Assignment No.

01
Macro Economics

Question No. 1

Explain different methods of measurement of National Income.

The national income accounts are an interlocking set of statistics on a national

economy’s consumption, production, and asset accumulation. National income accounts
have two roles: the measurement of economic activity and the measurement of economic
well-being, or progress. In an important sense, these two roles are one, as economic
activity derives its rationale from its social benefit.
According to A.C. Pigou (1938), whose work set forth the basic framework for welfare
analysis in economics, the national income is a measure of the part of national welfare
that can be “brought directly or indirectly into relation with a money measure.”
Pigou’s definition is limited to those elements of welfare that can be measured by money,
but it does not draw a fixed line between what can and cannot be measured. In practice,
that boundary has evolved over time.

The limited but highly practical achievement of this measurement task has been one of
the great accomplishments of economics and supports the claim that economics is an
empirical science. A nation’s national income accounts have grown to include analytical
detail on consumption, production, income, and foreign trade, as well as statistics on
saving and investment and their relation to stocks of physical capital and financial assets
and liabilities. These statistics are central to economic and political evaluation and
planning throughout the world.

In accepting the measuring rod of money, we accept limitations on our welfare measure
both in concept and in scope. The measure is largely plutocratic, as wealthy households
command more consumption than poor ones. As such, it is a measure that is comfortable
with the existing structures of economic power. As the American economist and 1971
Nobel laureate Simon Kuznets stressed, changes in income distribution across
households should be a crucial component of the evaluation of national income, but as of
2006, income distribution has not been included in national income accounts.

Monetized activity sets the general boundary for national income measurement.
Household production – the use of household time and energy in tasks such as studying,
cooking, and cleaning – is generally not included in consumption because it is unpriced.
One exception is that owner-occupied housing is treated as if the household were renting
from itself; otherwise, the shift from tenancy to owner occupation in many countries
would appear as a decline in consumption of shelter services. Another exception,
important in many countries, is owner-consumption of farm products.
Production has two objects: consumption and accumulation. We turn first to consumption
expenditures, which form the core of measured welfare benefits.

Consumption comparisons over time. As prices and money, or nominal expenditures,

change, is it possible to quantify how much consumers are better off in one period
compared to another? Within limits, yes. In two periods, the consumer buys two different
baskets of goods and services. Now suppose the items bought in the first period could
have been purchased in the second period for less than the items already purchased in
the second period. Then we can argue that the consumer must be better off, for the
alternative was freely chosen. If the consumer pays 2 percent more than the first period 6
basket would have cost, real consumption expenditures are said to have risen by (at least)
2 percent. While this does not amount to 2 percent more happiness, it does imply that we
could have remained as well off using 2 percent less products and 2 percent less work
and capital (assuming constant returns to scale), so it is a meaningful quantification.

To consumption, we now add investment. To capture overall economic progress, the rate
of net investment – gross investment less loss of existing capital due to depreciation,
called capital consumption — provides an idea of how much more production could have
been devoted to consumption without running down the capital stock and, at the same
time, of how rapidly the economy is likely to grow, since more net investment today
implies more capital input for tomorrow’s production.

Mainly for historical reasons, gross domestic product (GDP, product without deducting
capital consumption) has been the featured measure of real economic activity.
Consumption of fixed capital is about 10 percent of net domestic product in countries as
different as the US and India. Net domestic product, GDP less capital consumption,
would be more exact as a measure of progress, but GDP is easier to measure in detail.
One way to measure real investment in terms comparable to real consumption could be
to deflate nominal investment growth by the consumption inflation rate, a measure
showing the quantity of consumption that is given up to provide investment. The
alternative, the method actually employed in national income accounting, is to measure
the change in prices of these investment goods themselves, combining them into Fisher
ideal indexes. This measure is the appropriate one for measuring the contribution of the
new investment to the stock of capita assets.
 Question No. 2
Part (a)

• Explain the Inflationary and Deflationary Gaps with examples.

• Deflationary and Inflationary Gaps:

• When the equilibrium level of output is less than the natural rate, as
shown below, a
• Deflationary GAP exists. In the figure, the equilibrium level of
output, Y, is less than the natural level of output, Yn. A deflationary
gap calls for an Expansionary Fiscal Policy, such as an increase
in government spending or reduction in taxes, or an Expansionary
Monetary Policy.
• Such an expansionary policy shifts the AD curve to the right and
increases the equilibrium level of real GDP.

• When the equilibrium level of output is greater than the natural

rate, an Inflationary GAP exists. This is illustrated above, where
the equilibrium level of output, Y, exceeds the natural level of
output, Yn. When the economy experiences an inflationary gap, a
Concretionary Fiscal
• Policy, such as a decrease in government spending or increase in
taxes, or a Concretionary
• Monetary Policy is appropriate. These policies shift the AD curve
to the left.

• If the economy is in a deflationary gap then price expectations of workers are

higher than actual prices. Eventually price expectations will be revised
downward. This will shift short-run AS to the right and bring the economy
back to potential GNP.

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

• If expansionary fiscal policy is not anticipated then real GDP would be

increased and the price level would rise. If expansionary policy is fully
anticipated then the price level would rise even further but real GDP would
remain unchanged.
 Question No. 2
Part (b)
What are the determinants of investment? Explain briefly.

Investment is influenced by demand conditions, the effects of which

(including profitability) can be represented by the accelerator effect, and
cost conditions, as summarized by the user cost of capital. Researchers
have found that another independent determinant of investment behavior
is liquidity—the liquid assets a company has on hand plus the cash flow
it is currently generating. While the user cost of capital varies with the
cost of funds in credit markets or to firms issuing equity, many firms are
limited in their access to these markets. Because they must rely primarily
on internal funds to finance investment, liquidity matters. The liquidity
constraint seems particularly to affect smaller corporations and (along
with accelerator effects) helps explain investment volatility, because cash
flow itself (after-tax profits plus book depreciation) is very cyclical.

Liquidity also plays an important role in residential investment. About

two-thirds of all residential investment takes the form of owner-occupied
housing. The reliance of home buyers on the mortgage market has
wrought havoc on residential construction during periods of tight credit
that typically have accompanied recessions. As a result residential
investment has often been even more cyclical than other forms of fixed
investment. However, the reliance on borrowed money has, in certain
periods, actually encouraged investment in owner-occupied housing,
through the interaction of inflation and the tax system.

Inflation encourages housing investment in two ways. First, mortgage

interest payments are tax deductible. As interest rates rise with inflation,
so do tax deductions, even if the real interest rate, defined as the interest
rate less the inflation rate, does not. For example, if the interest rate is 8
percent and the inflation rate 4 percent, the real interest rate is 4 percent,
and an investor in the 28 percent tax bracket gains a tax reduction of
2.24 cents (28 percent of 8 percent) per dollar of debt. If the real interest
rate remains at 4 percent, but the inflation rate rises to 8 percent, the
nominal interest rate rises to 12 percent and the value of tax deductions
rises to 3.36 cents (28 percent of 12 percent) per dollar of debt.

Second, the increased value of a home that accompanies inflation is

essentially untaxed, because of provisions that allow a tax-free rollover if
another house is purchased and a one-time exclusion of gain (currently
$125,000) after age 55. [Editor's note: this provision of the tax code
changed dramatically in 1997.] This favors investment in owner-
occupied housing over other types of investment with taxable gains.
Another disadvantage of other types of fixed investment is that the
depreciation allowances that investors receive are based on original
asset cost, which may fall well short of true replacement cost in the
presence of inflation. (This is not a problem faced by owner-occupiers,
who do not receive depreciation allowances.)

The evidence in favor of the hypothesis of inflation-induced investment in

owner-occupied housing comes primarily from the late seventies, when
the hypothesis arose. During the economic expansion from 1976 to 1979,
when inflation averaged 7.3 percent (measured using the GNP deflator,
based on the prices of all goods and services included in GNP),
investment in owner-occupied housing accounted for 33.5 percent of
fixed investment. During the comparable expansion period of 1983 to
1986 with inflation averaging just 3.3 percent, residential investment's
share fell to 29.1 percent.

An alternative explanation, for which there is evidence, is that the

increase in housing investment in the late seventies was caused by the
increase in family formation during the period—the coming of age of the
baby boomers. If this explanation is correct, then housing prices and
demand are likely to decline into the next century, well past the housing
slump of the 1990-91 recessions.
 Question No. 3
What are the effects of government spending taxation on output of a
country?

Export Tax Effects on:

Exporting Country Consumers - Consumers of the product in the exporting

country experience an increase in well-being as a result of the export tax. The
decrease in their domestic price raises the amount of consumer surplus in the
market. Refer to the Table and Figure to see how the magnitude of the
change in consumer surplus is represented.

Exporting Country Producers - Producers in the exporting country experience

a decrease in well-being as a result of the tax. The decrease in the price of
their product in their own market decreases producer surplus in the industry.
The price decline also induces a decrease in output, a decrease in
employment, and a decrease in profit and/or payments to fixed costs. Refer
to the Table and Figure to see how the magnitude of the change in producer
surplus is represented.

Exporting Country Government - The government receives tax revenue as a

result of the export tax. Who benefits from the revenue depends on how the
government spends it. Typically the revenue is simply included as part of the
general funds collected by the government from various sources. In this case
it is impossible to identify precisely who benefits. However, these funds help
support many government spending programs which presumably help either
most people in the country, as is the case with public goods, or is targeted at
certain worthy groups. Thus, someone within the country is the likely
recipient of these benefits. Refer to the Table and Figure to see how the
magnitude of the tariff revenue is represented.

Exporting Country - The aggregate welfare effect for the country is found by
summing the gains and losses to consumers and producers. The net effect
consists of three components: a positive term of trade effect (c), a negative
consumption distortion (f), and a negative production distortion (h). Refer to
the Table and Figure to see how the magnitude of the change in national
welfare is represented.
Effects of an Export Tax
Importing Country Exporting Country
Consumer Surplus - (A + B + C + D) +e
Producer Surplus +A - (e + f + g + h)
Govt. Revenue 0 + (c + g)
National Welfare - (B + C + D) + c - (f + h)
World Welfare - (B + D) - (f + h)
Because there are both positive and negative elements, the net national
welfare effect can be either positive or negative. The interesting result,
however, is that it can be positive. This means that an export tax
implemented by a "large" exporting country may raise national welfare.

Generally speaking,

1) Whenever a "large" country implements a small export tax, it will raise

national welfare.
2) if the tax is set too high, national welfare will fall and
3) There will be a positive optimal export tax that will maximize national
welfare.

However, it is also important to note that everyone's welfare does not rise
when there is an increase in national welfare. Instead there is a redistribution
of income. Producers of the product and recipients of government spending
will benefit, but consumers will lose. A national welfare increase, then, means
that the sum of the gains exceeds the sum of the losses across all individuals
in the economy. Economists generally argue that, in this case, compensation
from winners to losers can potentially alleviate the redistribution problem.

Export Tax Effects on:

Importing Country Consumers - Consumers of the product in the importing

country suffer a reduction in well-being as a result of the export tax. The
increase in the price of both imported goods and the domestic substitutes
reduces the amount of consumer surplus in the market. Refer to the Table
and Figure to see how the magnitude of the change in consumer surplus is
represented.

Importing Country Producers - Producers in the importing country experience

an increase in well-being as a result of the export tax. The increase in the
price of their product on the domestic market increases producer surplus in
the industry. The price increase also induces an increase in output of existing
firms (and perhaps the addition of new firms), an increase in employment,
and an increase in profit and/or payments to fixed costs. Refer to the Table
and Figure to see how the magnitude of the change in producer surplus is
represented.

Importing Country Government - There is no effect on the importing country

government revenue as a result of the exporter's tax.

Importing Country - The aggregate welfare effect for the country is found by
summing the gains and losses to consumers, producers and the government.
The net effect consists of three components: a negative term of trade effect
(C), a negative production distortion (B), and a negative consumption
distortion (D). Refer to the Table and Figure to see how the magnitude of the
change in national welfare is represented.
Since all three components are negative, the export tax must result in a
reduction in national welfare for the importing country. However, it is
important to note that a redistribution of income occurs, i.e., some groups
gain while others lose. In this case the sum of the losses exceeds the sum of
the gains.

Export Tax Effects on:

World Welfare - The effect on world welfare is found by summing the national
welfare effects in

The importing and exporting countries. By noting that the terms of trade gain
to the exporter is equal to the terms of trade loss to the importer, the world
welfare effect reduces to four components: the importer's negative
production distortion (B), the importer's negative consumption distortion (D),
the exporter's negative consumption distortion (f), and the exporter's
negative production distortion (h). Since each of these is negative, the world
welfare effect of the export tax is negative. The sum of the losses in the world
exceeds the sum of the gains. In other words, we can say that an export tax
results in a reduction in world production and consumption efficiency.

Question No. 4
Part (a)

Public and Private Finance.

Public Finance:

“Public finance (government finance) is the field of economics that

deals with budgeting the revenues and expenditures of a public sector
entity, usually government.”

Matters addressed by the subject include:

• Effects of government spending, taxation, and borrowing on
households, businesses, and the economy
• rules that should apply to the conduct of such activity tax
incidence (who really pays a particular tax)
• Voluntary exchange vs. government-mandated provision of
goods and services
• Cost-benefit analysis of government activity
• The role of government in affecting income distribution through
taxes, government spending on goods, and transfer payments
 • Efficiency of spending - how efficient are governments at
obtaining their objectives? How much of their expenditure
actually goes to where it is intended? what types of waste exist?
• Efficiency and distribution effects of different kinds of taxes (for
example, on income or consumption)
• Scope of government activities - what do governments spend
money on? what should governments spend money on? What
can be left to markets? Why governments should be concerned
with externalities, public goods
• Fiscal politics, modeling public spending and taxation as affected
by interactions of self-interested voters, politicians, and
bureaucrats.

Question No. 4
Part (b)

Aggregate Demand:

Aggregate demand is the total demand for final goods and services in the economy (Y) at
a given time and price level[1]. This is the demand for the gross domestic product of a
country when inventory levels are static. It is often called effective demand or
abbreviated as 'AD'. In a general aggregate supply-demand chart, the aggregate demand
curve (AD) slopes downward (indicating that higher outputs are demanded at lower price
levels).

Components:

Yd = C +I + G ( X – M )

Where

• C is consumption = ac + bc*(Y - T),

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

• Personal consumption expenditures (C) or "consumption," demand by

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

In sum, for a single country at a given time, aggregate demand (D or AD) = C + Ip +

G + (X-M).

These macro variables are constructed from varying types of micro variables from the
price of each, so these variables are denominated in (real or nominal) currency terms.
 Question No. 5
Part (a)
Define Money and explain the functions of Money.

We say traditionally that money has four major functions. It is a

Medium of exchange:

Whatever people usually give in exchange for the things that they buy is the medium of
exchange. As we have seen, this is the function that defines money.

Unit of account:

The unit of account is the unit in which values are stated, recorded and settled. The
differences between this and the medium of exchange may seem subtle, but there are a
few cases in which the unit of account is different from the unit in which the medium of
exchange is expressed. In Britain a few decades ago, Guineas were often used as the unit
of account, while the medium of exchange was expressed in Pounds. Both Guineas and
Pounds in turn could be expressed in shillings -- the Pound was 20 shillings and the
Guinea was 21 shillings. (British currency has since been redefined).

Standard of deferred payment:

This is the unit in which debt contracts are stated. Deferred payment means a payment
made in the future, not now. Here, again, it is usually the same as the medium of
exchange, but not always. During periods of inflation, people may accept paper money
for immediate payment, but insist on some other medium, such as real goods and services
or gold, for deferred payment -- because the medium of exchange would lose much of its
value in the meanwhile.

Store of value:

Again, this is something that people keep in order to maintain the value of their wealth.
Again, while it would usually be the same as the medium of exchange, in inflationary
times other media might be substituted, such as jewelry, land or collectable goods. In this
sense, money is "set aside" for the future.

Question No. 5
Part (b)

Briefly discuss the functions of State Bank of Pakistan.

REGULATION OF LIQUIDITY:

Being the Central Bank of the country, State Bank of Pakistan has been entrusted with the
responsibility to formulate and conduct monetary and credit policy in a manner consistent
with the Government’s targets for growth and inflation and the recommendations of the
Monetary and Fiscal Policies Co-ordination Board with respect to macro-economic
policy objectives. The basic objective underlying its functions is two-fold i.e. the
maintenance of monetary stability, thereby leading towards the stability in the domestic
prices, as well as the promotion of economic growth.

REGULATION AND SUPERVISION:

One of the fundamental responsibilities of the State Bank is regulation and supervision of
the financial system to ensure its soundness and stability as well as to protect the interests
of depositors. The rapid advancement in information technology, together with growing
complexities of modern banking operations, has made the supervisory role more difficult
and challenging. The institutional complexity is increasing, technical sophistication is
improving and technical base of banking activities is expanding. All this requires the
State Bank for endeavoring hard to keep pace with the fast-changing financial landscape
of the country. Accordingly, the out dated inspection techniques have been replaced with
the new ones to have better inspection and supervision of the financial institutions. The
banking activities are now being monitored through a system of ‘off-site’ surveillance
and ‘on-site’ inspection and supervision. Off-site surveillance is conducted by the State
Bank through regular checking of various returns regularly received from the different
banks. On other hand, on-site inspection is undertaken by the State Bank in the premises
of the concerned banks when required.

EXCHANGE RATE MANAGEMENT AND BALANCE OF PAYMENTS:

The Bank is responsible to keep the exchange rate of the rupee at an appropriate level and
prevent it from wide fluctuations in order to maintain competitiveness of our exports and
maintain stability in the foreign exchange market. To achieve the objective, various
exchange policies have been adopted from time to time keeping in view the prevailing
circumstances. Pak-rupee remained linked to Pound Sterling till September, 1971 and
subsequently to U.S. Dollar. However, it was decided to adopt the managed floating
exchange rate system w.e.f. January 8, 1982 under which the value of the rupee was
determined on daily basis, with reference to a basket of currencies of Pakistan’s major
trading partners and competitors. Adjustments were made in its value as and when the
circumstances so warranted. During the course of time, an important development took
place when Pakistan accepted obligations of Article-VIII, Section 2, 3 and 4 of the IMF
Articles of Agreement, thereby making the Pak-rupee convertible for current international
transactions with effect from July 1, 1994.

DEVELOPMENTAL ROLE OF STATE BANK:

The responsibility of a Central Bank in a developing country goes well beyond the
regulatory duties of managing the monetary policy in order to achieve the macro-
economic goals. This role covers not only the development of important components of
monetary and capital markets but also to assist the process of economic growth and
promote the fuller utilization87 of a country’s resources.