Question 10(a):

Marginal Propensity to Consume:

The ratio of the change in consumption to the change in disposable income is called Marginal
Propensity to Consume (MPC). (Arnold Roger A., Macro Economics, pg no. 202)

It is expressed as the derivative of the consumption (C) function with respect to disposable income
(Y).the formula is as follows:

Here, is the change in consumption, and is the change in disposable income that produced the
consumption.

The above consumption function is calculated through the help of MPC. Here consumption as well
as disposable income increases.

Taken from Roger A. Arnold.

Question 10(b):

We know that,

= 60/100

=.60

Here, ∆C=( 400-340)bn

∆Y= (650-550) bn

So, MPC is .60.

Taken from Roger A. Arnold.

Question 10(c):
If the MPC remains constant then the consumption level would increase. The consumption function
tells that it will be changed if MPC, disposable income or autonomous consumption changes.

According to “Consumption Function” the formula of consumption is as follows:

C = Co + (MPC) Yd

=100 + (.60)700

=100 + 420

=520

Note:

It is assumed that autonomous consumption (Co) was 100. MPC was .60. GDP refers to the
disposable income.

Taken from Roger A. Arnold.

Question 10(d):

Aggregate Expenditure is the summation of consumption, investment and Government expenditure.

E = C + I + GE + Net Export

= 400+120+150+(export- import)

=670+( 140-145)

=670 – 5

=665

Taken from Roger A. Arnold.

Question 10(e):

According to above question, if GDP is $650 bn then it means that GDP and expenditure is same
according to the expenditure approach. GDP can be calculated in several ways. Expenditure
approach is one of them.

Taken from Roger A. Arnold.

Question 12(a):

Demand-pull inflation:

An inflation, which occurs when there is an increase in aggregate demand is called demand-pull
inflation. The aggregate demand can be classified as four sections, such as, households, businesses,
governments and foreign buyers. It is called demand-pull inflation when the four factors want to
purchase more output than economy can provide. As the demand is high and supply is limited so
price goes up. (Ahuza 1980)

P= price level

GDP=Gross Domestic Product

AD=Aggregate Demand

LRAS= long run aggregate supply curve.

The diagram tells that demand curve shifts rightward from AD1 to AD2. Because of shifting of
demand curve prices of good increase. As the inflation is occurred by rise of demand, so it is called
demand-pull inflation.

Cost-Push Inflation:

An inflation occurs because of increase of the cost of production is called Cost-Push Inflation. Here
supply decreases as production cost increases. Price increases because of four factors. Such as:
labor, capital, land or entrepreneurship. (Ahuza 1980)
P= price level

GDP=Gross Domestic Product

AD=Aggregate Demand

S=supply curve.

Here price increases from p2 to p1. The rise is occurred because of increase of factors of production.
As the price increases capital to the producers are not capable to produce more. Hence, supply of
goods decreases. It is clear that because of rise of production cost the supply of goods decreases.
Ultimately, the price of the goods would be increased. This is called Cost-Push Inflation.

Demand-pull inflation Cost-Push Inflation

It occurs when demand for product increases.

It occurs when production cost increases.

The factors that influence the inflation are households, businesses, governments and foreign buyers.

The factors that influence the inflation are labor, capital, land or entrepreneurship.

Demand-pull inflation can occur the influence of households, businesses, governments.

To maintain (or increase) profit margins, they will need to raise the retail price paid by consumers,
thereby causing inflation.

It is not too easy to recover the inflation. Industries can recover the inflation by sacrificing
their desired profit.

Taken from H. L. Ahuza.

Question 12(b):

Demand-pull inflation:

Two reasons of demand-pull inflation are as follows:

• Increased income:

If disposable income of people increases then, their demand increases to the limited supply of
goods. As new demand curve takes place so with the interaction price also rises. It in turn induces
inflation.

• Foreign buyers:

If the no. of foreign buyers increases then producers want to export products at a higher price to
them. Because of the increased demand of foreign buyers demand-pull inflation occurs. As a result,
supply of products decreases locally as well as prices go up.

Cost-Push Inflation:

The reasons behind cost-push inflation are as follows:

• Increasing raw material prices:

The price of raw materials can increase. Raw materials, which are directly or indirectly related with
the factors of production, will push up the production cost directly. Producers are not capable to
produce more as before. As a result, supply decreases. It increases the price of product again.

• Profit push of business monopoly power:

Monopolists have the power to fix a price according their wish, as there is no other seller in that
market. This in turn induces the cost-push inflation. To increase the levels of their profit they
increase the price of products.

Taken from Roger A. Arnold & H. L. Ahuza.

Question 13(a):

An increase in money supply causes inflation to a country. There are differences between Keynesian
and Monetarist views in this regard. ( Arnold 2007, Macro Economics).

According to Keynesian Transmission Mechanism, it has indirect influence to the supply of money.
P= price level

GDP= Gross Domestic Product

AD=Aggregate Demand

LRAS= long run aggregate supply curve.

Here demand curve shows the demand for money and investment at a particular time. LRAS
represents the supply of money.

This is the inflation period. Here prices go up as well as demand decreases. The above graph shows
the interaction of inflation because of money supply changes.

According to Monetarist view, changes in the money supply have a direct influence on aggregate
demand. As demand increases, price goes up. Rising price tells about the inflation.
P= price level

GDP= Gross Domestic Product

AD=Aggregate Demand Curve

AS=Aggregate supply curve

As money supply changes in the short run price goes up. But in the long run it becomes stable.

Taken from Roger A. Arnold.

Question 13(b):

Supply curve is important to both Keynesian and Monetarist controversy. Keynesian approach tells
about straight-line money supply which is vertical to OY axis. If supply increases, new curve takes
place in the long-run. Supply curve shifts rightward. It does not maintain the law of supply curve.
Here supply is limited in the short-run, although price increases. ( Arnold, 2007, Macro Economics)

According to monetarist approach, there are two supply curves.

• Short-run aggregate supply curve (SRAS).

• Long-run aggregate supply curve (LRAS).

LRAS is straight line curve looking like OY axis. SRAS is not like that. It is looking like normal supply
curve. It represents the law of supply curve. ( Dewett 1997, Modern Economic Therory.)
Here the supply curve is not vertical.

Taken from Roger A. Arnold & K. K. Dewett.

Question 14(a):

A significant destruction in an economy’s capital stock because of an earthquake:

P= price level

GDP= Gross Domestic Product

AD=Aggregate Demand Curve

AS=Aggregate supply curve

Because of destruction in the capital stock, the capital to the producers decreases than ever before.
So supply of production decreases. As supply decreases the supply curve shifts leftward. The demand
is still constant. Therefore, price goes up.
Taken from Roger A. Arnold.

Question 14(b):

(a) An increase in personal income tax:

P= price level

GDP= Gross Domestic Product

AD=Aggregate Demand Curve

AS=Aggregate supply curve

Here demand curve shifts leftward from DD1 to DD2 as personal income tax increases. Supply curve
remains same. With the interaction of the demand and supply curve, new price has been taken
place. Price becomes rises.

Taken from Roger A. Arnold.

Question 14(c):

An increase in exports:

As export increases local supply would decrease from rightward to leftward. Demand curve remains
same. New price takes place. Price has been increased.( Arnold, 2007,Macroeconomics)
P= price level

GDP= Gross domestic Product

AD= AggregateDemand Curve

AS=Aggregate supply curve

Taken from Roger A. Arnold.

Question 14(d):

An improvement in the marketing and selling skills of firm managers:

P= price level

GDP=Gross domestic Product

AD=Aggregate Demand Curve

AS=Aggregate supply curve

As marketing skill have been improved consumer demand increases from DD1 to DD2. According to
the law of demand, demand curve shifts rightward if consumers’ interest, income, or taste increases
to a particular product. Supply curve remains same. Therefore, prices go up.

Taken from Roger A. Arnold.

Question 17(a):

The selling of government securities to banks:

Yes, It will affect the frowth of money supply.

As government sells securities to banks, moneyfrom banks would go to government. Therefore

money supply in the consumer market would decrease from rightward to leftward. Demand for
money remains same in this stage. But after some time period interest rate would increase so
demand for money would decrease at a higher interest rate. ( Arnold, 2007, Macroecoomics).

P= price level

GDP= Gross Domestic Product

AD= AggregateDemand Curve

AS=Aggregate supply curve

Taken from Roger A. Arnold.

Question 17(b):

A fall in interest rates:

Yes it will affect money supply. As interest rate falls the demand for money increases. Demand curve
shifts rightward. So money supply increases.
P= price level

GDP= Gross Domestic Product

AD= Aggregate Demand Curve

AS=Aggregate supply curve

Taken from Roger A. Arnold.

Question 17(c):

An increase in government expenditure, financed by borrowing from the banking sector:

Ye it will decrease money supply. As government expenditure increases through borrwing from
banking sector, the money supply to banks would decrease. Supply curve shifhts leftward. With
limited money banks tend to increase interest rates. Ultimately demand for money decreases.

P= price level

GDP=Gross domestic Product

AD=Aggregate Demand Curve

AS=Aggregate supply curve

Taken from Roger A. Arnold.

Question 17(d):

The purchase of government securities by the Central Bank from the banking sector:

P= price level

GDP=Gross Domestic Product

AD=Aggregate Demand Curve

AS= Aggregate supply curve

As government purchases securities from banking sector money to the banks, banks would have
enormous amount of money. As money to the banks increases so interest rate would decrease.

Taken from Klingman David C.

Question 17(e):

It is agreed by the Treasurer and the Governor of the Central Bank to reduce the target rate of
inflation:

Possibly. It may influence the growth of money. If target rate of inflation reduces then money supply
would decrease. Under this situation the consumer demand and needs must be stable. Economic
condition also needs to be stable enough. Government expenditure must be stable with that time.
P= price level

GDP=Gross domestic Product

AD=Aggregate Demand Curve

AS=Aggregate supply curve

Taken from Samuelson & Nordhaus.

References:

• Ahuza, H, L 1980, Modern Economics, S. Chand & Co. ltd., New Delhi, India.

• Arnold, Roger A 2007, Macro Economics, 8th Edition, Thomson South-Western, Mason.

• Dewett, K, K 1997, Modern Economic theory, Multicolor Illustrative Diamond Jubilee Edition,
S. Chand & Co. ltd., New Delhi.

• David C., Klingman n.d., Principles of Macroeconomics, Wordsworth Publishing company.

• Samuelson & Nordhaus 1985, Economics, McGraw Hill Book Co., New York, USA.