Assignment Code: BECC-106/ASST/BECC 106/ 2021-22

Course Code: BECC-106

Assignment Name: Intermediate Macroeconomics - I

Year: 2021-22

Verification Status: Verified by Professor

Assignment I

Answer the following Descriptive Category Questions in about 500 words each. Each question

carries 20 marks. Word limit does not apply in the case of numerical questions. 2 × 20 = 40

Q 1) Derive the equations for IS and LM curves. Specify the parameters of the model. Explain how

the levels of equilibrium output and interest rate are influenced by changes in these

parameters.

Ans) The IS curve depicts the equilibrium of the goods market at a given interest rate I and output level (Y). The products market is in equilibrium at every point on the IS curve. The IS curve is slanted downward. It can be calculated using the following formula:

Y = α𝐴 – 𝛼𝑏𝑖               …..(1.1)

where A is autonomous spending,

α = autonomous spending multiplier,

b = sensitivity of investment function to interest rate, and

i = rate of interest.

While plotting the IS curve (see Figure given below) we take output (Y) on the x-axis and i on the y-axis. Thus, the slope of the IS curve ( di ) as we can observe from the (1.1), will be – ( 1 )

                                                         dY                                                                     ab

(you have to re-arrange equation (1.1) and specify i in terms Y, and then differentiate the equation). From equation (1.1), however, we find that a given change in the rate of interest leads to a larger change in the income level for larger value of 𝛼𝑏. It means that if the autonomous spending multiplier (α) or the sensitivity of investment spending to rate of interest (b) or the product of both (αb) is larger, then the change in interest rate would be larger. We have also seen that IS curve can shift due to a change in autonomous spending A or due to change in the value of multiplier α. Thus an expansionary fiscal policy, an investment subsidy, optimism of investors leading to higher investment at each rate of interest, an increase in autonomous consumption, etc. lead to a rightward shift of IS curve in a closed economy (see Figure).

The LM curve shows the combination of i and Y at which the money market is in equilibrium. You may recall that the LM curve is upward sloping. It is given by the equation

M / P = kY - hi …(1.2)

As we observe from (1.2), the slope of the LM curve is k / h (again, you have to rearrange

the equation, specify i in terms of Y, and then differentiate it). A rightward shift of the LM curve (see Figure below) means that the money market equilibrium occurs at higher income level corresponding to each interest rate or a lower interest rate corresponding to each income level. A leftward or inward shift implies the converse. The LM curve shifts down (or to the right) in response to an increase in money supply (real) or a fall in money demand. However, a situation of liquidity trap makes money demand infinitely responsive to rate of interest and the corresponding LM curve becomes flat at that rate of interest. In this situation, an increase (change) in money supply fails to shift the LM curve.

Simultaneous Equilibrium in Goods and Money Markets

The intersection of the IS and LM curves gives the equilibrium levels of i and Y. Let us bring the IS and LM curves together in order to derive the equilibrium income level and equilibrium rate of interest simultaneously.

Solving equations simultaneously gives us the following equation:

𝑌 = 𝛾𝐴 + 𝛽 M

                       P

Here, 𝛾 = H=  ha    and 𝛽 = 𝛾 b

                   h+abk                  h

The intersection of the IS and LM curves gives us equilibrium levels of output and interest rates. In Figure, the equilibrium rate of interest is 𝑖∗ and equilibrium income level is 𝑌∗

This equilibrium levels can change on account of shifts in (i) IS curve only, (ii) LM curve only, and (iii) both IS and LM curves. Let us look at the impact of shifts in these curves on equilibrium i and equilibrium Y.

Figure : Equilibrium Output and Interest Rate

Equilibrium Level of Output and Interest Rate change

Output will increase because a falling interest rate will trigger higher investment expenditures by firms. ... But then the higher income will shift money demand up, which will increase the equilibrium interest rate, and the same chain will be triggered leading to a decrease in the equilibrium level of output.

Q 2) Bring out the salient features of Dornbusch’s overshooting model.

Ans) The overshooting model, often known as the exchange rate overshooting hypothesis, is a theoretical explanation for high levels of exchange rate volatility first proposed by economist Rudi Dornbusch. The model's fundamental assumptions are that goods prices are sticky, or slow to move, in the short run, while currency prices are flexible, that asset market arbitrage exists via the uncovered interest parity equation, and that exchange rate expectations are "consistent": that is, logical. The model's most important finding is that adjustment lags in some parts of the economy can cause compensating volatility in others; specifically, when an exogenous variable changes, the short-term effect on the exchange rate can be greater than the long-run effect, causing the exchange rate to overshoot its new long-term equilibrium value in the short term.

Dornbusch created this model at a time when many economists believed that perfect markets should reach and maintain equilibrium. Volatility in a market could only be the result of incomplete or asymmetric information or adjustment barriers in that market, according to this perspective. Dornbusch disagreed, claiming that volatility is a considerably more fundamental quality than that.

Asset markets, capital mobility, and expectations are three significant variables in this model. The rate of adjustment of the asset market to a monetary shock is substantially faster than the rate of adjustment of the goods market. In this model, the dynamic characteristics of exchange rates originate from the fact that exchange rates and asset markets adjust more quickly than the products market. We assume that the country is minor in the global financial market for the sake of this model, and that it is subject to a fixed interest rate.

Capital mobility will ensure that predicted net yields are equalised under the given conditions. If the interest rate on one currency (say, the dollar) is higher than the interest yield on the other, capital inflow will occur (say, euro). If the opposite occurs, capital will flow out as well. We also make the implicit assumption that assets denominated in local and foreign currencies are ideal equivalents for one another. Capital flows ensure that the ‘uncovered interest parity' (UIP) condition is maintained at all times in the early phases. This indicates that the interest rate disparity between two countries will always match the predicted change in the two currencies' exchange rates.

When monetary policy changes (for example, an unanticipated permanent rise in the money supply), the market adjusts to a new equilibrium between prices and quantities, according to the model. Because of the "stickiness" of goods prices, the new short run equilibrium level will be reached first through price changes in financial markets. The foreign exchange market then gradually reprices, approaching its new long-term equilibrium level, as goods prices "unstick" and shift to the new equilibrium. Only until this process has completed its course will the domestic money market, currency exchange market, and products market reach a new long-run equilibrium.

As a result, when a monetary adjustment occurs, the foreign exchange market would first overreact, resulting in a new short-run equilibrium. Over time, goods prices will adjust, allowing the foreign exchange market to correct its overreaction and the economy to find a new long-run equilibrium in all markets.

Assignment II

Answer the following Middle Category Questions in about 250 words each. Each question

carries 10 marks. Word limit does not apply in the case of numerical questions. 3 × 10 = 30

Q 3) Describe the role of financial markets in an economy.

Ans) Financial markets play an important role in the economy.

a) Channelization of Funds

Financial markets are critical in improving economic efficiency by channelling monies from those who do not have a profitable use for them to those who do. Financial markets route cash from lenders/savers who have saved money by spending less than their income to those who need money because they want to spend more than their income. Households are the primary lenders and savers, but businesses, governments, and foreigners occasionally lend if they have excess funds. Businesses and governments are the largest borrowers and spenders. Borrowing is used by both households and foreigners to finance their spending.

b) Promotion of Economic Efficiency

A well-functioning financial sector is an important driver of strong economic growth and can help a country escape the low-income trap. A well-functioning financial market makes it easier for money to flow from people who don't have access to lucrative investment opportunities to those who do. When used to produce additional capital, this efficient deployment of capital adds to improved total productivity and efficiency, facilitating faster economic growth.

c) Improvement in Economic Welfare

Financial market activities have a direct impact on personal wealth, corporate and consumer behaviour, and business cycles. Consumers benefit from a well-functioning market because it allows them to plan their purchases. It allows consumers to purchase what they want without having to wait until they have saved up the complete buying price.

Q 4) What is the significance of the traditional Phillips Curve? Why does the shape of the Phillips Curve change when we introduce expectations into our analysis?

Ans) The Phillips curve, named after A W Phillips, illustrates how unemployment and inflation are related. Phillips, then a professor at the London School of Economics, attempted to establish a relationship between the rate of unemployment and the rate of increase in nominal wage rate in the United Kingdom during the period 1861-1957 in 1958. He created a simple linear equation that looked like this:

𝑤̇ = 𝑎 − 𝑏𝑢

where 𝑤̇ is the rate of wage increase, a and b are constants and u is the rate of unemployment. Phillips found that there exists a stable and inverse relationship between 𝑤̇ and u, with the implication that lower rate of unemployment is associated with higher rate of wage increase.

Following Phillips' release of the data, a slew of economists tried their hand at similar exercises for other countries. Following that, it was discovered that a steady association exists between rising wage rates and rising price levels. As a result, several economists refined Phillips' simple equation by using inflation (the rate of growth in prices) instead of wage rate increases. In many situations, the scatter of the variable plot looked like a curve that was convex to the origin. The Phillips curve quickly became an important instrument of policy research as empirical investigations confirmed the inverse relationship between the rate of inflation and the rate of unemployment.

The policy implications of such a finding were staggering: an economy cannot have both low inflation and low unemployment at the same time. To keep unemployment under control, an economy must accept a greater rate of wage growth, and vice versa. As a result, the Phillips curve validates a government's discretionary stabilising policy.

Q 5) Describe the relationship between international capital flows and trade balance.

Ans) To see the relationship between international capital flows and the trade balance, let us look at the national income account’s identity in terms of saving and investment.

Y = C + I + G + NX

Subtract (C + G) from both sides to obtain

Y– C– G = I + NX

Since (Y– C– G) is national saving, S,

S = I + NX , or (S – I) = NX

This type of national income account identification demonstrates that a country's net exports are always equal to the difference between its savings and investments. The trade balance is the right-hand side of the identity, NX, or net export of goods and services. It shows how our goods and services trade differs from a baseline of equal imports and exports.

The left hand side of the identity is the difference between domestic saving and domestic investment, (S – I), the net capital outflow. Net capital outflow equals the amount that domestic residents are lending minus the amount that foreigners are lending to us. The national income accounts identity shows that net capital outflows always equals the trade balance.

If (S – I) and NX are positive, we have a trade surplus. In this case, we are net lenders in the world financial markets and we are exporting more goods than we are importing. If (S – I) and NX are negative, we have a trade deficit. In this case we are net borrowers in the world, and we are importing more goods than we are exporting. If (S – I) and NX are exactly zero, we are said to have a balanced trade because the value of imports equal the value of exports.

Assignment III

Answer the following Short Category Questions in about 100 words each. Each question carries

6 marks. 5 ×6 = 30

Q 6) Distinguish between the concepts of future contract and forward contract.

Ans) In many ways, forward and futures contracts are similar: both include a commitment to buy and sell assets at a future date, and both have prices generated from an underlying asset. A forward contract, on the other hand, is an over-the-counter (OTC) agreement between two counterparties who negotiate and agree on the contract's exact terms, such as the contract's expiration date, the number of units of the underlying asset represented in the contract, and the underlying asset to be delivered, among other things. At the end of the deal, forwards only settle once. Futures, on the other hand, are pre-determined contracts with predetermined maturity dates and underlying’s. These are exchanged and settled on a daily basis on exchanges.

Q 7) Write a short note on the concept of covered interest arbitrage in the context of financial derives.

Ans) The covered interest rate arbitrage is the most common type of interest rate arbitrage. Interest rates differ between countries depending on their current economic cycles, providing an opportunity for overseas investors. Investors can profit from the difference in interest rates between two countries by purchasing a foreign currency with a home currency. A forward contract is used to protect against exchange rate risk. Covered interest rate arbitrage is the technique of investing in a higher yielding currency and hedging the exchange risk with a forward currency contract while taking advantage of favourable interest rate differentials.

Q 8) What are the implications of policy ineffectiveness proposition?

Ans) Robert Lucas was the first economist to stress the significance of public expectations in macroeconomic policy and forecasting. The expectations of economic agents, according to Lucas, are more relevant than those of politicians. As a result, policymakers must grasp how the economy works and what economic agents expect.

By applying the reasonable expectations premise, Robert E. Lucas produced an alternate model of Phillips' Curve. Lucas demonstrated that incomplete information about the price level in the economy can lead to a positive link between output and inflation. According to the Lucas Model, only unanticipated changes in the money supply have an impact on real production when rational expectations are present. All projected changes in the money supply, on the other hand, solely affect the price level. The Policy Ineffectiveness Proposition is what it's called.

Q 9) Describe how an economy can achieve both internal and external balance under a fixed exchange rate regime.

Ans) The most significant economic goals or objectives for countries are to: 1. internal balance is adequate, and 2. a reasonable level of external balance The economy should be in balance with the balance of payments in terms of external balance. The reserves should be kept constant in the short term, but they may increase or decrease in the long run. When output is at full employment, internal balance exists. If a country's interest rate is higher than the global rate, capital flows into that country from other countries will be unrestricted.

Countries use two policy instruments to achieve the goal of achieving equilibrium in both internal and external balances. These are the following: 1. policy changes in terms of spending and 2. strategies of switching expenditures Fiscal and monetary policies are both examples of expenditure-changing policies. Changes in government spending, taxation, or both are referred to as fiscal policy.

Q 10) State the reasons behind exchange rate overshooting.

Ans) Overshooting refers to when monetary policy adjustments result in bigger fluctuations in exchange rates. Changes in interest rates, expectations, and other circumstances compel a change in the stock of financial assets to occur immediately. Because modifications in the actual sector (trade flows) take time, the financial markets bear the immediate weight of exchange rate fluctuations. In order to achieve this, the exchange rate overshoots or bypasses its long-run equilibrium level in order to quickly reach a timely equilibrium.

Over time, as the real trade sector's cumulative contribution to adjustment is felt, the exchange rate reverses its movement, removing the overshooting. This aids in the restoration of equilibrium closer to the pre-shoot-up phase.