ECO104 MID-TERM Marks: 25 sum 2021.

Time: 1 hour 10 minutes

Course faculty: Humaira Husain (Sr. Lecturer, Econ dept. NSU)
Name: ______Naeem Ahmed______ ID:________2011913630____________
Sec:_______15______
Q1. Explain with help of diagram how adjustment in interest rate help reach equilibrium in the
financial market? (8 Marks)

r1 C F

r* E

r2 k L I(r)

0 I S, I

Here r1 interest rate, the demand for Loanable Fund = r1C and Supply for Loanable Fund = r1 F
From the graph, r1 F is greater than r1C which reveals an excess supply (CF) of loanable fund.
At this higher rate of interest, the market will be in disequilibrium. So, the market force will
exert the interest rate lower at r* to bring the excess supply to 0 at the point E.
Again, at a lower interest rate r2 than equilibrium r2, the demand for loanable fund is r2L and
supply for loanable fund is r2k. This shows an excess demand in the market and will ultimately
drive the interest rate high to the equilibrium interest rate.
So, we conclude that the interest rate is the driving force that helps to reach equilibrium in the
financial market
Q2. Consider the following problem. Suppose Govt. has reduced its purchase by 50 million
USD. (Taxes = constant). If MPS = 0.7, what impact does this fiscal policy have on the
followings? (7 marks) (Picture is not needed)
a) Public Savings b) Private savings c) National savings d) Investment

a) Public Savings
Given Tax remains constant for the change in G (govt purchase).

From the National Income account’s identity:

Y=C+I+G

Or, Y- C- G = I

Or, (Y-T-C) + (T-G) = I(r)

∴ Private savings + Public savings = national savings = I(r).

Here the G (govt purchase) only effects the Public Savings(T-G).

Therefore, the reduction Government purchase of 50 million USD will increase the Public Savings by 50
million USD.

b) Private savings
From (a)
(Y-T-C) + (T-G) = I(r)

With the tax remaining constant and decreasing G (govt purchase) by 50 million USD constant the
Private Savings will remain unaffected. There will be no change in the private saving.

c) National savings
We know,

 National savings = Private savings + Public savings

Here the public saving decrease by 50 million USD (from a) and the private savings remains unchanged.
Therefore, the national savings will also fall by 50 million USD.

d) Investment
As the national saving falls it will shift the national saving function towards the right; thus, the
interest rate will increase. This increase in the interest rate effect the invest to fall. To conclude
as the national saving falls for the decrease in government purchase, eventually the investment
will also fall for the interest being increased
Q3. Write short notes on the followings: (10 marks) (You will write maximum of 7 sentences for
each short note)
a) Sectoral shift b) Adverse Selection
Sectoral shift
Sometimes demand for goods shifts and also the demand for the labor that produces those
goods shifts. So, during the time taken to shift those labor along with the demand, those
labor remain unemployed. For example, the invention of email has reduced the demand
of postman. So, the workers who used to work as postman will remain unemployed for
some time before they are cable of newly growing sectors. This is called sectoral shift.
b) Adverse Selection