannot be measured. In practice, that boundary has evolved over time. The limited but highly practical achievement of this measurement task has been one of the great accomplishments of economics and supports the claim that economics is an empirical science. A nation’s national income accounts have grown to include analytical detail on consumption, production, income, and foreign trade, as well as statistics on saving and investment and their relation to stocks of physical capital and financial assets and liabilities. These statistics are central to economic and political evaluation and planning throughout the world. In accepting the measuring rod of money, we accept limitations on our welfare measure both in concept and in scope. The measure is largely plutocratic, as wealthy households command more consumption than poor ones. As such, it is a measure that is comfortable with the existing structures of economic power. As the American economist and 1971 Nobel laureate Simon Kuznets stressed, changes in income distribution across households should be a crucial component of the evaluation of national income, but as of 2006, income distribution has not been included in national income accounts. Monetized activity sets the general boundary for national income measurement. Household production – the use of household time and energy in tasks such as studying, cooking, and cleaning – is generally not included in consumption because it is unpriced. One exception is that owner-occupied housing is treated as if the household were renting from itself; otherwise, the shift from tenancy to owner occupation in many countries

would appear as a decline in consumption of shelter services. Another exception, important in many countries, is owner-consumption of farm products. Production has two objects: consumption and accumulation. We turn first to consumption expenditures, which form the core of measured welfare benefits. Consumption comparisons over time. As prices and money, or nominal expenditures, change, is it possible to quantify how much consumers are better off in one period compared to another? Within limits, yes. In two periods, the consumer buys two different baskets of goods and services. Now suppose the items bought in the first period could have been purchased in the second period for less than the items already purchased in the second period. Then we can argue that the consumer must be better off, for the alternative was freely chosen. If the consumer pays 2 percent more than the first period 6 basket would have cost, real consumption expenditures are said to have risen by (at least) 2 percent. While this does not amount to 2 percent more happiness, it does imply that we could have remained as well off using 2 percent less products and 2 percent less work and capital (assuming constant returns to scale), so it is a meaningful quantification. To consumption, we now add investment. To capture overall economic progress, the rate of net investment – gross investment less loss of existing capital due to depreciation, called capital consumption — provides an idea of how much more production could have been devoted to consumption without running down the capital stock and, at the same time, of how rapidly the economy is likely to grow, since more net investment today implies more capital input for tomorrow’s production. Mainly for historical reasons, gross domestic product (GDP, product without deducting capital consumption) has been the featured measure of real economic activity. Consumption of fixed capital is about 10 percent of net domestic product in countries as different as the US and India. Net domestic product, GDP less capital consumption, would be more exact as a measure of progress, but GDP is easier to measure in detail. One way to measure real investment in terms comparable to real consumption could be to deflate nominal investment growth by the consumption inflation rate, a measure showing the quantity of consumption that is given up to provide investment. The alternative, the method actually employed in national income accounting, is to measure the change in prices of these investment goods themselves, combining them into Fisher ideal indexes. This measure is the appropriate one for measuring the contribution of the new investment to the stock of capita assets.

Question No. 2 Part (a) •

Explain the Inflationary and Deflationary Gaps with examples.

• Deflationary and Inflationary Gaps: •

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When the equilibrium level of output is less than the natural rate, as shown below, a Deflationary GAP exists. In the figure, the equilibrium level of output, Y, is less than the natural level of output, Yn. A deflationary gap calls for an Expansionary Fiscal Policy, such as an increase in government spending or reduction in taxes, or an Expansionary Monetary Policy. Such an expansionary policy shifts the AD curve to the right and increases the equilibrium level of real GDP. When the equilibrium level of output is greater than the natural rate, an Inflationary GAP exists. This is illustrated above, where the equilibrium level of output, Y, exceeds the natural level of output, Yn. When the economy experiences an inflationary gap, a Concretionary Fiscal Policy, such as a decrease in government spending or increase in taxes, or a Concretionary Monetary Policy is appropriate. These policies shift the AD curve to the left.

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If the economy is in a deflationary gap then price expectations of workers are higher than actual prices. Eventually price expectations will be revised downward. This will shift short-run AS to the right and bring the economy back to potential GNP.

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f the economy is in an inflationary gap then price expectations are lower than the actual price level. Eventually price expectations will be revised upward. This will shift short-run AS back to the left, resulting in a higher price level as the economy returns to potential GDP.

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If expansionary fiscal policy is not anticipated then real GDP would be increased and the price level would rise. If expansionary policy is fully anticipated then the price level would rise even further but real GDP would remain unchanged.

Question No. 2 Part (b) What are the determinants of investment? Explain briefly. Investment is influenced by demand conditions, the effects of which (including profitability) can be represented by the accelerator effect, and cost conditions, as summarized by the user cost of capital. Researchers have found that another independent determinant of investment behavior is liquidity—the liquid assets a company has on hand plus the cash flow it is currently generating. While the user cost of capital varies with the cost of funds in credit markets or to firms issuing equity, many firms are limited in their access to these markets. Because they must rely primarily on internal funds to finance investment, liquidity matters. The liquidity constraint seems particularly to affect smaller corporations and (along with accelerator effects) helps explain investment volatility, because cash flow itself (after-tax profits plus book depreciation) is very cyclical. Liquidity also plays an important role in residential investment. About two-thirds of all residential investment takes the form of owner-occupied housing. The reliance of home buyers on the mortgage market has wrought havoc on residential construction during periods of tight credit that typically have accompanied recessions. As a result residential investment has often been even more cyclical than other forms of fixed investment. However, the reliance on borrowed money has, in certain periods, actually encouraged investment in owner-occupied housing, through the interaction of inflation and the tax system. Inflation encourages housing investment in two ways. First, mortgage interest payments are tax deductible. As interest rates rise with inflation, so do tax deductions, even if the real interest rate, defined as the interest rate less the inflation rate, does not. For example, if the interest rate is 8 percent and the inflation rate 4 percent, the real interest rate is 4 percent, and an investor in the 28 percent tax bracket gains a tax reduction of 2.24 cents (28 percent of 8 percent) per dollar of debt. If the real interest rate remains at 4 percent, but the inflation rate rises to 8 percent, the

nominal interest rate rises to 12 percent and the value of tax deductions rises to 3.36 cents (28 percent of 12 percent) per dollar of debt. Second, the increased value of a home that accompanies inflation is essentially untaxed, because of provisions that allow a tax-free rollover if another house is purchased and a one-time exclusion of gain (currently $125,000) after age 55. [Editor's note: this provision of the tax code changed dramatically in 1997.] This favors investment in owneroccupied housing over other types of investment with taxable gains. Another disadvantage of other types of fixed investment is that the depreciation allowances that investors receive are based on original asset cost, which may fall well short of true replacement cost in the presence of inflation. (This is not a problem faced by owner-occupiers, who do not receive depreciation allowances.) The evidence in favor of the hypothesis of inflation-induced investment in owner-occupied housing comes primarily from the late seventies, when the hypothesis arose. During the economic expansion from 1976 to 1979, when inflation averaged 7.3 percent (measured using the GNP deflator, based on the prices of all goods and services included in GNP), investment in owner-occupied housing accounted for 33.5 percent of fixed investment. During the comparable expansion period of 1983 to 1986 with inflation averaging just 3.3 percent, residential investment's share fell to 29.1 percent. An alternative explanation, for which there is evidence, is that the increase in housing investment in the late seventies was caused by the increase in family formation during the period—the coming of age of the baby boomers. If this explanation is correct, then housing prices and demand are likely to decline into the next century, well past the housing slump of the 1990-91 recessions.

Question No. 3 What are the effects of government spending taxation on output of a country? Export Tax Effects on: Exporting Country Consumers - Consumers of the product in the exporting country experience an increase in well-being as a result of the export tax. The decrease in their domestic price raises the amount of consumer surplus in the market. Refer to the Table and Figure to see how the magnitude of the change in consumer surplus is represented. Exporting Country Producers - Producers in the exporting country experience a decrease in well-being as a result of the tax. The decrease in the price of their product in their own market decreases producer surplus in the industry. The price decline also induces a decrease in output, a decrease in employment, and a decrease in profit and/or payments to fixed costs. Refer to the Table and Figure to see how the magnitude of the change in producer surplus is represented. Exporting Country Government - The government receives tax revenue as a result of the export tax. Who benefits from the revenue depends on how the government spends it. Typically the revenue is simply included as part of the general funds collected by the government from various sources. In this case it is impossible to identify precisely who benefits. However, these funds help support many government spending programs which presumably help either most people in the country, as is the case with public goods, or is targeted at certain worthy groups. Thus, someone within the country is the likely recipient of these benefits. Refer to the Table and Figure to see how the magnitude of the tariff revenue is represented. Exporting Country - The aggregate welfare effect for the country is found by summing the gains and losses to consumers and producers. The net effect consists of three components: a positive term of trade effect (c), a negative consumption distortion (f), and a negative production distortion (h). Refer to the Table and Figure to see how the magnitude of the change in national welfare is represented. Effects of an Export Tax Importing Country Exporting Country Consumer Surplus - (A + B + C + D) +e Producer Surplus +A - (e + f + g + h) Govt. Revenue 0 + (c + g) National Welfare - (B + C + D) + c - (f + h) World Welfare - (B + D) - (f + h)

Because there are both positive and negative elements, the net national welfare effect can be either positive or negative. The interesting result, however, is that it can be positive. This means that an export tax implemented by a "large" exporting country may raise national welfare. Generally speaking, 1) Whenever a "large" country implements a small export tax, it will raise national welfare. 2) if the tax is set too high, national welfare will fall and 3) There will be a positive optimal export tax that will maximize national welfare. However, it is also important to note that everyone's welfare does not rise when there is an increase in national welfare. Instead there is a redistribution of income. Producers of the product and recipients of government spending will benefit, but consumers will lose. A national welfare increase, then, means that the sum of the gains exceeds the sum of the losses across all individuals in the economy. Economists generally argue that, in this case, compensation from winners to losers can potentially alleviate the redistribution problem. Export Tax Effects on: Importing Country Consumers - Consumers of the product in the importing country suffer a reduction in well-being as a result of the export tax. The increase in the price of both imported goods and the domestic substitutes reduces the amount of consumer surplus in the market. Refer to the Table and Figure to see how the magnitude of the change in consumer surplus is represented. Importing Country Producers - Producers in the importing country experience an increase in well-being as a result of the export tax. The increase in the price of their product on the domestic market increases producer surplus in the industry. The price increase also induces an increase in output of existing firms (and perhaps the addition of new firms), an increase in employment, and an increase in profit and/or payments to fixed costs. Refer to the Table and Figure to see how the magnitude of the change in producer surplus is represented. Importing Country Government - There is no effect on the importing country government revenue as a result of the exporter's tax. Importing Country - The aggregate welfare effect for the country is found by summing the gains and losses to consumers, producers and the government. The net effect consists of three components: a negative term of trade effect (C), a negative production distortion (B), and a negative consumption distortion (D). Refer to the Table and Figure to see how the magnitude of the change in national welfare is represented.

Since all three components are negative, the export tax must result in a reduction in national welfare for the importing country. However, it is important to note that a redistribution of income occurs, i.e., some groups gain while others lose. In this case the sum of the losses exceeds the sum of the gains. Export Tax Effects on: World Welfare - The effect on world welfare is found by summing the national welfare effects in The importing and exporting countries. By noting that the terms of trade gain to the exporter is equal to the terms of trade loss to the importer, the world welfare effect reduces to four components: the importer's negative production distortion (B), the importer's negative consumption distortion (D), the exporter's negative consumption distortion (f), and the exporter's negative production distortion (h). Since each of these is negative, the world welfare effect of the export tax is negative. The sum of the losses in the world exceeds the sum of the gains. In other words, we can say that an export tax results in a reduction in world production and consumption efficiency.

Question No. 4 Part (a) Public and Private Finance. Public Finance: “Public finance (government finance) is the field of economics that deals with budgeting the revenues and expenditures of a public sector entity, usually government.” Matters addressed by the subject include: • Effects of government spending, taxation, and borrowing on households, businesses, and the economy • rules that should apply to the conduct of such activity tax incidence (who really pays a particular tax) • Voluntary exchange vs. government-mandated provision of goods and services • Cost-benefit analysis of government activity • The role of government in affecting income distribution through taxes, government spending on goods, and transfer payments

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Efficiency of spending - how efficient are governments at obtaining their objectives? How much of their expenditure actually goes to where it is intended? what types of waste exist? Efficiency and distribution effects of different kinds of taxes (for example, on income or consumption) Scope of government activities - what do governments spend money on? what should governments spend money on? What can be left to markets? Why governments should be concerned with externalities, public goods Fiscal politics, modeling public spending and taxation as affected by interactions of self-interested voters, politicians, and bureaucrats.

Question No. 4 Part (b) Aggregate Demand: Aggregate demand is the total demand for final goods and services in the economy (Y) at a given time and price level[1]. This is the demand for the gross domestic product of a country when inventory levels are static. It is often called effective demand or abbreviated as 'AD'. In a general aggregate supply-demand chart, the aggregate demand curve (AD) slopes downward (indicating that higher outputs are demanded at lower price levels). Components: Yd = C +I + G ( X – M ) Where •

C is consumption = ac + bc*(Y - T),

• I is Investment, • G is Government spending, • X – M is Net export, • X is total exports, and • M is total imports = am + bm*(Y - T),. These four major parts can be stated in either 'nominal' or 'real' terms are: • • • •

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Personal consumption expenditures (C) or "consumption," demand by households and unattached individuals; its determination is described by the consumption function. The consumption function is C= a + (mpc)(Y-T) A is autonomous consumption, mpc is the marginal propensity to consume, (Y-T) is the disposable income. Gross private domestic investment (I), such as spending by business firms on factory construction. This includes all private sectors spending aimed as the production of some future consumable. In Keynesian economics, not all of gross private domestic investment counts as part of aggregate demand. Much or most of the investment in inventories can be due to a short-fall in demand (unplanned inventory accumulation or "general over-production"). The Keynesian model forecasts a decrease in national output and income when there is unplanned investment. (Inventory accumulation would correspond to an excess supply of products; in the National Income and Product Accounts, it is treated as a purchase by its producer.) Thus, only the planned or intended or desired part of investment (Ip) is counted as part of aggregate demand. (So, I does not include the 'investment' in running up or depleting inventory levels.) Investment is affected by the output and the interest rate (i). Consequently, we can write it as I(Y,i). Investment has positive relationship with the output and negative relationship with the interest rate. For example, when Y goes up, the investment will increase. Gross government investment and consumption expenditures (G). Net exports (NX and sometimes (X-M)), i.e., net demand by the rest of the world for the country's output.

In sum, for a single country at a given time, aggregate demand (D or AD) = C + Ip + G + (X-M). These macro variables are constructed from varying types of micro variables from the price of each, so these variables are denominated in (real or nominal) currency terms.

Question No. 5 Part (a) Define Money and explain the functions of Money. We say traditionally that money has four major functions. It is a Medium of exchange: Whatever people usually give in exchange for the things that they buy is the medium of exchange. As we have seen, this is the function that defines money. Unit of account: The unit of account is the unit in which values are stated, recorded and settled. The differences between this and the medium of exchange may seem subtle, but there are a few cases in which the unit of account is different from the unit in which the medium of

exchange is expressed. In Britain a few decades ago, Guineas were often used as the unit of account, while the medium of exchange was expressed in Pounds. Both Guineas and Pounds in turn could be expressed in shillings -- the Pound was 20 shillings and the Guinea was 21 shillings. (British currency has since been redefined). Standard of deferred payment: This is the unit in which debt contracts are stated. Deferred payment means a payment made in the future, not now. Here, again, it is usually the same as the medium of exchange, but not always. During periods of inflation, people may accept paper money for immediate payment, but insist on some other medium, such as real goods and services or gold, for deferred payment -- because the medium of exchange would lose much of its value in the meanwhile. Store of value: Again, this is something that people keep in order to maintain the value of their wealth. Again, while it would usually be the same as the medium of exchange, in inflationary times other media might be substituted, such as jewelry, land or collectable goods. In this sense, money is "set aside" for the future.

Question No. 5 Part (b) Briefly discuss the functions of State Bank of Pakistan. REGULATION OF LIQUIDITY: Being the Central Bank of the country, State Bank of Pakistan has been entrusted with the responsibility to formulate and conduct monetary and credit policy in a manner consistent with the Government’s targets for growth and inflation and the recommendations of the Monetary and Fiscal Policies Co-ordination Board with respect to macro-economic policy objectives. The basic objective underlying its functions is two-fold i.e. the maintenance of monetary stability, thereby leading towards the stability in the domestic prices, as well as the promotion of economic growth. REGULATION AND SUPERVISION:

One of the fundamental responsibilities of the State Bank is regulation and supervision of the financial system to ensure its soundness and stability as well as to protect the interests of depositors. The rapid advancement in information technology, together with growing complexities of modern banking operations, has made the supervisory role more difficult and challenging. The institutional complexity is increasing, technical sophistication is improving and technical base of banking activities is expanding. All this requires the State Bank for endeavoring hard to keep pace with the fast-changing financial landscape of the country. Accordingly, the out dated inspection techniques have been replaced with the new ones to have better inspection and supervision of the financial institutions. The banking activities are now being monitored through a system of ‘off-site’ surveillance and ‘on-site’ inspection and supervision. Off-site surveillance is conducted by the State Bank through regular checking of various returns regularly received from the different banks. On other hand, on-site inspection is undertaken by the State Bank in the premises of the concerned banks when required. EXCHANGE RATE MANAGEMENT AND BALANCE OF PAYMENTS: The Bank is responsible to keep the exchange rate of the rupee at an appropriate level and prevent it from wide fluctuations in order to maintain competitiveness of our exports and maintain stability in the foreign exchange market. To achieve the objective, various exchange policies have been adopted from time to time keeping in view the prevailing circumstances. Pak-rupee remained linked to Pound Sterling till September, 1971 and subsequently to U.S. Dollar. However, it was decided to adopt the managed floating exchange rate system w.e.f. January 8, 1982 under which the value of the rupee was determined on daily basis, with reference to a basket of currencies of Pakistan’s major trading partners and competitors. Adjustments were made in its value as and when the circumstances so warranted. During the course of time, an important development took place when Pakistan accepted obligations of Article-VIII, Section 2, 3 and 4 of the IMF Articles of Agreement, thereby making the Pak-rupee convertible for current international transactions with effect from July 1, 1994. DEVELOPMENTAL ROLE OF STATE BANK: The responsibility of a Central Bank in a developing country goes well beyond the regulatory duties of managing the monetary policy in order to achieve the macroeconomic goals. This role covers not only the development of important components of monetary and capital markets but also to assist the process of economic growth and promote the fuller utilization87 of a country’s resources.