8920867614 | Rohit Sehrawat

Test-2

Economics Optional
Paper – 1

Time allowed: 2:15 hrs. Maximum marks: 165

There are 20 questions divided into 3 sections.

Section-A

(a) Using the IS-LM model shows how expected deflation may cause equilibrium
output to remain at less than full employment level.

Ans.
To understand how expected changes in prices can affect income, we need to add a new
variable to the IS–LM model. Our discussion of the model so far has not distinguished
between the nominal and real interest rates. Yet we know from previous chapters that
investment depends on the real interest rate and that money demand depends on the
nominal interest rate. If i is the nominal interest rate and Ep is expected inflation, then the
ex-ante real interest rate is r = i − Ep.

We can now write the IS–LM model as

Y = C (Y − T) + I (i − E p) + G - IS,
M/P = L (i, Y) - LM.
Expected inflation enters as a variable in the IS curve. Thus, changes in expected inflation
shift the IS curve.

Let’s use this extended IS–LM model to examine how changes in expected inflation
influence the level of income. We begin by assuming that everyone expects the price level to
remain the same. In this case, there is no expected inflation (Ep = 0), and these two
equations produce the familiar IS–LM model. Figure 11-8 depicts this initial situation with
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the LM curve and the IS curve labelled IS1. The intersection of these two curves
determines the nominal and
real interest rates, which for now are the same.

Now suppose that everyone suddenly expects that the price level will fall in the future, so
that Ep becomes negative. The real interest rate is now higher at any given nominal interest
rate. This increase in the real interest rate depresses planned investment spending, shifting
the IS curve from IS1 to IS2. (The vertical distance of the downward shift exactly equals
the expected deflation.) Thus, an expected deflation leads to a reduction in national income
from Y1 to Y2. The nominal interest rate falls from i1 to i2, while the real interest rate rises
from r1 to r2.

Here is the story behind this figure. When firms come to expect deflation, they become
reluctant to borrow to buy investment goods because they believe they will have to repay
these loans later in more valuable dollars. The fall in investment depresses planned
expenditure, which in turn depresses income. The fall in income reduces the demand for
money, and this reduces the nominal interest rate that equilibrates the money market. The
nominal interest rate falls by less than the expected deflation, so the real interest rate rises.

(b) Show that in a simple Keynesian model, equal expansion in tax and government
expenditure does not always lead to balanced budget theorem.

Ans.
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In the Keynesian model multiplier is the value by which income changes due to unit change
in autonomous expenditure of AD.

Balanced Budget Multiplier - It is a budget neutral yet fiscally stimulating method of

increasing output in the economy by one time (equal to the amount of government
spending) when tax revenue equals government expenditure.

𝜟Y = -c𝜟T/1-c
𝜟Y = 𝜟G/1-c
When T = G we have, 𝜟Y = (𝜟G/1-c) - (c𝜟G/1-c)
𝜟Y/𝜟G = 1

Where T is the lump sum tax and cT is the decrease in income induced consumption, G is
the autonomous expenditure and any increase in G increases Y by G directly.

But this is a unique case of a closed economy and no income tax. When imports are a
function of income (m = 𝒎 ̅ + mY) and income tax a function of income (c = 𝒄̅ + c (Y - T -
tY) when value to multiplier decreases as leakages have increased.

𝜟Y = (𝜟G/1-c+ct+m) - 𝜟Gc/1-c+ct+m
𝜟Y = 𝜟G(1-c)/1-c+ct+m
Multiplier value is less than 1.
𝜟Y/𝜟G = 1-c/1-c+ct+m
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(c) Automatic stabilisers are supposed to mitigate cyclical fluctuations, but there
exist limitations which dampen the effect of these stabilisers. Analyse.

Ans.

Automatic stabilisers are fiscal policy

instruments used to dampen the value of
multiplier and reduce the fluctuations in the
business cycle. They help in minimising the use
of counter cyclical fiscal/monetary policy tools
during shocks.

Eg. of Automatic stabilisers:

1. Income Tax - Increases leakage during
boom and decrease leakage during recession (as
tax liabilities decreases)
2. Marginal propensity to import (m)
3. Unemployment Allowances - MNREGA to stabilise AD
4. “t” and “m” acts as automatic stabilisers.

Efficiency of automatic stabiliser depends on the following factors:

1. Extent of informal/unorganised economic activities. Eg. If more people are out of
tax bracket or part of black economy ‘ct’ will not make much difference.
2. Hawala systems - Affect on ‘m’ and decrease its value.
3. Trade openness of the country.
4. Trust in the central bank and government policies without which mass hysteresis
can exacerbate the shock.
5. Fraud payments in MNREGA - Dummy job cards as R. Khera pointed out.

Therefore, inclusive institutions are most crucial to ensure efficiencies of automatic

stabilisers.

(d) Suppose that the money supply, instead of being constant, increases (slightly)
with the interest rate.

1. How would this change affect the construction of the LM curve?

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2. Could you see any reason why RBI might follow a policy increasing the
money supply along with the interest rate?

Ans.

LM Curve is constructed in the money market due to interplay of change in money

demand due to income change and money supply.

̅ /𝑷
MD = kY - hi = MS = 𝐌 ̅

If money supply is a function of interest rate then LM curve will be flatter as less change in
interest rate will be required to bring money market in equilibrium.

1. As Y increases, there is excess MD at i1

2. Interest rate starts increasing to decrease speculative demand for money
3. With increase in interest rate, MS increases and MD falls and equilibrium is achieved
faster and at a lower interest rate i3 then i2.

RBI might increase money supply along with interest rate to reduce the effect of crowding
out of private investments due to increasing interest rate. It can also do so to decrease the
borrowing cost or debt burden of the government.

(e) Freidman’s restatement of QTM is a compromise between classical’s QTM and

Keynes speculative money demand. Comment.

Ans.
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Friedman's statement of quantity theory of money includes the stability of velocity of

money like classicals and unlike Keynesians but it also includes the role of money as an
asset. Hence, it finds a compromise between Classicals and Keynesians.

Friedman’s Restatement of Quantity Theory

MDD = k ( rb , re , rs , G, R, P*/P , W) PV

1) Classicals considers k to be dependent on institutional factors and hence constant in

the short run.

̅.PY
MD =𝒌

Keynesians considered k to be a function of (i) as money and bond were the only
assets. Their k was highly volatile thus making ‘v’ volatile.

MD = k(i).PY

Friedman gave a rigorous definition of k by accepting the role of money as an asset

but also expanding the portfolio. This makes Friedman’s k dependent on (i) but also
stable. As the basket of assets broadens, money hoarding is less. Hence when ‘i’
changes lesser money is added or subtracted from circulation making ‘v’ & there by
‘k’ stable.

2) Classical believed that money as per M = k(PY) can only affect price (nominal
income) in the short & long run.

Keynesians believed that k will be so volatile that it is not necessary that money and
nominal income have a one-to-one relationship. This is what happens in a liquidity trap.

M↑ V↓ = ̅̅̅̅
𝐏𝐘

Also, Monetarists believed that only money matters and change in money supply can bring
change in real income also in the short run.

Hence, we can conclude that Friedman’s restatement of QTM is a compromise between

Keynes alternative uses of money and fairly stable velocity of money assumption by
classicals.

(f) In the simple Keynesian model Keynesian model if consumption and investment
are both functions of income how would the multiplier be affected?
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Ans.

Multiplier effect is central to the Keynesian Model where a change in one segment of the
economy is spilled over to all other segments, having a multiplier effect in change un
output.

C = 𝒄̅ + c(Y)

I = 𝑰̅ - bi + dY

(When both consumption and investments are functions of output)

In equilibrium, AD = Y

̅ + cY + 𝑰̅ - bi +dY + 𝑮
Y= 𝑪 ̅+𝒙 ̅
̅- 𝑴

̅ + cY - bi + dY
Y=𝐀

̅ - bi
Y (1-c-d) = 𝑨

̅ = 1/1-c-d
ΔY/Δ𝐀

Therefore, the value of the multiplier increases. This is because a change in income now
increases both consumption and investment multiple times over a time period.

The graph shows how change in slope of AD increases output from Y1 to Y2.

Section-B
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1. Milton Friedman often said that the real trade off was not between inflation
and unemployment but between unemployment today and unemployment in
future. What do you think he meant by this?

Milton Friedman belongs to the Monetarist School who believed that workers have
adaptive expectations about inflation in the medium run, considering the inefficiency of
policy tools in the medium run, even though they can be used to fool workers in the short
run.

Friedman modified the original Phillips Curve by adding expected inflation in period t is
equal to actual inflation in period t-1: 𝜫te = ϴ𝜫t-1 where ϴ = 1.

Expectation Augmented PC: 𝜫t - 𝜫t-1 = - 𝛂 (Ut - Un).

Un represents natural level of employment where wage setting equals price setting and
actual inflation in period t is equal to actual inflation in period t 𝜫t = 𝜫te

If the government tries to decrease unemployment to Ut (Ut < Un) by increasing money
supply, then
1. Short Run: Price increase => Real wages fall => Firms increase output and
unemployment (Workers are fooled by the price rise)
2. Long Run: Workers revise their adaptive expectations about inflation (at 𝜫1) and
demand higher nominal wage. Therefore, the real wage is constant again at Un with
higher nominal wage and higher inflation. Thus, as per Friedman no real trade off,
only higher inflation with Un - natural rate of unemployment.
3. The Process repeats period after period.

To maintain Ut < Un, with adaptive expectation hypothesis the inflation level will rise, rising
at the same rate, and the trade-off between unemployment & constant inflation rate
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breaks. PC becomes vertical in the medium run. Ultimately, Inflation/Stagflation becomes

a bigger problem while unemployment is maintained at natural level, determined by supply
side factors.

Trade-off between unemployment now and the future:

To tackle the higher inflation resulted due to the policy objective of keeping Ut < Un in the
short run, the government will have to follow deflationary monetary policy. Eg. Decreasing
Money supply based on sacrifice ratio (Easy lending Vs Hard Lending).
1. Short Run - Ut+1 > Un but prices fall.
2. Long Run - Workers revise their money wages down due to adaptive
expectations and Un is maintained.

Hence, to achieve Ut < Un in ‘t’ time period, the government had to face Ut+1 > Un in ‘t+1’
time period. The future generation pays with higher unemployment for the luxury of lower
unemployment for the present generation.

Empirical Evidence: Post COVID Lockdown - Easy MP to beat recession, but MP expanded
far too much. Along with the Ukraine crisis, inflation reached dangerous levels in the US/UK
to approximately 10%. Even in India, it crossed the 6% level repeatedly. Then came tight MP
with repo hikes around the world, and the IMF/WB predicted slower growth around 2.5 - 3%
at the global level. However, we avoided stagflation like in the 1970’s. Why? Inflation
targeting and better policy coordination among various central banks. Furthermore, we are less
dependent on oil today.
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2. Do you agree with the view that Keynes general theory is a special case of
classical theory obtained by imposing certain restrictive assumptions on the
latter? Elaborate.

Keynes general theory deals with showing involuntary unemployment equilibrium as the general
case/phenomenon while classical theory shows full employment equilibrium at all the times as
general case/phenomenon.

Both the theories derive their Aggregate Supply in the labour market. However, while the
Aggregate Demand of Keynes is based on goods & money demand, the Classicals AD is entirely
decided in the money market as money has only one role. So, if you have money that means you
demand goods. Money means transactions. But they have contradicting conclusions due to
restrictive assumptions of externality placed by Keynes in the Labour, Money and goods
markets.

Restrictive Assumptions

Classical Keynes

1. The Labour Market has perfect 1. Imperfect Labour Market.

competition. a. Downward wage rigidity due to
a. Full Information staggered wage contract. (labour
b. Wage Price flexibility union & Insider - outsider
model)- First restriction.
b. Money illusion and foolishness
on part of workers.
2. Any deviation of AD from YF leads to
adjustment in price along with 2. Any deviation from YF of AD affects
nominal wages so that real wages and real wage and supply deviates too =>
supply stays constant. Demand then Supply follows demand.
follows supply.

3. Hence, equilibrium output is 3. Equilibrium output is determined in the

determined in the labour market goods and money market by both real
caused by supply side/real factors. and nominal factors. (goods market -
AD shock due to investment shock;
Money market - Liquidity trap).

4. Leakages from AD in form of

4. No leakages in form of speculative Speculative Demand of money which
demand of money early Keynesians assumed to be highly
interest elastic and tending infinitely
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Md = k(PY) i.e, money only has elastic during recession.

transaction demand.
Md = kY - hi where h = ∞ leading to a
situation of liquidity trap.
This is second restriction.

5. Self-adjusting property of interest rate 5. Investments based on animal spirits and

so that savings are always invested. in deep recession investments become
interest insensitive(b=o). So, no
investment even in the absence of
liquidity trap. This is the 3rd
restriction.

6. Shock in AD shifts equilibrium to Y1 as

real wages increase to W0/P1.

Therefore, the economy is always at

full employment either due to
adjustment in prices or adjustment in
real interest rate.

The other 2 restrictions will make AD vertical and we would stuck at below full
employment equilibrium even with flexible money wages.
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Hence, Keynes general theory is a special case of classical theory achieved by imposing
restrictive assumptions on the latter.

3. Distinguish between monetarist and neo-Keynesian approaches to expectation

augmented Phillips curve.

Ans.

After Friedman’s attack the new generation of Keynesians accepted the adaptive
expectation hypothesis and the resulted expectation augmented Phillips curve which was
downward sloping in short run and vertical in long run as a result of workers revising their
expectations.

However there exists the difference between monetarist and neo-Keynesian approaches to
expectation augmented Phillips curve.

The differences originate from two dimensions:

1. Micro-foundation: While monetarists assume perfect competition in labour and

product markets, the neo-Keynesian works with imperfect market structure in both
labour and goods market. This also has implication for relative equilibrium rate of
unemployment, the equilibrium rate of unemployment is higher in neo-Keynesian
model.
2. Process of inflation generation: Inflation in monetarism initiates from the monetary
impulse which creates money illusion and workers supply more labour reducing the
unemployment rate below natural. On the other hand, in neo-Keynesians the initiating
factor is change in AD which reduces unemployment below natural thus increases
bargaining of workers and leading to wage-price inflation spiral.

For the better and exhaustive understanding of the students the process is explained
below:

In comparing the two, the first point to note is that we can draw the labour supply on the
imperfect competition diagram; it will lie below bargained real wage curve as bargaining
power increases real wage. Similarly, a MPL curve can be superimposed on the imperfect
competition diagram. This illustrate that the constant inflation rate of unemployment
arising from the competitive behaviour of economic agents in labour and product market
would be different from that arising from imperfectly competitive behaviour represented
by BRW (Bargained real wage) and PRW (price determined real wage) curves. Why the
PRW is horizontal? Think.
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Under imperfect competition, the market power of unions enables them to achieve a
higher bargained real wage than the real wage at which the individual workers would be
prepared to take a job. Similarly, the market power of the imperfectly competitive firms
enables them to mark up their marginal cost when setting the price. By contrast, for the
perfectly competitive firm, price equals marginal cost; there are no supernormal profits
under perfect competition.

Now we turn to a comparison between the mechanism through which inflation is

generated in each case: relate the argument with the given diagram below.

Neo-Keynesians: NAIRU

Bargaining power of Markup pricing increases

Increase in AD Higher money wages
labour increases prices in line with wages

To maintain E1 in next
To maintain E1 with high
In the next round round money wage rises
Economy moves along inflation RBI increases
expected inflation is expected inflation plus
short run PC to E1. money supply to
increased . amount necessary to
maintain higher AD
secure real wage at E1.
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Monetarists: NRU

Increases demand and Money illusion workers Movement along short-

Increased money supply
prices supply more labour run PC

To again reach E1 with

higher inflation
Next period workers
expectaion another
revise expectations
injection of money
supply is needed.

In both the imperfect competition model and Freidman’s model, there is a unique
unemployment rate at which inflation is constant and equal to the growth rate of money
supply, and this defines a vertical long-run PC. The crucial difference between the models
is the labour and product market behaviour.

4. In Keynesian theory, "rate of interest is what it is because it is expected to

become other than it is. If it is not expected to become other than it is, there is
nothing to tell us why it is what it is " Critically evaluate this comment and
explain the role of rate of interest in determination of equilibrium income.

Ans.
In the Keynesian model of Liquidity preference rate of interest is determined by bearish
and bullish sentiments prevalent based on their expectations about future interest rate and
subsequent capital gain or capital loss.
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When r > ri for an individual, they will expect it to

fall to ri in future which would increase bond price
in future and help them earn capital gain. Hence,
they act as bull and buy bonds. Similarly when r <
ri , they act as bears and sell bonds with infinite
speculative demand for money.
Different individuals have different subjective ri
where some act as bear and some as bull. This
interplay between results in the interest rate that is
presently existing.

Case of Liquidity Trap

At a very low rc when everyone turns bearish

and expects interest rate to rise in the future,
Speculative demand for money will become
infinite and everyone wants to sell bonds.

Limitations - Critical Evaluation Part

1. If the portfolio was expanded to include

more assets, then the relation may not have
been that strong (as explained by monetarists).
2. Portfolio is assumed to have only bonds
or only assets. However, in real world a risk
averse individual would have a mix of both
(Baumol - Tobin model for inventory)

Role of interest rate in determination of equilibrium output:

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Interest rate determined in the money market is used to determine AD in the goods market
which in turn influences interest rate.

At point A both money and goods markets are in disequilibrium. An EDM with a given MS
increases interest rate and brings the money market in equilibrium. As at i1 , there is excess
demand for goods, supply increases (Y↑ → MD ↑ → given 𝑴𝒔 → r↑). This process continues
till equilibrium output is achieved. Hence, rate of interest while it is itself influenced by
Regressive expectation or Speculative MD, by influencing investments brings equilibrium
outputs.

5. The advent of new classical macroeconomics has tended to upset the Apple
cart of Keynesian and to a great extent that of monetarists. Discuss.

New classicals were based on rational expectations theory where agents would make their
decision based on all relevant information available i.e., expectations were forward looking.
This is in contrast to the assumption of non-adaptive expectation of Keynesian and
adaptive expectations of monetarists.
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New classical Keynesian

1. Agents/Workers have 1. Agents/workers have non adaptive

a. All relevant information expectations - Money illusion and
b. Make sense of information downward wage rigidity.
Have rational expectations and wage
flexibility even in the short run.

2. Policy ineffectiveness - if central 2. Effectiveness of FP and MP in

banks policy was credible or MP & FP stimulating AD against shocks by
are systematic or anticipated then creating money illusion and hence
workers will revise their nominal achieving unemployment other than
wages so that real wages stay constant full employment level or bringing
even in the short run. back the economy to full employment
level.

3. Breakdown of inverse relation of 3. Inverse relation of inflation &

unemployment even in the short run. unemployment (non-adaptive inflation
Therefore, policymakers can’t achieve expectation) believing that
Ut by increasing inflation and any policymakers can forever keep Ut < Un
attempt at decreasing Un will only by accepting higher inflation. Their PC
create higher inflation. is downward sloping even in the long
run – original PC.

This is what Friendman called

Keynesian orthodoxy based on non
adaptive only to be proven later that
lower Un eq is stable only with ever
rising inflation as expectations are
adaptive. Leading to stagflation.

New Classical and Monetarists

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Monetarists' long run view align with new classicals. But Monetarists assume that workers
have adaptive expectations of inflation, hence in short run, monetary policy can fool
workers and achieve lower unemployment rate but in long run nominal wages get revised
again to keep real wages constant. This is in contrast to New classical who argue
anticipated monetary policy cant fool workers even in the short run. New classical align
with monetarists only when monetary policy is unanticipated.

Hence, the New Classicals upset the short run policy goals of monetarists. Although both
new classicals and monetarists suggest non-interventionist policy as per the long run
mission.

NOTE:

Phillips Curve SR LR

Monetarists Negatively Sloped Vertical

New Classicals Vertical Vertical

6. Is stagflation a logical outcome of Keynesian orthodoxy? Give reasons.

Ans.

Stagflation in simple terms is stagnant output growth (corresponding unemployment rate)

with rising inflation.
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Early Keynesians argued that the trade-off between inflation rate and unemployment rate
is permanent. Hence with optimal policy measures (MP/FP) one can achieve lower
unemployment rate than natural level, correspondingly higher output growth in perpetuity
if one is ready to tolerate higher but constant inflation rate.

Eg. With expansionary MP/FP one can lower unemployment rate to 5% than the natural
level of 10% with an inflation of 10% rate in perpetuity.

However, Friedman termed this naive assumption of Keynesian as “Keynesian Orthodoxy”.

Friedman argued that permanent trade-off between inflation and unemployment is possible
only when the labour has non adaptive expectations about inflation which is a “keynesian
Orthodoxy” as they cannot be fooled to accept higher actual inflation with lower nominal &
real wages in perpetuity. Instead, they will realise their mistake soon and would adapt to
higher inflation by asking for higher nominal wages and initial real wages. Thus returning
to the natural level of unemployment & corresponding output growth only with higher
inflation.

Therefore, trade-off is only in the short run as workers have adaptive expectations. This is
shown in the diagram below.

Further to Friedman any attempt to keep lower unemployment rate (higher output growth)
would come only at the cost of accelerating inflation. Also, the accelerated inflation rate
would only ensure the existing given level of unemployment rate (corresponding output
growth) and would not decrease unemployment rate further (and increase corresponding
output growth further) as the orthodox Keynesian predicted.
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This is shown in the diagram below as a vertically shifted Phillips Curve where the
unemployment rate is U1 while inflation rate rises after every period to keep U1 constant.
This is stagflation constant U1 unemployment rate (hence constant output growth) with
ever increasing inflation rate, the logical outcome of Keynesian orthodoxy.

Thus, the fundamental reason for Keynesian orthodoxy is their naive assumption of
non-adaptive expectation of inflation by the workers.

7. What is hysteresis? Explain the impact of hysteresis in Gradualist Monetarist

and Eclectic Keynesian frameworks.

Ans.
Hysteresis is an effect of a shock where, once a variable has moved away from equilibrium,
it has the tendency to stay there or to move to a new equilibrium.

Hysteresis in Eclectic Keynesian

The Keynesian model is based on imperfect competition in the product market and labour
market rigidities. Hence, it depicts pure hysteresis, i.e., the new equilibrium after the shock
is over is away from the old equilibrium.
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Reasons:

1. Downward wage rigidity due to staggered wage contract labour market.

2. Insider - outsider model where insiders after the shock is over wants to maximise
their utility and keep real wages high.
3. Loss of skill and employability of those unemployed during shock time.

Hysteresis in gradual Monetarist.

Monetarists' labour market is based on perfect competition and workers have adaptive
expectations in the medium run. Their hysteresis is therefore not pure but gradual.

This, implies that unemployment stays away from equilibrium level for a very long time
even when the shock is over but it ultimately returns to the same level in the long run.
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The difference in two hysteresis is due to different assumptions about the labour market and
workers expectations.

Empirical Evidences

1. In Europe higher Natural Unemployment Rate post WW2.

2. Post Covid US experiencing higher Natural Unemployment Rate due to great
resignation.
3. In India too, it has been pointed out by some economists that since Post
Demonetisation/GST? Covid, India’s Natural Unemployment Rate shifted from 3.5 to
7.5%.

8. What do you mean by Tobin’s “q” theory of investment? How would you
modify the standard IS-LM functions in the presence of Tobin’s “q”?

Ans.

Tobin's q theory of investment is forward looking. Firms choose the amount of

investment to undertake with a view to maximising the expected discounted profits
over the lifetime of the project.

The q theory amounts to comparing the benefits from investment in an increase in

the capital stock with the costs of doing so: if the expected benefits exceed the costs,
investment should take place.

MARGINAL ‘q’ model of investment

q = MB of investment/MC of investment

q = Pfk/α + r

where,

P = price of output; fk =marginal product of capital α = depreciation rate ; r = rate

of interest.
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q > 1 = make investment

q< 1 = don’t make investment

q = 1 = optimal capital stock

Criticism of MARGINAL q theory

Testing q theory directly is difficult because q itself is difficult to measure. This is

because it depends on the marginal product of capital and a measure of technology,
which cannot be observed. In the real world, firms do not know their production
functions and do not think explicitly in terms of marginal products.

AVERAGE Q theory of investment

To operationalize the theory, the market value of the firm as reflected in its stock
market valuation is compared with the replacement cost of the capital stock. If the
market value is higher then this signals that the firm should increase investment. On
the other hand, if the market value is below the replacement cost, then the firm
would not want to build a new factory because it could buy an existing one more
cheaply.

We can define average Q as follows: Q = Market value of firm / Replacement cost of

capital. For publicly listed companies, the stock market provides a forward-looking
measure of the market value of the firm, which can be used in the numerator of the
Q equation: when the firm’s market value rises relative to the replacement cost of
the firm, as reflected in a rise in the price of its shares, the model suggests that
investment should go up. A higher interest rate and depreciation rate will raise the
replacement cost of capital.

The idea is that the market value incorporates information about how well the firm
is expected to be able to implement the investment, whether new competitors will
enter the market, whether there are new technological innovations likely to affect
the firm’s value, the state of the macro-economy and the labour market and the
future path of the interest rate. Since investing in a firm is a wager on this uncertain
future, investors continuously evaluate these factors and, under certain conditions,
the share price and hence the market value of the firm will reflect all the
information available.
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INTEGRATING TOBIN’S Q THEORY INTO IS-LM MODEL

Tobin’s marginal q predicts that the following factors will shift the IS curve to the
right:

1. An increase in the price of output, P.

2. An increase in the marginal productivity of capital, fK; and

3. A reduction in the rate of depreciation, α.

Lastly, the average Q equation highlights the role of expectations of future profits as
a shift factor for the IS curve: a rise in the stock market tends to boost fixed
investment as it signals a rise in the value of companies relative to their replacement
cost.

EFFECT OF Q ON LM CURVE

Tobin’s q may influence speculative demand for money as it will broaden the basket
of assets thereby moderating the effect of r on speculative demand for money this in
turn will influence the slope of LM curve to be steeper.
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Section-c

1. Explain how Keynesian speculative demand for money is restated in regressive

expectation model. Point out its limitations.

Ans.

Keynes argued that money is demanded broadly for 2 purposes.

1) Transaction: which depends upon income level

2) speculative: which depends upon current rate of interest in money market. Keynes found
inverse relation between interest rate and speculative money demand. Speculative money
demand rises when rate of interest falls. However, Friedman and Tobin later criticised
Keynes as according to them an investor not only invest in bonds exclusively but in a broad
asset’s basket portfolio.

Regression: return of random variable to its average value.

Under regressive expectation model every individual holds his/her subjective view about
the long- term average interest rate. Further she/he expect market the interest rate to
return to its average value.

INDIVIDUAL BEHAVIOUR

If the current rate of interest is 6% then the individual will expect the interest rate to
regress towards 5% (its long-term average value) as bonds price and interest rate are
inversely related therefore, he expects capital gain hence would invest entire money
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exclusive of transaction balances in bonds and there will be 0 money demand for
speculative balances.

However, if market rate of interest goes slightly below 5% then he would hold entire extra
money balances (exclusive of transaction balances) in cash and would not make any
investment in bonds as he expects capital loss. This individual would behave like a
bull(optimist) in bonds market by investing his entire excess cash balances until market
interest rate is above 5% but will turn into bear(pessimist) once interest rate goes below
5%.

However other people have their own subjective idea about the average rate of interest so
they might still be expecting capital gain by investing in bonds even below 5%. The reason
for different subjective idea about average interest rate may be due to asymmetric
information and different risk appetite of individuals.

MARKET BEHAVIOUR
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Unlike individual speculative money demand, market money demand for speculation is
smooth curve and becomes horizontal only at a very low interest rate level of 2%. Why the
curve is smooth? Because there are large number of people each having their own expected
average rate of interest thus creation large number of such kinks and then joining those we
gate a smooth curve of speculative demand for money for the market as a whole. As the
rate of interest keep falling a greater number of individual starts believing that the current
rate of interest is below its long-term average and it would regress toward its average in
future hence, they expect capital loss and prefer holding cash balances.

When the interest rate becomes 2% almost everyone becomes bear and expect capital loss
at this level, they hold whatever cash is provided to them and no one invests in bond. This
is liquidity trap where monetary policy becomes impotent. In short it is regressive
expectation about the subjective average rate of interest in the economy which guides and
individual whether to invest in bonds or hold the cash for speculative purpose.

LIMITATIONS

1. Assumption Kinked speculative money demand curve of individual based on regressive

expectation is quite unreasonable. A smart investor will optimise his/her risk and would
invest some cash in bonds and hold the rest.

2. It is assumed that there is asymmetric market information among individuals hence

everyone has different idea about long-term average interest rate. This assumption does
not hold water as most of the investors in bonds market are rational and consider all the
relevant information.

3. Friedman and Tobin criticised Keynes as they clarified that an investor does not
necessarily invest in only one class of assets that is bonds.

2. Show that liquidity preference is neither necessary nor sufficient for the
existence of involuntary unemployment in Keynesian system.

Ans.

Liquidity preference theory states that money demand is a function of Y = income and i =
interest rate. Liquidity Preference (LP) = MD (Y*, i*) & hence determined ‘i’. Further through
interest rate determination unlike classicals it interlinks money and goods market. Now, any
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change in money demand or supply affects ‘i’ & through that investment which in turn affects
AD & equilibrium Y = Output.

Keynes further argued that in case of LP (extreme case of liquidity preference) speculative
money demand becomes infinite and the adjustment channel through interest rate and investment
fails. This leads to involuntary unemployment equilibrium. However, it can be shown that LP
(Liquidity Trap) is neither necessary nor sufficient for the existence of involuntary
unemployment equilibrium.

Case 1: Neither Necessary

It means even in the absence of LP theory economy can be stuck at involuntary

unemployment equilibrium when the money wages are downward inflexible.
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For instance if due to some demand shock AD0 shifts to AD1 then prices fall from P1 to P2
level and we reach point e1. Economy stocks at e1 as money wages are not flexible so real
wage rises and the labour market does not clear and is stuck at e1 (W1/P2 - higher real
wages than equilibrium real wage). Hence, involuntary unemployment equilibrium occurs
at e1 even in the absence of LP theory.

Case 2: Nor Sufficient

Keynes argued that LP theory includes extreme case of LT which can block the
adjustment mechanism in the product market and can lead to involuntary unemployment
equilibrium even when money wages are downward flexible.

In the LT case AD becomes vertical as the entire increase in real money supply due to
decrease in prices is willingly hoard by the public and hence no change in ‘i’ and no change
in investment ultimately leading to no change in output.

The vertical AD then blocks the economy from reaching full employment equilibrium even
in the presence of downward flexible money wages. This can be shown with the following
diagram.

Initially the economy is at full employment equilibrium ‘e’ where AD overlaps AS. But
when due to some demand shock AD shifts to AD1 the new equilibrium stocks at e1. Now,
even with the flexible money wage AS1(w1) shifts downward to AS2(w2). Again the economy
remains at below full employment equilibrium.

However, there still remains a possibility of reaching full employment equilibrium with the
help of Pigou’s Real Balance Effect.
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Pigou defined his consumption based on Y = income & Real cash balances = M/P
C (Y+, M/P+).

Therefore, when real cash balances increase due to fall in prices, consumption increases
which increases AD & Y = income thereby again producing downward sloping AD. This
helps achieve full employment equilibrium again.

Therefore, even in the presence of LT under LP theory full employment equilibrium is

ensured with the help of Real Balance Effect.

Hence, LP theory is not sufficient for involuntary unemployment equilibrium.

3. Explain how the equilibrium employment and real wage would change in a
typically classical model if, in the event of increase in supply of labour, money
wage becomes rigid.

Ans.

In case of money wages rigid, the real wages would rise above full employment equilibrium
in a typical classical model when there is increase in supply of labour. The classical model
would convert to Keynes involuntary unemployment equilibrium case with money wage
rigidity hypothesis. Let’s see how it proceeds:
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Classical model is based on the following assumptions

1. Perfect Competition in product and labour market which means flexible prices and
wages (Money/Nominal)
2. Perfect and complete information flow about price level and real wages among both
firms/workers.
3. Money is used only as a medium of exchange and MS is exogenously determined.
4. Technology remains constant in the short run, Hence, any increase in output can arise
only by employing more labour.

In a perfect classical model real factors like technology and labour determine the
equilibrium level of employment. In the given case labour market equilibrium will occur
given MPL = W/P - perfect competition firm behaviour at e1 where w1 = W1/P1 is the real
wage and L* is equilibrium labour employment. This labour at a given state of technology
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and capital stock fixed in short run would produce Y* level of output which would remain
fixed and price level would be determined by the given MS determined exogenously (M1).

Now, Consider an increase in supply of labour. In usual situation this would shift the LS
curve rightward and put pressure on real wage.

In a typical classical case this would lead to lower money wage and real wage would fall
which ultimately would lead to increase in Y and decrease in P at a given stock of money
fixed (M1).

However, money wage has been assumed to be fixed so there would be no change in real
wages due to fall in money wages.

However real wages can still fall to absorb all the increased labour if prices can be
increased by increasing money supply and shifting AD rightward. This would increase
prices from P1 to P2. Given fixed money wage w1 but higher price P2. Real wage can fall to
w2 = W1/P2. If this does not happen then in the absence of downward flexibility money
wages and assuming money supply constant, there would be an excess supply of labour at
the given real wage which represents Keynesian case of involuntary unemployment at the
prevailing real wages.

The economy with rigid money wages even with increased supply of labour would remain
stuck at its original position e1 with L*, Y* and P1 along with involuntary unemployment.
Such a case is possible in the presence of a strong labour union.

4. Macroeconomics is usually approached via the outcomes of economic

interaction in the following four mark–commodities, money, bonds, and labour
markets. The Classical economists focused on which three of these four
markets? In which market does the loanable fund theory of interest rate
determination of the Classical economists focus and how is the interest rate
determined? The Neo-Classical synthesis focuses on which three markets? In
which market is the interest rate primarily determined in the liquidity
preference theory?
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Ans.

Four major markets of macroeconomics

1. Good
2. Money
3. Bond
4. Labour
Classicals - Focused on goods, bond and labour market.

1. Labour Market - Labour demand (MPN) and labour supply

based on labour preferences gives equilibrium employment
(based on real supply side factors)
2. Goods Market - Equilibrium employment at given
technology gets translated into equilibrium output in goods
based on the production function slope.
3. Bond Market: Loanable fund theory focuses on bond
markets where;
● (LFSS) Supply of Loanable Fund = Demand for Bond
● (LFDD) Demand for loanable Funds = Supply of Bonds
● LFSS is done by household savings preferences and LFDD is
demand by government and investment in a closed economy.
Equilibrium point occurs at i* and Lf.
● An increase in LDdd to LFdd’ increase interest rate →
Household saving in private investment decreases
simultaneously (crowding out) till new equilibrium is reached
at i**.
4. Money Market: It is missing in classical due to the
assumption of money’s demand only for transaction purposes.
Hence money is interest inelastic and is demanded as a stable
proportion of nominal income. Therefore, money only
determines price level (nominal variable) and not the real
variable-output which is determined in labour, goods and bonds
market. MS = MD = k(PY). In classical model both MP and FP are ineffective.
MP only leads to increase in prices no effect on real output (classical dichotomy).
While FP leads to fall in private investment and consumption equivalent to fiscal
stimulus thus neutralising the effect.
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Neo Classical Synthesis: It was a compromise between early Keynesians and classicals that
while in short run Keynesian economics apply, in the long run it is classicals conclusions
which are more realistic. It focused on money, goods and labour market.

1. Money Market: Determination of interest rate due to change in money supply by the
central bank or change in money demand due to income level and interest rate. – LM
MARKET.
2. Goods Market: Determination of output based on relationship between interest rate and
output via investment channel along with other demand components. – IS MARKET
3. Labour Market: Determination of AS shift based on adaptive expectations of wages in
the medium run and while movement along AS curve due to money illusion on the part of
labour. -PHILLIPS CURVE

Neo classical synthesis is basically the integration of IS-LM model with PC model

Liquidity Preference Theory of Keynesians

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Keynesians assumed only money and bonds in

the portfolios. Equilibrium in the money
market is equal to equilibrium in the bond
market. Hence, interest rate is determined in
the money market based on money demand
and money supply and assumes it to be the
same for the bond market.
Therefore, interest rate is primarily determined
based on speculative demand for money as
transaction demand for money is
comparatively stable – it only changes with
income, so whenever there is change in exogenous money supply its primarily speculative
money demand which adjust and determine equilibrium interest rate alternative it’s the bond
market which primarily determines the interest rate. When MD > MS, interest rate increases to
decrease speculative demand for money and vice-versa.

5. Use the IS–LM model to predict the effects of each of the following shocks on
income, the interest rate, consumption, and investment. In each case, explain
what the RBI should do to keep income at its initial level.

1. After the invention of a new high-speed computer chip, many firms decide to
upgrade their computer systems.
2. A wave of credit-card and UPI fraud increases the frequency with which
people make transactions in cash.
3. A best-seller titled “Retire Rich” convinces the public to increase the
percentage of their income devoted to saving.

Ans.

Invention of new high speed computer chip

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1. Since firms decide to upgrade computers,

autonomous investment will increase & shift IS curve to the
right by 𝛂G multiplier times.
2. Increase in Y increases money demand. Therefore,
the interest rate rises to decrease speculative demand for
money (r1 to r2).
3. Effect on Output - Output increase by less than
multiplier (𝛂G) times due to crowding out of private
investment with increase in interest rate.
4. Effect on Consumption - Autonomous consumption remains unchanged but cΔY
increases due to change in income (0 < c <1).
5. Net effect on investment: Increase in Autonomous I (from I1 to I2) - Investment crowding
out = Positive increase in net investment.
(Not -Ve because - Y↑ as AD↑. Therefore, investment now must be higher than earlier.)
(What would RBI do? – Its should Reduce Money Supply shifting LM backward to have
higher interest rate but along with initial level of employment).

A wave of UPI and Credit Card fraud increases the frequency with which people make
transactions in cash.

From money demand perspective this implies that sensitivity of transactions demand for
money has increased (k↑) as the velocity of money falls (V↓). It makes the LM steeper as a rise
in Mdd due to rise in income will require a larger increase in interest rate to keep the money
market in equilibrium.
From the money supply perspective money multiplier would decrease due to higher currency
holding this would shift the LM curve backward. Hence the combined effect is both LM shifting
backward and LM becoming steeper.
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1. Effect on interest rate: Increase due to higher money demand high k and lower money
supply due to lower money multiplier.
2. Effect on investment: Fall in interest rate induced investment due to higher interest.
3. Effect on output: Fall in output due to lower AD due to lower investment demand.
4. Effect on consumption: induced consumption falls due to fall in income.

Solution: increasing money supply by either through increasing high-powered money or through
decreasing repo rate and thus increasing money multiplier.

Retire rich:

If percent of income to be saved increases,

c=mpc will fall, which implies consumption
will fall at every income level and bring a
multiplier effect making IS curve steeper. 𝛂G =
1/1-c, and slope of IS is 1/𝛂Gb , therefore IS
become steeper and a change in interest rate
will bring lesser impact on output due to
decreased multiplier.

S = -𝐶̅ + (1-c)Y
𝑐̅ - Autonomous Consumption
c - Marginal Propensity to Consume

1. Effect on Interest Rate: Decrease due to increased supply of savings.

2. Effect on Investment: It rises unambiguously due to fall in the interest rate.
3. Consumption falls due to fall in MPC
4. Income falls due to fall in consumption.
Therefore, dynamic changes in the economy and their assets can be interpreted using the IS-LM
model.

Solution: Shift LM rightwards by increasing MS

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6.What are the similarities and differences between the new classicals model, real
business cycle and new Keynesians models?

Ans.

characteristics New classicals Real business New Keynesians

cycle
• Consumer • Consumer • Consumer
Micro-foundation utility max. utility max. utility max.
• Profit max. by • Profit max. by • Profit max.by
producer producer producers

Rational -forward Rational -forward Rational – forward

Expectations looking looking looking

Perfectly competitive Perfectly competitive Imperfect labour and

Market structure labour and product labour and product product market
market market
• Below full • Chain of • Sustained
Equilibrium status employment dynamic below full
only in short equilibriums employment
run when adjusting to equilibrium
policy change every shock. due to
or shock is Explaining coordination
unanticipated. business cycle. failure and
• Do not explain • Explain social cost
sustained long- sustained arising from
term below full below full labour union’s
employment employment negative
equilibrium. equilibrium. externality
• Do not support and menu
response to cost’s negative
unanticipated externality.
fluctuation in • Explain
demand as sustained
agents optimize below full
by paying for employment
information. equilibrium.
So, we are • Anticipation
always on full of shocks is
employment not possible
equilibrium for agents as
but that level government
of full always possess
employment more
equilibrium information.
itself keep
changing.
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On demand side shocks On supply side On demand side

Primary Focus or changes which are technological changes. shocks.
unanticipated in short-
run.
Do not support activist MP and FP lead to “Day light saving”
Policy support MP and FP. suboptimal analogy and resulting
Unanticipated shock is optimisation. coordination failure
unanticipated for both Therefore, MP and FP due to demand shocks
government and public. should be used only for leads to below full
Once it is known to stabilization and employment
government then it is correcting the prices to equilibrium.
also known to public so help optimisation by Forwarding of watches
no surprise and hence the agents. of the whole nation can
no requirement for help. Therefore, they
activist MP and FP. support visible hand of
Rather use MP and FP government and
for stabilising the activist role for MP
economy. It assumes and FP for watches
symmetric information. coordination.

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