Intermediate Macroecon Final

7/21/2019 Intermediate Macroecon Final

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INTEMEDIATE MACROECONOMICS

Q 1

a) Key areas of departur e of the classical and keynesian economists.

1. New classical economists argued that Keynesian economics was theoretically inadequate because it wa

not based on microeconomic foundations. According to them, macroeconomic models should be based o

firm microeconomic foundations.

New Keynesians agree on this but they differ how markets work. New classical economists base their mode

on perfectly competitive consumer, producer and labour markets. On the other hand, new Keynesians ba

their models on the real world imperfectly competitive markets where consumers, producers and labo

market participants operate with imperfect information.

2. New classical base their theories on market-clearing models where demand and supply adjust quickly o

the assumption that wages and prices are flexible. New Keynesians believe that market-clearing mode

cannot explain short-run economic fluctuations. So they base their models on sticky wages and prices th

also explain why involuntary unemployment exists.

3. New Keynesian economics differs from new classical economics in explaining aggregate fluctuations

terms of microeconomic foundations. The new classical explain the forces at work in terms of rational choic

made by households and firms. But in new Keynesian analysis, households and firms do not coordinate the

choices without costs. And coordination costs lead to coordination failure.

4. New classical and new Keynesians also differ over the notion of equilibrium. In new classical model

markets clear continuously and wages and prices adjust quickly so that the quantity of labour demande

equals the quantity of labour supplied and there is full employment equilibrium.



But in new Keynesian models, wages and prices fail to adjust rapidly enough to clear markets within a sho

time so as to keep the quantity demanded of labour equal to its quantity supplied. But this is a

unemployment equilibrium.

Economists call it disequilibrium or low-employment equilibrium. In fact, in new Keynesian economics, th

actual quantities of labour demanded and supplied do not balance but the expected quantities of labou

demanded and supplied balance.

5. New classical and new Keynesians differ substantially over the use of stabilisation policy. The ne

classical analysis holds that with rational expectations and flexible prices and wages, and anticipated chang

in aggregate demand will have no effect on output and employment in the short run by following a systemati

monetary policy.

This is the policy ineffective proposition. Therefore, new classical economists advocate monetary rules an

avoidance of discretionary monetary policy to prevent unanticipated changes in aggregate demand whe

unemployment deviates from the natural level. In new Keynesian economics, when there is decrease

aggregate demand due to wage and price rigidities and market failures, active monetary and fiscal policies ca

prevent fall in output and employment.

b)

Main advantages of f lexible exchange rate with regards to balance of payments deficits.

i.

Automatic balance of payments adjustment - Any balance of payments disequilibrium will tend to b

rectified by a change in the exchange rate. For example, if a country has a balance of payments deficit the

the currency should depreciate. This is because imports will be greater than exports meaning the supply o

sterling on the foreign exchanges will be increasing as importers sell pounds to pay for the imports. This w

drive the value of the pound down. The effect of the depreciation should be to make your exports cheaper an

imports more expensive, thus increasing demand for your goods abroad and reducing demand for foreig





direct impact on the asset markets; since the two markets are connected to each other via the tw

macrovariables output and interest rates, the policies interact while influencing output and interest rates.

The Central Bank formulates a policy to expand or contract money supply in the economy after detaile

analysis and estimation of the demand for money in the economy. The following instruments are used t

conduct monetary policy in Kenya:

i. Reserve Requirement: commercial banks are required by law to deposit 6% of their deposits with th

CBK. This is used to influence the amount of loans banks can advance the public and thus affects th

supply of money. An increase in this proportion reduces the amount of money available f

commercial banks to lend while a reduction has the opposite effect.

ii. Open Market Operations (OMO): Central Bank buys and sells Government securities in the mone

market in order to achieve a desired level of money in circulation. When the Central Bank sel

securities, it reduces the supply of money and when it buys securities it increases the supply of mone

in the market.

iii. Lending by the Central Bank: The Central Bank from time to time lends to commercial bank

overnight when they fall short of funds thus affecting the amount of money in circulation and th

amount deposited by banks at the CBK.

iv. Moral persuasion: The Central Bank persuades commercial banks to make decisions or follow certa

paths to achieve a desired result like changes in the level of credit to specific sectors of the economy

Fiscal policy plays an important role in influencing the economic direction of the Kenyan economy. Whe

speaking of fiscal policy, we are generally referring to two major governmental economic activities, taxatio

and spending. The national budget is the major fiscal instrument by which the Kenya government determine

how much of its energy and resources to devote to these two major activities. The development of a fisc

policy generally has four primary purposes or functions.



i. Allocation; The first major function of fiscal policy is to determine exactly how funds will be allocated. Th

is closely related to the issues of taxation and spending, because the allocation of funds depends upon th

collection of taxes and the government using that revenue for specific purposes. The national budg

determines how funds are allocated. This means that a specific amount of funds is set aside for purpose

specifically laid out by the government. This has a direct economic impact on the country.

ii. Distribution; Whereas allocation determines how much will be set aside and for what purpose, the distributio

function of fiscal policy is to determine more specifically how those funds will be distributed throughout eac

segment of the economy. For instance, the government might allocate Ksh. 1 billion toward social welfa

programs, but Ksh. 100 million could be distributed to food stamp programs, while another Ksh. 250 millio

is distributed among low-cost housing authority agencies. Distribution provides the specific explanation

what allocation was intended for in the first place.

iii. Stabilization; In that, the purpose of budgeting is to provide stable economic growth. Without some restrain

on spending, the economic growth of the nation could become unstable, resulting in periods of unrestraine

growth and contraction. While many might frown upon governmental restraint of growth, the stock mark

crash of 1929 made it clear that unfettered growth could have serious consequences. The cyclical nature of th

market means that unrestrained growth cannot continue for an indefinite period. When growth periods en

they are followed by contraction in the form of recessions or prolonged recessions known as depression

Fiscal policy is designed to anticipate and mitigate the effects of such economic lulls.

iv. Development; Development seems to indicate economic growth, and that is, in fact, its overall purpos

However, fiscal policy is far more complicated than determining how much the government will tax citizen

one year and then determining how that money will be spent. True economic growth occurs when variou

projects are financed and carried out using borrowed funds. This stems from the the belief that the priva

sector cannot grow the economy by itself. Instead, some government input and influence are neede

Borrowing funds for this economic growth is one way in which the government brings about developmen

This economic model developed by John Maynard Keynes has been adopted in various forms since the Wor

War II era.



d) The possible remedies to the unemployment problem

Attempts to reduce the level of unemployment beyond the Natural rate of unemployment generally fa

resulting only in less output and more inflation. However the following ways may reduce unemployment.

Phillips Curve

It used to be largely believed that unemployment could be solved using the Phillips curve. This involv

increasing inflation to reduce unemployment by fooling workers into accepting jobs at a lower rate than the

would otherwise have done, due to the declining value of money. However, since the work of Milto

Friedman, it is widely accepted that the Phillips curve is vertical in the long run: you cannot achieve

lowering of the unemployment rate in the long run, and attempts to do so will only cause inflation.

Demand side policies

Monetary policy and fiscal policy can both be used to increase short-term growth in the economy, increasin

the demand for labour and decreasing unemployment. The demand for labour in an economy is derived fro

the demand for goods and services. As such, if the demand for goods and services in the economy increase

the demand for labour will increase, increasing employment and wages.

Supply side policies

Minimum wages and union activity keep wages from falling, which means too many people want to sell the

labour at the going price but cannot. Supply-side policies can solve this by making the labour market mor

flexible. These include removing the minimum wage and reducing the power of unions, which act as a labo

cartel.

Other supply side policies include education to make workers more attractive to employers. Cutting taxes on

businesses and reducing regulation, create jobs and reduce unemployment.

Shifting tax burden



This method will shift tax burden to capital intensive firms and away from labour intensive firms. In theor

this will make firms shift operations to a more politically desired balance between labour intensive and capit

intensive production. The excess tax revenue from the jobs levy would finance labour intensive publ

projects. However, by raising the value of labour artificially above capital, this would discourage capit

investment, the source of economic growth. With less growth, long-run employment would fall.

A number of other solutions to the unemployment problem have been advanced in the literature. For exampl

work sharing, early retirement, and reduced migration have been discussed. These policies affect the lab

market by reducing the supply of labor. However, they have not won a great deal of support amon

economists

Q2

a)

Using classical model to il lustrate a disturbance brought about by population

A real disturbance takes place on the aggregate supply side of the classical model and has an effect on; rea

wages, employment, real income and, price and money wages

In this case population growth affects labour supply hence the effect on the economy by a shift in labou

supply owing to such change in population variable.

Population change for example through population growth is one factor which will cause disturbance in th

classical model by a rightward and downward shift in the supply of labour as shown in the figure bellow

As the population increases, the supply of labor increases, or shifts to the right. There are now more peop

who are willing to work at each wage level. On the other hand, if a country enacts tougher immigration law



that result in lower overall population, that may cause a shift of the labor supply curve to the left because o

the smaller pool of workers.

In the following figure, the supply of labor has increased as illustrated by the rightward shift in

the supply curve from S 0 to S

1 . The increase in labor supply lowers the equilibrium wage rate

from W* to W 1 which results in greater quantities supplied and demanded to L1 .

In the following figure, the demand for labor has increased as illustrated by the rightward shift

in the demand curve from D 0

to D 1 . This results in an increase in the equilibrium wage rate to

W 1 and additional quantities demanded and supplied to L1 .



b) The relevance of the classical model in understandi ng the real sector

By help of the classical model we develop a commodities market equilibrium function called the IS o

investment-Saving function. In the development of IS model the interest rates is allowed to vary and to affe

investment.

I – I(i)

Where; change in I is less than zero

Change in i

This condition means that investment will increase as interest rate fall and vice versa. We assume that th

economy is closed, excluding the foreign trade sector. And the assumption is relaxed to effects of foreig

trade sector on IS-LM model

Fiscal sector on government expenditure and taxation is included into the model when deriving the IS model

Neoclassical theory is essentially equilibrium theory, and as a rule, a strong tendency towards equilibrium

explicitly or implicitly assumed. Prices are supposed to contain all the relevant information upon whi

decisions are to be taken. On account of the homogeneity of financial assets financial markets are considere

most perfect. Given this, Walras considered the stock exchange the ideal market where the auctioneer ca

easily establish the equilibrium between supply and demand. In neoclassical theory money and finance a

certainly important, not fundamentally important, however. And the relationship between money, the bankin

system, specifically bank credits, and financial markets and the markets in the real sector is not clear at all,

theory is compared with real world events. In fact, money is notoriously unimportant in neoclassical theor

banks channel saving into the most profitable investment projects and financial markets simply seem

reflect what happens in the real markets.

For example, rising prices in already existing capital goods indicate higher profit rates, suggesting exce

demand. Given this, share prices rise, and so does investment in new capital goods in view of increasin

supply in order to get nearer to equilibrium. This vision of things implies that savings govern investmen



Say‘s Law holds. Given this, general overproduction and involuntary unemployment are impossible. An

financial crises, in principle, cannot occur, and if they do occur, the neoclassical theorists have the greate

difficulties to explain them, or cannot explain them at all. The modern version of Say‘s Law states that th

rate of interest brings saving and investment into equilibrium, implying that saving, whatever its amoun

tends to get invested. In this view, the financial sector constitutes an extremely efficient market to dire

saving to the most profitable investment projects. Share prices established at the stock exchange indica

growth possibilities to enterprises and, simultaneously, provide them with the financial means to realise th

growth. Saving thus governs investment and the rationality of individuals coincides with the rationality of th

system. Hence utility and profit maximising behaviour of all individuals results in a general equilibriu

which is also a social optimum. Prices summarise all the relevant information and lead the economic acto

from disequilibrium to equilibrium. Or, in the case of rational expectations, economies are always

equilibrium and prices indicate equilibrium positions, around which estimated and realised prices an

earnings are normally distributed; according to this theory, prices changes would reflect shifts in equilibriu

positions; such shifts are supposed to be caused by external factors, which, if considerable in size, becom

external shocks.

In a monetary production economy money is intimately linked to the labour force as well as to the primar

intermediate and final commodities circulating in the real sector. Indeed, in the process of real circulation (M

C ... P ... C‘-M‘), there is always an exchange of money (M) and commodities, that is, labour (force) an

means of production (C) and final goods (C‘), never exchange of commodities against commodities, wi

money as an intermediary (C - M - C‘). Labour and means of production are bought and, subsequently, pa

through the social process of production (P). Here, new values are generated which are represented by C‘, th

is, gross domestic product Q. Hence new values are created in the real sector of an economy. In the processe

of circulation taking place within the real sector, money represents values, since it has no intrinsic valu

However, once money leaves the real sector for the financial sector, there is no longer any real equivalent an

this money does, consequently, not represent any real values. Given this, money circulating in the financi

sector always looks for already existing goods; some of these goods are reproducible (houses, industri



equipment, or enterprises, to give instances), others are not reproducible (for example, land or old masters

money circulating in the financial sector may also look for already existing financial titles, for exampl

already existing state bonds and shares which ought to represent the value of already existing enterprises

Q3

a) Using r elevant proof to explain the relationship between the pri ce of a bond and the market intere

rate of the bond

There is a direct relationship between the price of a bond and its yield. The price is the amount the investo

will pay for the f uture cash flows; the yield is a measure of return on those future cash flows. Hence pric

will change in the opposite direction to the change in the required yield. There are a number of differen

formulae for the relationship between price and yield

Looking at the price-yield relationship of a standard i.e. non-callable bond, we would expect to see a shap

such as:

Price

Yield



As the required yield increases, the factor by which future cash flows are discounted also increases an

therefore the present value of the cash flow decreases. Hence the price decreases as yield increases

Once a bond is issued the issuing corporation must pay to the bondholders the bond's stated interest for th

life of the bond. While the bond's stated interest rate will not change, the market interest rate will b

constantly changing due to global events, perceptions about inflation, and many other factors which occ

both inside and outside of the corporation.

The following terms are often used to mean market interest rate: effective interest rate, yield to maturit

discount rate, desired rate

When Market Interest Rates Increase

Market interest rates are likely to increase when bond investors believe that inflation will occur. As a resul

bond investors will demand to earn higher interest rates. The investors fear that when their bond investme

matures, they will be repaid with dollars of significantly less purchasing power.

Let's examine the effects of higher market interest rates on an existing bond by first assuming that

corporation issued a 9% Ksh.100,000 bond when the market interest rate was also 9%. Since the bond's state

interest rate of 9% was the same as the market interest rate of 9%, the bond should have sold for Ksh.100,00

Next, let's assume that after the bond had been sold to investors, the market interest rate increased to 10%

The issuing corporation is required to pay only Ksh.4,500 of interest every six months as promised in its bon

agreement (Ksh.100,000 x 9% x 6/12) and the bondholder is required to accept Ksh.4,500 every six month

However, the market will demand that new bonds of Ksh.100,000 pay Ksh.5,000 every six months (mark

interest rate of 10% x Ksh.100,000 x 6/12 of a year). The existing bond's semiannual interest of Ksh.4,500

Ksh.500 less than the interest required from a new bond. Obviously the existing bond paying 9% interest in

market that requires 10% will see its value decline.

Here's a Tip



An existing bond's market value will decrease when the market interest rates increase. The reason is that a

existing bond's fixed interest payments are smaller than the interest payments now demanded by the market.

When Market Interest Rates Decrease

Market interest rates are likely to decrease when there is a slowdown in economic activity. In other words, th

loss of purchasing power due to inflation is reduced and therefore the risk of owning a bond is reduced.

Let's examine the effect of a decrease in the market interest rates. First, let's assume that a corporation issue

a 9% Ksh.100,000 bond when the market interest rate was also 9% and therefore the bond sold for its fac

value of Ksh.100,000.

Next, let's assume that after the bond had been sold to investors, the market interest rate decreased to 8%. Th

corporation must continue to pay Ksh.4,500 of interest every six months as promised in its bond agreemen

(Ksh.100,000 x 9% x 6/12) and the bondholder will receive Ksh.4,500 every six months. Since the market

now demanding only Ksh.4,000 every six months (market interest rate of 8% x Ksh.100,000 x 6/12 of a yea

and the existing bond is paying Ksh.4,500, the existing bond will become more valuable. In other words, th

additional Ksh.500 every six months for the life of the 9% bond will mean the bond will have a market valu

that is greater than Ksh.100,000.

In essence, this means that an existing bond's market value will increase when the market interest rate

decrease. An existing bond becomes more valuable because its fixed interest payments are larger than th

interest payments currently demanded by the market.

As shown above, the market value of an existing bond will move in the opposite direction of the change

market interest rates;

- When market interest rates increase, the market value of an existing bond decreases.



- When market interest rates decrease, the market value of an existing bond increases.

The relationship between market interest rates and the market value of a bond is referred to as an invers

relationship. Perhaps "Bond prices and bond yields move in opposite directions" or "Bond prices rallie

lowering their yield..." or "The rise in interest rates caused the price of bonds to fall."

b)

To discuss the reasons why money is both neutr al in classical case and non neutr al in Keynesia

analysis

In the Keynesian model, money is not neutral in the short run, but it is neutral in the long run. In the short ru

an increase in the money supply increases output and the real interest rate, while the price level and re

(efficiency) wage are unchanged. In the long run, however, only the price level is changed, with no change

output, the real interest rate, or the real wage.

In the basic classical model, money is neutral in both the short run and the long run, so only the price level

affected by a change in the money supply, just as in the long-run Keynesian model. The extended classic

model with misperceptions is similar to the Keynesian model. In the short run, an increase in the mone

supply increases output and the real interest rate, just as in the Keynesian model. However, unlike th

Keynesian model, the price level rises, as does the real wage. The long run of the extended classical model

identical to the classical model or the long run of the Keynesian model — only the price level is affected.

Q4

a) To discuss the cri ti cisms leveled against each of the four pi ll ars of classical macroeconomics

(1) Underemployment Equilibrium:



Keynes rejected the fundamental classical assumption of full employment equilibrium in the economy. H

considered it as unrealistic. He regarded full employment as a special situation. The general situation in

capitalist economy is one of underemployment.

This is because the capitalist society does not function according to Say‘s law, and supply always exceeds i

demand. We find millions of workers are prepared to work at the current wage rate, and even below it, b

they do not find work.

Thus the existence of involuntary unemployment in capitalist economies (entirely ruled out by the classicist

proves that underemployment equilibrium is a normal situation and full employment equilibrium is abnorm

and accidental.

(2) Refutation of Say‘s Law:

Keynes refuted Say‘s Law of markets that supply always created its own demand. He maintained that a

income earned by the factor owners would not be spent in buying products which they helped to produce.

A part of the earned income is saved and is not automatically invested because saving and investment a

distinct functions. So when all earned income is not spent on consumption goods and a portion of it is save

there results in a deficiency of aggregate demand.

This leads to general overproduction because all that is produced is not sold. This, in turn, leads to gener

unemployment. Thus Keynes rejected Say‘s Law that supply created its own demand. Instead he argued th

it was demand that created supply. When aggregate demand rises, to meet that demand, firms produce mo

and employ more people.

(3) Self-adjustment not Possible:



Keynes did not agree with the classical view that the laissez-faire policy was essential for an automatic an

self-adjusting process of full employment equilibrium. He pointed out that the capitalist system was n

automatic and self-adjusting because of the non-egalitarian structure of its society. There are two princip

classes, the rich and the poor.

The rich possess much wealth but they do not spend the whole of it on consumption. The poor lack money

purchase consumption goods. Thus there is general deficiency of aggregate demand in relation to aggrega

supply which leads to overproduction and unemployment in the economy. This, in fact, led to the Gre

Depression.

Had the capitalist system been automatic and self-adjusting, this would not have occurred. Keynes, therefor

advocated state intervention for adjusting supply and demand within the economy through fiscal an

monetary measures.

(4) Equality of Saving and Investment through Income Changes:

The classicists believed that saving and investment were equal at the full employment level and in case of an

divergence the equality was brought about by the mechanism of rate of interest. Keynes held that the level o

saving depended upon the level of income and not on the rate of interest.

Similarly investment is determined not only by rate of interest but by the marginal efficiency of capital. A lo

rate of interest cannot increase investment if business expectations are low. If saving exceeds investment,

means people are spending less on consumption.

As a result, demand declines. There is overproduction and fall in investment, income, employment an

output. It will lead to reduction in saving and ultimately the equality between saving and investment will b

attained at a lower level of income. Thus it is variations in income rather than in interest rate that bring th

equality between saving and investment.



(5) Importance of Speculative Demand for Money:

The classical economists believed that money was demanded for transactions and precautionary purpose

They did not recognise the speculative demand for money because money held for speculative purpos

related to idle balances.

But Keynes did not agree with this view. He emphasised the importance of speculative demand for mone

He pointed out that the earning of interest from assets meant for transactions and precautionary purposes ma

be very small at a low rate of interest.

But the speculative demand for money would be infinitely large at a low rate of interest. Thus the rate o

interest will not fall below a certain minimum level, and the speculative demand for money would becom

perfectly interest elastic. This is Keynes ‗liquidity trap‘ which the classicists failed to analyse.

(6) Rejection of Quantity Theory of Money:

Keynes rejected the classical Quantity Theory of Money on the ground that increase in money supply will n

necessarily lead to rise in prices. It is not essential that people may spend all extra money. They may depos

it in the bank or save.

So the velocity of circulation of money (V) may slow down and not remain constant. Thus V in the equatio

MV = PT may vary. Moreover, an increase in money supply, may lead to increase in investment, employmen

and output if there are idle resources in the economy and the price level (P) may not be affected.

(7) Money not Neutral:

The classical economists regarded money as neutral. Therefore, they excluded the theory of outpu

employment and interest rate from monetary theory. According to them, the level of output and employme

and the equilibrium rate of interest were determined by real forces.



Keynes criticised the classical view that monetary theory was separate from value theory. He integrate

monetary theory with value theory, and brought the theory of interest in the domain of monetary theory b

regarding the interest rate as a monetary phenomenon. He integrated the value theory and the monetary theor

through the theory of output.

This he did by forging a link between the quantity of money and the price level via the rate of interest. Fo

instance, when the quantity of money increases, the rate of interest falls, investment increases, income an

output increase, demand increases, factor costs and wages increase, relative prices increase, and ultimately th

general price level rises. Thus Keynes integrated monetary and real sectors of the economy.

(8) Refutation of Wage-Cut:

Keynes refuted the Pigovian formulation that a cut in money wage could achieve full employment in th

economy. The greatest fallacy in Pigou‘s analysis was that he extended the argument to the economy whic

was applicable to a particular industry.

Reduction in wage rate can increase employment in an industry by reducing costs and increasing demand. B

the adoption of such a policy for the economy leads to a reduction in employment. When there is a genera

wage-cut, the income of the workers is reduced. As a result, aggregate demand falls leading to a decline

employment.

From the practical view point also Keynes never favoured a wage cut policy. In modern times, workers hav

formed strong trade unions which resist a cut in money wage. They would resort to strikes. The conseque

unrest in the economy would bring a decline in output and income. Moreover, social justice demands th

wages should not be cut if profits are left untouched.

(9) No Direct and Proportionate Relation between Money and Real Wages:



Keynes also did not accept the classical view that there was a direct and proportionate relationship betwee

money wages and real wages. According to him, there is an inverse relation between the two. When mone

wages fall, real wages rise and vice versa.

Therefore, a reduction in the money wage would not reduce the real wage, as the classicists believed, rather

would increase it. This is because the money wage cut will reduce cost of production and prices by more tha

the former.

Thus the classical view that fall in real wages will increase employment breaks down. Keynes, howeve

believed that employment could be increased more easily through monetary and fiscal measures rather tha

by reduction in money wage. Moreover, institutional resistances to wage and price reductions are so stron

that it is not possible to implement such a policy administratively.

(10) State Intervention Essential:

Keynes did not agree with Pigou that ―frictional maladjustments alone account for failure to utilise fully ou

productive power.‖ The capitalist system is such that left to itself it is incapable of using productiv

powerfully. Therefore, state intervention is necessary.

The state may directly invest to raise the level of economic activity or to supplement private investment.

may pass legislation recognising trade unions, fixing minimum wages and providing relief to workers throug

social security measures.

―Therefore‖, as observed by Dillard, ―it is bad politics even if it should be considered good economics

object to labour unions and to liberal labour legislation.‖ So Keynes favoured state action to utilise fully th

resources of the economy for attaining full employment.

(11) Long-Run Analysis Unrealistic:



The classicists believed in the long-run full employment equilibrium through a self-adjusting process. Keyne

had no patience to wait for the long period for he believed that ―In the long-run we are all dead‖.

As pointed by Schumpeter, ―His philosophy of life was essentially a short-term philosophy.‖ His analysis

confined to short-run phenomena. Unlike the classicists, he assumes tastes, habits, techniques of productio

supply of labour, etc. to be constant during the short period and so neglects long-run influences on demand.

Assuming consumption demand to be constant, he lays emphasis on increasing investment to remov

unemployment. But the equilibrium level so reached is one of underemployment rather than of fu

employment. Thus the classical theory of employment is unrealistic and is incapable of solving the prese

day economic problems of the capitalist world

b) To highl ight some of the factors that cause a shi ft i n the IS and LM curves

It is important to remember the two equations for IS and LM, any that change in the included variables could

cause a change in the graph:

The IS (Investment and savings equilibrium) equation:

Y = C(Y-T(Y))+I(r)+G+NX(Y)

Where

1. Y = national income or real GDP

2. C(Y-T(Y)) = consumption or consumer spending which is a function of disposable income



3. (Y-T(Y)) = disposable income which is equal to national income minus tax (which is a function of

income)

4. I(r) = Investment which is a function of the real interest rate

5. G = Government spending/expenditures

6. NX(Y) = Net exports, where imports depend on income (Y)

Possible shifts in the IS curve:

Change in Fiscal policy (G):

1. The government can increase government spending (shifting IS right) or decrease government

spending (shifting IS left).

2. The government can increase taxes which lowers consumer spending (shifting IS left) or decrease

taxes which increases consumer spending (shifting IS right).

Consumers can change their savings rate (C):

1. If consumers decide to save more (marginal propensity to consume declines) then consumer spending

declines and the IS curve shifts left.

http://1.bp.blogspot.com/-UFDOXqUgftQ/T3qQb_x9wBI/AAAAAAAAAhY/mcd_XzKMhdg/s1600/IS+LM+model+with+IS+shift.png



2. If consumers decide to save less (marginal propensity to consume rises) then consumer spending

increases and the IS curve shifts right.

Change in exports (NX):

1. If exports increase (due to currency depreciation) we will see the IS curve shift right.

2.

If exports decrease (due to currency appreciation) we will see the IS curve shift left.

3. Note: Imports are endogenous in the model (they are a function of Y) so generally change in imports

has no effect on the IS curve. However, depending on your professor, a change in imports will have

the opposite effect on the IS curve that exports has, so a decrease in imports shifts IS right, and an

increase shifts IS left.

A change in private fixed investment (I)

1. If consumers/firms feel more confident about the future, they may invest more regardless of the

interest rate. This will cause an increase in investment (IS shifts right).

2. If consumers/firms feel less confident about the future, they may invest less regardless of the interest

rate. This will cause a decrease in investment (IS shifts left).

The LM (Liquidity preference and money supply equilibrium) equation:

M/P = L(i,Y)



Where

1. M/P = the real money supple where M is the actual amount of money in the economy and P is the

overall price level

2. L(i,Y) = the real demand for money which is a function of the interest rate (i) and national income (Y

Possible shifts in the LM curve:

A change in money supply (M):

1. If the central bank (or Federal Reserve) decides to increase the money supply (by buying t bills) then

the LM curve shifts right.

2. If the central bank (or Federal Reserve) decides to decrease the money supply (by selling t bills) then

the LM curve shifts left.

A change in transaction technologies, ie credit cards (L):

http://4.bp.blogspot.com/-pRoHdH2x3-M/T3qQVvj8tZI/AAAAAAAAAhQ/_MKSdppiGXY/s1600/is+lm+model+with+lm+shift.png



1. If improvement in the velocity of money occurs such that people require less money to conduct all of

their transactions, the LM curve will shift right (because the opportunity cost of holding money goes

down because there is now an alternative).

A change in the overall price level (P):

1. If the price level rises, the LM curve shifts left. This occurs because people need more money to pay

the higher prices, but the higher resulting interest rates lower the demand for money.

2. If the price level declines, the LM curve shifts right. This occurs because people need less money to

pay the lower prices, and the lower interest rates increase their demand for holding money.

Q5

a) To discuss the main feature of the Permanent I ncome Hypothesis (PIH)

The permanent-income hypothesis was proposed by Milton Friedman in 1957 (who also a leader of th

Chicago monetarist school of economics and won the Nobel Prize in 1976 for his work on the money theo

and analysis on consumption behaviour).

The central idea of the permanent-income hypothesis is simple: people base consumption on what the

consider their "normal" income. In doing this, they attempt to maintain a fairly constant standard of livin

even though their incomes may vary considerably from month to month or from year to year. As a resu

increases and decreases in income which people see as temporary have little effect on their consumptio

spending.

Assumptions





A change in spending changes income, but people only slowly adjust to it. As they do, their extra spendin

changes income further. An initial increase in spending tends to have effects that take a long time

completely unfold (reveal).

The existence of lags also makes government attempts to control the economy more difficult. Policies take

do not have their full effect immediately, but only gradually. By the time they have their full effect, th

problems which they were designed to attack may have disappeared

b)

The appli cation of the PIH in the Afr ican context

According to Duesenberry (1948) consumption of the individual depends upon its relative income rather tha

its absolute income. Whereas according to PIH, consumption of individual which is explained by i

permanent income rather than its relative and current income, while life-cycle hypotheses (LCH) forwards th

same argument in a different perspective. According to LCH the consumption of individual is explained by i

expected life time income, so the PIH and LCH share the same optimizations model and conclusio

However, empirically PIH is more popular than LCH, while the RIH is not tested widely because o

unavailability of data for key variables. To test the PIH, Friedman (1957) estimated the permanent income b

using the distributive lags of current income. Lucas (1976) postulated that the lags of current income do n

explain the current consumption. In the response to Lucas (1976) critique, Hall (1978) showed that witho

current consumption other variables have no explanatory power to predict future consumption i.e. change

consumption is a random walk.

Same attributes of PIH are difficult to be comprehensively applied in the African context whereby A

increase in income should not immediately increase consumption spending by very much, but with time

should have a greater and greater effect.



A change in spending changes income, but people only slowly adjust to it. As they do, their extra spendin

changes income further. An initial increase in spending tends to have effects that take a long time

completely unfold (reveal).

The existence of lags also makes African governments attempts to control the economy more difficu

Policies taken do not have their full effect immediately, but only gradually. By the time they have their fu

effect, the problems which they were designed to attack may have disappeared

There is therefore invalidity of PIH in African context because the predictable change in income affec

consumption. This is the clear violation of the neoclassical consumption hypothesis. Furthermore, the reason

of the rejection of the PIH, is the Myopia and liquidity constraint. The results are supported by the presence

liquidity constraints rather than myopia and perverse asymmetry. Its is evident that small fraction

individuals support PIH in Africa. So, the asymmetry responses in consumption to the expected incom

suggest that the reason for the rejection of PIH in Africa is the liquidity constraint.

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Intermediate Macroecon Final