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Q 1: Compare the classical and Keynesian views on the speed of wage and price adjustment. What are the important consequences of the difference in their wages?
The classical economy automatically and quickly adjusts during a recession. Prices and wages fall during a recession. That affects profits positively. Production increases and more people are hired. The economy bounces back out of a recession. No government spending or tax reduction (fiscal policy) is necessary to bring economy out of recession. The price mechanism (the invisible hand) works like magic in the classical market economy to rectify economic ills.
In Keynesian economy, prices and wages are sticky downwards. They do not fall during a recession. Economy doesn’t automatically adjust. The result is prolonged unemployment. Government spending and tax reductions (or more generally, fiscal policy) is necessary to stimulate the economy to bring it out of a recession.
Q 2: What are the various fiscal measures the Government of India has taken recently to increase the level of aggregate demand in the economy? Support your answer with relevant examples.
Fiscal policy is the use of government expenditure and revenue collection to influence the economy. The three possible stances of fiscal policy are neutral, expansionary, and contractionary:
a). A neutral stance of fiscal policy implies a balanced budget where G = T (Government spending = Tax revenue). Government spending is fully funded by tax revenue and overall the budget outcome has a neutral effect on the level of economic activity.
b). An expansionary stance of fiscal policy involves a net increase in government spending (G > T) through rises in government spending, a fall in taxation revenue, or a combination of the two. Expansionary fiscal policy is usually associated with a budget deficit.
c). A contractionary fiscal policy (G < T) occurs when net government spending is reduced either through higher taxation revenue, reduced government spending, or a combination of the two. Contractionary fiscal policy is usually associated with a surplus.
Following are the fiscal measures taken recently to increase the level of aggregate demand:-
1. Government spending on publicly provided goods and services including public and merit goods. Transfer payments in the form of social security benefits (pensions, job-seekers allowance etc.) are not included as they are not a payment to a factor of production for output produced. A substantial increase in government spending would be classified as an expansionary fiscal policy.
2. A change in one of the components of aggregate demand will cause a shift in the aggregate demand curve. For example there might be an increase in export demand causing an injection of foreign demand into the domestic economy. The government may also increase its own expenditure and businesses may raise the level of planned capital investment spending.
3. If disposable income increases, consumption will also increase. There are many ways that consumption can be increased. A decrease in taxes would have this effect. Similarly, an increase in income–holding taxes stable–would also have this effect. Finally, an increase in the marginal propensity to consume or an decrease in the savings rate would also increase consumption and hence demand.
4. Government spending tends to change regularly. When government spending increases, regardless of tax policy, aggregate demand increases, thus shifting to the right.
Q 3: Why does aggregate demand curve slope downwards? Give real world examples of three effects that explain the slope of the curve?
The first reason for the downward slope of the aggregate demand curve is Pigou’s wealth effect. The nominal value of money is fixed, but the real value is dependent upon the price level. This is because for a given amount of money, a lower price level provides more purchasing power per unit of currency. When the price level falls, consumers are wealthier, a condition which induces more consumer spending. Thus, a drop in the price level induces consumers to spend more, thereby increasing the aggregate demand.
The second reason for the downward slope of the aggregate demand curve is Keynes’s interest-rate effect. The quantity of money demanded is dependent upon the price level. That is, a high price level means that it takes a relatively large amount of currency to make purchases. Thus, consumers demand large quantities of currency when the price level is high. When the price level is low, consumers demand a relatively small amount of currency because it takes a relatively small amount of currency to make purchases. Thus, consumers keep larger amounts of currency in the bank. As the amount of currency in banks increases, the supply of loans increases. As the supply of loans increases, the cost of loans–that is, the interest rate–decreases. Thus, a low price level induces consumers to save, which in turn drives down the interest rate. A low interest rate increases the demand for investment as the cost of investment falls with the interest rate. Thus, a drop in the price level decreases the interest rate, which increases the demand for investment and thereby increases aggregate demand.
The third reason for the downward slope of the aggregate demand curve is Mundell-Fleming’s exchange-rate effect. As the price level falls the interest rate also tends to fall. When the domestic interest rate is low relative to interest rates available in foreign countries, domestic investors tend to invest in foreign countries where return on investments is higher. As domestic currency flows to foreign countries, the real exchange rate decreases because the international supply of dollars increases. A decrease in the real exchange rate has the effect of increasing net exports because domestic goods and services are relatively cheaper. Finally, an increase in net exports increases aggregate demand, as net exports is a component of aggregate demand. Thus, as the price level drops, interest rates fall, domestic investment in foreign countries increases, the real exchange rate depreciates, net exports increases, and aggregate demand increases.
Q 4: Why is consumption so much stable over the business cycle than investment? In formulating your answer discuss household behaviour as well as business behaviour?
The term business cycle (or economic cycle) refers to economy-wide fluctuations in production or economic activity over several months or years. These fluctuations occur around a long-term growth trend, and typically involve shifts over time between periods of relatively rapid economic growth (expansion or boom), and periods of relative stagnation or decline (contraction or recession).
These fluctuations are often measured using the growth rate of real gross domestic product. Despite being termed cycles, most of these fluctuations in economic activity do not follow a mechanical or predictable periodic pattern.
Business cycles are a type of fluctuation found in the aggregate economic activity of nations that organize their work mainly in business enterprises: a cycle consists of expansions occurring at about the same time in many economic activities, followed by similarly general recessions, contractions, and revivals which merge into the expansion phase of the next cycle; in duration, business cycles vary from more than one year to ten or twelve years; they are not divisible into shorter cycles of similar characteristics with amplitudes approximating their own.
Q 5: List three major economic problems faced by India. What steps the Indian government has taken to overcome these problems?
Poverty is one of the main issues, attracting the attention of sociologists and economists. It indicates a condition in which a person fails to maintain a living standard adequate for a comfortable lifestyle.Though India boasts of a high economic growth, it is shameful that there is still large scale poverty in India. Poverty in India can be defined as a situation when a certain section of people are unable to fulfil their basic needs. India has the world’s largest number of poor people living in a single country.
Steps Taken by Government to Reduce Rural Poverty:
The government of India has been trying its best to remove poverty. Some of the measures which the government has taken to remove rural poverty are:
Small farmer’s development Programme.
Drought area development Programme.
Minimum needs Programme.
National rural employment Programme.
Assurance on employment.
Causes for Urban Poverty.
India as a nation is faced with massive problem of unemployment. Unemployment can be defined as a state of worklessness for a man fit and willing to work. It is a condition of involuntary and not voluntary idleness.
The Government can do many things to try and influence the level of employment. However some policies the govt use can conflict with other policies for example…if the Govt were to spend more on education and training (so increasing the skills of workers) they would have to spend less on other things such as health-care.
They could lower taxes, which in turn will promote companies to grow, which in turn will create jobs, which in turn lowers unemployment.
Contrary to raising taxes, which causes companies to downsize, doesn’t stimulate growth, and does promote higher unemployment.
In conclusion the govt could do any of the following:
Subsidize business investment.
Increase Government spending.
As with many developing nations, corruption is widespread in India. India is ranked 84 out of a 180 countries in Transparency International’s Corruption Perceptions Index, although its score has improved consistently from 2.7 in 2002 to 3.4 in 2008 (Although this may be due to the change in polling that the survey has undergone). Corruption has taken the role of a pervasive aspect of Indian politics and bureaucracy.
1.Right to information act
The Right to Information Act (2005) and equivalent acts in the states, that require government officials to furnish information requested by citizens or face punitive action, computerisation of services and various central and state government acts that established vigilance commissions have considerably reduced corruption or at least have opened up avenues to redress grievances. The 2006 report by Transparency International puts India at the 70th place and states that significant improvements were made by India in reducing corruption.
Bhoomi is a project jointly funded by the Government of India and the Government of Karnataka to digitize the paper land records and create a software mechanism to control changes to the land registry in Karnataka. The project was designed to eliminate the long-standing problem of inefficiency and corruption.
Whistleblowers play a major role in the fight against corruption. India currently does not have a law to protect whistleblowers. However, subsequent to the murder of whistleblower Satyendra Dubey, the Government of India issued an order directing the Central Vigilance Commission to welcome and protect whistleblowers. The latest Administrative Reforms Commission also has suggested encouraging whistleblowing and protecting whistleblowers. However, this protection is not available to whistleblowers working under state governments.
Q 6: Consumption function is an epoch making contribution to the tools of economic analysis analogous to but even more important than Marshall’s discovery of demand function.
Consumption function can be defined as the relationship between consumption and income.
Consumption = f (income) or C = f(y)
Consumption expenditure increases with increase in income. But increase consumption is less than increase in income. Consumption does not increase at the same rate as the income does. It is due to psychological behaviour of the people.
“As the income of people rises, their consumption also rises. But the whole increase in income is not changed into consumption.A part of it is saved.”
In economics, the Hicks-Marshall laws of derived demand assert that, other things equal, the own-wage elasticity of demand for a category of labour is high under the following conditions:
When the price elasticity of demand for the product being produced is high (scale effect). So when final product demand is elastic, an increase in wages will lead to a large change in the quantity of the final product demanded affecting employment greatly.
When other factors of production can be easily substituted for the category of labour (substitution effect).
When the supply of other factors of production is highly elastic (that is, usage of other factors of production can be increased without substantially increasing their prices) (substitution effect). That is, employers cannot easily replace labour as doing so will lead to a large increase in other factor prices making it useless.
Thus, in consumption function we came to know about consumption expenditure. But in Marshall’s discovery we studied about the demand function. So, in economics consumption function is much more better than Marshall’s discovery of demand function.
Q 7: If saving dropped sharply in the economy, what would be likely to happen to investment? Why? Defend your answer with justification.
Investment is an addition to the capital stock. It is the thing that really makes our economy go and grow.Income that is not consumed by immediately buying goods and services is saved.The decision to save is linked directly to the decision to invest. If a nation is to devote a larger share of its production to investment, then it must devote a smaller share to consumption, all other things unchanged. And that requires people to save more. if saving falls below investment, it can lead to a growth of aggregate demand and an economic boom. In the long term if saving falls below investment it eventually reduces investment and detracts from future growth. Future growth is made possible by foregoing present consumption to increase investment.
Investment is affected by the interest rate; the negative relationship between investment and the interest rate is illustrated by the investment demand curve. The position of this curve is affected by expectations, the level of economic activity, the stock of capital, the price of capital, the prices of other factors, technology, and public policy.
Because investment is a component of aggregate demand, a change in investment shifts the aggregate demand curve to the right or left. The amount of the shift will equal the initial change in investment times the multiplier.
In an economy that is closed to the outside world, investment can come only from the forgone consumption-the saving-of private individuals, private firms, or government. In an open economy, however, investment can surge at the same time that a nation’s saving is low because a country can borrow the resources necessary to invest from neighbouring countries.
Q 8: Suppose the government announces it will pay half of any new investment undertaken by firms. How this affect the investment demand curve. Support your answer with example.
A graphical depiction of the negative relation between investment expenditures and the interest rate, based on the marginal efficiency of investment for different capital investment projects. According to question if government pay half of any new investment may be capital investment then it will lead to increase in the investment demand curve.
If we think of the next 15 years, a very substantial portion of the investment in all regulated industries in India is going to come from the private sector. It would be myopic for the government to have a regulator who is conflicted, which reduces the quantum of investment and drive up user charges. It makes more sense for the government to reorganise itself, shifting into the role of the umpire and away from the role of the player. We must move towards a simple and clean solution: government as an umpire and the private sector as players
Changes in business confidence, the costs of capital and demand lead to shifts in the investment demand curve. For example, an increase in export sales overseas might be an increase in the expected rates of return on capital investment and thus an outward shift of the investment demand curve.
Q 9: Suppose the government is currently in a recession. If policy makers take no action,how will the economy change overtime? Explain in words using an aggregate demand and aggregate supply diagram.
The Effect of the Expansionary Monetary Policy on Aggregate Demand:
When interest rates are cut (which is our expansionary monetary policy), aggregate demand (AD) shifts up due to the rise in investment and consumption. The shift up of AD causes us to move along the aggregate supply (AS) curve, causing a rise in both real GDP and the price level. We need to determine the effects of this rise in AD, the price level, and real GDP (output) in each of our two countries.
Recession starts when there is a downward descends from the ‘peak’ which is of a short duration. “It marks the turning period during which the forces that make for contraction finally win over the forces of expansion. Its outward signs are liquidation in the stock market, strain in the banking system and some liquidation of bank loans, and the beginning of the decline of prices.” As a result, profit margins decline further because costs start overtaking prices. Some firms close down. Others reduce production and try to sell out of accumulated stocks. Investment, employment, incomes and demand decline. This process becomes cumulative.
Classics on Saving and Investment.
The classical economists argued that interest rates would fall due to the excess supply of “loanable funds”. The first diagram, adapted from the only graph in The General Theory, shows this process. Assume that fixed investment in capital goods falls from “old I” to “new I”. Second the resulting excess of saving causes interest-rate cuts, abolishing the excess supply: so again we have saving (S) equal to investment. The interest-rate (i) fall prevents that of production and employment.
Keynes had a complex argument against this laissez-faire response. The graph below summarizes his argument, assuming again that fixed investment falls First, saving does not fall much as interest rates fall, since the income and substitution effects of falling rates go in conflicting directions. Second, since planned fixed investment in plant and equipment is mostly based on long-term expectations of future profitability, that spending does not rise much as interest rates fall. So S and I are drawn as steep (inelastic) in the graph. Given the inelasticity of both demand and supply, a large interest-rate fall is needed to close the saving/investment gap. As drawn, this requires a negative interest rate at equilibrium (where the new I line would intersect the old S line). However, this negative interest rate is not necessary to Keynes’s argument.
Keynes on Saving and Investment.
Third, Keynes argued that saving and investment are not the main determinants of interest rates, especially in the short run. Instead, the supply of and the demand for the stock of money determine interest rates in the short run. (This is not drawn in the graph.) Neither changes quickly in response to excessive saving to allow fast interest-rate adjustment.
Finally, a recession undermines the business incentive to engage in fixed investment. With falling incomes and demand for products, the desired demand for factories and equipment (not to mention housing) will fall. This accelerator effect would shift the I line to the left again, a change not shown in the diagram above. This recreates the problem of excessive saving and encourages the recession to continue.
Q 10: According to Keynes full employment is not a normal feature of the economy. What are the various factors suggested by Keynes which are helpful in increasing the level of employment in India.
Achieving full employment, according to the Keynesian system and at least of employment and output has been the central objective of the fiscal or monetary policies or a combination of both will be a more effective total of achieving full employment with stability.
Employment effect of the Fiscal policy:-A cut in tax rates, whereas increase in government expenditure is expected, under normal conditions to generate additional employment. We will therefore explain here the employment and output effect of increase in the government expenditure.
Employment effect of the Monetary policy :- Suppose that government chooses to achieve full level of employment through monetary policy. In that case, it will be required to increase the supply of money so that the curve aggregate shifts to aggregate demand shifted.
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