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ASSIGNMENT SOLUTIONS GUIDE (2020-2021)

BECC-103: INTRODUCTORY MACROECONOMICS
Disclaimer/Special Note: These are just the sample of the Answers/Solutions to some of the Questions
given in the Assignments. These Sample Answers/Solutions are prepared by Private
Teacher/Tutors/Authors for the help and guidance of the student to get an idea of how he/she can

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answer the Questions given the Assignments. We do not claim 100% accuracy of these sample
answers as these are based on the knowledge and capability of Private Teacher/Tutor. Sample
answers may be seen as the Guide/Help for the reference to prepare the answers of the Questions

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given in the assignment. As these solutions and answers are prepared by the private teacher/tutor so
the chances of error or mistake cannot be denied. Any Omission or Error is highly regretted though
every care has been taken while preparing these Sample Answers/Solutions. Please consult your own
Teacher/Tutor before you prepare a Particular Answer and for up-to-date and exact information, data

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and solution. Student should must read and refer the official study material provided by the
university.
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Answer the following Descriptive Category Questions in about 500 words each. Each question
carries 20 marks. Word limit does not apply in the case of numerical questions.
Q1. (a) What is Say’s Law of market? What are its implications for an economy?
Ans. Say's Law of Markets comes from chapter XV, "Of the Demand or Market for Products" of
French economist Jean-Baptiste Say's 1803 book, Treatise on Political Economy. It is a classical economic
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theory that says that the income generated by past production and sale of goods is the source of
spending that creates demand to purchase current production. Modern economists have developed
varying views and alternative versions of Say's Law.
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Understanding Say's Law of Markets: Say's Law of Markets was developed in 1803 by the French
classical economist and journalist, Jean-Baptiste Say. Say was influential because his theories address
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how a society creates wealth and the nature of economic activity. To have the means to buy, a buyer
must first have sold something, Say reasoned. So, the source of demand is prior to the production and
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sale of goods for money, not money itself. In other words, a person's ability to demand goods or
services from others is predicated on the income produced by that person's own past acts of
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production.
Say's Law ran counter to the mercantilist view that money is the source of wealth. Under Say's Law,
money functions solely as a medium to exchange the value of previously produced goods for new
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goods as they are produced and brought to market, which by their sale then, in turn, produce money
income that fuels demand to subsequently purchase other goods in an ongoing process of production
and indirect exchange. To Say, money was simply a means to transfer real economic goods, not an
end in itself.
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According to Say's Law, a deficiency of demand for a good in the present can occur from a failure of
the production of other goods (which would otherwise have sold for sufficient income to purchase
the new good), rather than from a shortage of money. Say went on to state that such deficiencies of
production of some goods would, under normal circumstances, be relieved before long by the
inducement of profits to be made in producing the goods that are in short supply.
However, he pointed out that the scarcity of some goods and glut of others can persist when the
breakdown in production is perpetuated by ongoing natural disaster or (more often) government
interference. Say's Law, therefore, supports the view that governments should not interfere with the
free market and should adopt laissez-faire economics.
Implications of Say's Law of Markets: Say drew four conclusions from his argument.

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1. The greater the number of producers and a variety of products in an economy, the more
prosperous it will be. Conversely, those members of a society who consume and do not
produce will be a drag on the economy.
2. The success of one producer or industry will benefit other producers and industries whose
output they subsequently purchase, and businesses will be more successful when they locate
near or trade with other successful businesses. This also means that government policy that
encourages production, investment, and prosperity in neighboring countries will redound to
the benefit of the domestic economy as well.

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3. The importation of goods, even at a trade deficit, is beneficial to the domestic economy.
4. The encouragement of consumption is not beneficial, but harmful, to the economy. The
production and accumulation of goods over time constitutes prosperity; consuming without

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producing eats away the wealth and prosperity of an economy. Good economic policy should
consist of encouraging industry and productive activity in general, while leaving the specific
direction of which goods to produce and how up to investors, entrepreneurs, and workers in
accord with market incentives.
Say's Law thus contradicted the popular mercantilist view that money is the source of wealth, that the

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economic interests of industries and countries are in conflict with one another, and that imports are

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harmful to an economy.
Later Economists and Say's Law: Say's Law still lives on in modern neoclassical economic models,
and it has also influenced supply-side economists. Supply-side economists especially believe that tax
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breaks for businesses and other policies intended to spur production, without distorting economic
processes, are the best prescription for economic policy, in agreement with the implications of Say's
Law.
Austrian economists also hold to Say's Law. Say's recognition of production and exchange as
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processes occurring over time, focus on different types of goods as opposed to aggregates, emphasis
on the role of the entrepreneur to coordinate markets, and conclusion that persistent downturns in
economic activity are usually the result of government intervention, are all particularly consistent
with Austrian theory.
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Say’s Law was later simply (and misleadingly) summarized by economist John Maynard Keynes in
his 1936 book, General Theory of Employment, Interest and Money, in the famous phrase, "supply creates
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its own demand," though Say himself never used that phrase. Keynes rewrote Say's Law, then argued
against his own new version to develop his macroeconomic theories.
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Keynes reinterpreted Say's Law as a statement about macroeconomic aggregate production and
spending, in disregard of Say's clear and consistent emphasis on the production and exchange of
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various particular goods against one another. Keynes then concluded that the Great
Depression appeared to overturn Say's Law. Keynes' revision of Say's Law led him to argue that an
overall glut of production and deficiency of demand had occurred and that economies could
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experience crises that market forces could not correct.

Keynesian economics argues for economic policy prescriptions that are directly contrary to the
implications of Say's Law. Keynesians recommend that governments should intervene to stimulate
demand—through expansionary fiscal policy and money printing—because people hoard cash in
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hard times and during liquidity traps.

(b) Explain why and how, according to the classical economists, the economy always operates at
full employment level.
Ans. Above full employment equilibrium is a macroeconomic term used to describe a situation in
which an economy’s real gross domestic product (GDP) is higher than usual. This, in turn, means it is
in excess of its long-run potential level. The amount that the current real GDP is greater than the
historic average is called an inflationary gap, as this will create inflationary pressures in this
particular economy.

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How Above Full Employment Equilibrium Works?: An economy that operates above its full
employment equilibrium means it produces goods and services at a higher rate than its potential or
long-run average levels as measured by its GDP. The amount by which the current real GDP is
greater than the historic average is called an inflationary gap.
When the market is in equilibrium, there is no excess supply in the short run. So, everything is in
harmony. But an overly active economy creates more demand for goods and services. This increase in
demand pushes both prices and wages upward as companies increase production to meet that
demand. Companies can only ramp up production only so much before hitting capacity constraints.

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Therefore, increases in supply will be finite.
Economists see this as a cautionary period as this results in a situation where too much money chases
too few goods. This creates inflationary pressures in the economy—something that isn’t sustainable

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for long periods.
Over time, the economy and employment markets will shift back into equilibrium as higher prices
bring demand back down to normal run-rate levels.
Special Considerations
When an economy is at full employment, all available labor is being utilized. This level varies by

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economy and can change over time, so it isn't a static situation. A number of factors can cause

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employment to rise beyond its equilibrium level.
There are a number of different factors that can push an economy to exceed full employment. A
significant increase in demand—also called a positive demand shock—is one example. This is caused
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by an unexpected event like a natural disaster or technological advances. Other factors include, but
aren't limited to government spending or government stimulus packages. A good example of the
former is the growth of the U.S. economy during World War II. These types of demand-stimulating
activities from government are known as expansionary fiscal policy.
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An increase in the demand for a country’s goods and services as well as an increase in household
consumption can cause an inflationary gap. Fiscal policies such as increasing taxes or reducing
spending and/or monetary policy actions through the central bank, or increasing the level of interest
rates can be used to bring an overheating economy back into equilibrium. But these take time to make
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an impact, and also come with risks of overcorrecting and causing a recessionary gap.
Above vs. Below Full Employment Equilibrium
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Below full employment equilibrium is the opposite of above full employment equilibrium. This term
refers to the situation in an economy that has a recessionary gap between both the economy's real and
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long-run real GDP. Economies with below full employment equilibrium run with an employment
shortfall, and usually at the risk of running into a recession.
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Q2. (a) Briefly explain the implications of the IS curve. What does a point outside the IS curve
mean? What do the position and slope the IS curve imply?
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Ans. The IS curve represents all combinations of income (Y) and the real interest rate (r) such that the
market for goods and services is in equilibrium. That is, every point on the IS curve is an income/real
interest rate pair (Y,r) such that the demand for goods is equal to the supply of goods (where it is
implicitly assumed that whatever is demanded is supplied) or, equivalently, desired national saving
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is equal to desired investment. The graphical derivation of the IS curve is given below.

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Consider an initial equilibrium in the goods market where r = 5% and income is equal to Y0. This

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equilibrium is illustrated in the graph on the right with r on the vertical axis and Y on the horizontal

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axis as the big black dot (middle dot). Now suppose Y increases to Y1 (say supply increases). This
increase in Y shifts the desired savings curve down and right lowering the equilibrium real interest
rate to 3%. The new equilibrium in the goods market with higher income and a lower real interest rate
is illustrated in the graph on the right as the big blue dot (bottom dot). Similarly, if Y decreases from
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Y0 to Y2 then the savings curve shifts up and left and the equilibrium real interest rises. The new
equilibrium in the goods market with lower income and a higher real interest rate is illustrated in the
graph on the right as the big red dot (top dot). Notice that as income increases (decreases) the real
interest must fall (rise) in order to maintain equilibrium in the goods market. This is the relationship
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that is represented in the downward sloping IS curve.

Every point on the IS curve represents an intersection between desired national saving and desired
investment for some income/interest rate pair (Y,r). As such the IS curve is derived holding the
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determinants of saving and investment, other than Y and r, fixed. When these factors change the IS
curve will shift. Since points on the IS curve represent points where aggregate demand is equal to
aggregate supply any factor that increases the demand for goods and services will shift the IS curve
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up and to the right and any factor that decreases the demand for goods and services will shift the IS
curve down and to the left. From the savings/investment diagram it follows that any shift of the
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savings or investment curve that increases the real interest rate, holding Y fixed, will shift up the IS
curve. Functionally, the IS curve is represented as
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Pluses (+) above the exogenous variables indicate that increases in the variables shift the IS curve up
and to the right (increases demand).
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(b) Briefly explain the implications of the LM curve. What does a point outside the LM curve
mean? What do the position and slope of the LM curve imply?
Ans. The LM curve, "L" denotes Liquidity and "M" denotes money, is a graph of combinations of real
income, Y, and the real interest rate, r, such that the money market is in equilibrium (i.e. real money
supply = real money demand). The graphical derivation of the LM curve is illustrated below.

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The left-hand side of the graph illustrates money market equilibrium for a given level of Y. For

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example, when Y = Y0 the equilibrium real interest rate is 5%. The right-hand-side of the graph gives

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the LM curve. The LM curve is plotted with the real interest rate on the vertical axis and real income
(GDP) on the horizontal axis. Each point on the LM curve represents a money market equilibrium for
a particular real interest rate and income pair (r, Y). For example, the money market equilibrium at
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(r=5%, Y=Y0) is given by the black (middle) dot on the LM curve.
At a higher level of income, Y1 > Y0, the money demand curve shifts up and right and a new
equilibrium occurs at r = 7%. This equilibrium is represented by the blue (upper) dot on the LM curve.
Similarly, at a lower level of income Y2 < Y0 the money demand curve shifts down and left and a new
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equilibrium occurs at r = 3%. This equilibrium is given the by the red (lower) dot on the LM curve.
The above analysis shows that the LM curve is an upward sloping curve in the graph with r on the
vertical axis and Y on the horizontal axis. Every point on the LM curve represents an intersection
between the real money supply (M/P) and real money demand (Ld). The LM curve will shift
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whenever the variables we hold fixed, other than Y, in the money-supply/money-demand diagram
change. These variable are M/P and e. In particular, if M/P increases holding expected inflation fixed
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then r falls in the money market and so the LM curve shifts down and right. Similarly, if expected
inflation increases real money demand falls, lowering the interest rate, and the LM curve shifts down
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and to the right. Functionally, we represent the LM curve as

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The (+) sign indicates that an increase in the variables shifts the LM curve down and to the right.

Assignment II
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Answer the following Middle Category Questions in about 250 words each. Each question carries
10 marks. Word limit does not apply in the case of numerical questions.
Q3. What are the functions of money? Explain how paper money or fiat money performs all these
functions.
Ans. Functions of money are as follows:

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Money is any object that is generally accepted as payment for goods and services and repayment of
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debts in a given socioeconomic context or country. Money comes in three forms: commodity money,
fiat money, and fiduciary money.
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Many items have been historically used as commodity money, including naturally scarce precious
metals, conch shells, barley beads, and other things that were considered to have value. The value of
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commodity money comes from the commodity out of which it is made. The commodity itself
constitutes the money, and the money is the commodity.
Fiat money is money whose value is not derived from any intrinsic value or guarantee that it can be
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converted into a valuable commodity (such as gold). Instead, it has value only by government order
(fiat). Usually, the government declares the fiat currency to be legal tender, making it unlawful to not
accept the fiat currency as a means of repayment for all debts. Paper money is an example of fiat
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money.
Fiduciary money includes demand deposits (such as checking accounts) of banks. Fiduciary money is
accepted on the basis of the trust its issuer (the bank) commands.
Most modern monetary systems are based on fiat money. However, for most of history, almost all
money was commodity money, such as gold and silver coins.
Functions of Money
Money has three primary functions. It is a medium of exchange, a unit of account, and a store of
value:
1. Medium of Exchange: When money is used to intermediate the exchange of goods and
services, it is performing a function as a medium of exchange.

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2. Unit of Account: It is a standard numerical unit of measurement of market value of goods,

services, and other transactions. It is a standard of relative worth and deferred payment, and
as such is a necessary prerequisite for the formulation of commercial agreements that involve
debt. To function as a unit of account, money must be divisible into smaller units without loss
of value, fungible (one unit or piece must be perceived as equivalent to any other), and a
specific weight or size to be verifiably countable.
3. Store of Value: To act as a store of value, money must be reliably saved, stored, and retrieved.
It must be predictably usable as a medium of exchange when it is retrieved. Additionally, the

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value of money must remain stable over time.
Economists sometimes note additional functions of money, such as that of a standard of deferred
payment and that of a measure of value. A “standard of deferred payment” is an acceptable way to

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settle a debt–a unit in which debts are denominated. The status of money as legal tender means that
money can be used for the discharge of debts. Money can also act a as a standard measure and
common denomination of trade. It is thus a basis for quoting and bargaining prices. Its most
important usage is as a method for comparing the values of dissimilar objects.

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Q4. Give an outline of the value-added method of measurement of Gross Domestic Product.

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Explain how the problem of ‘double counting’ is taken care of in this method.
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Q5. Explain impact of inflation on various segments of society.

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Ans.
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Assignment III
Answer the following Short Category Questions in about 100 words each. Each question carries 6
marks.
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Q6. Explain the concept of money multiplier.

Ans. In monetary economics, a money multiplier is one of various closely related ratios
of commercial bank money to central bank money (also called the monetary base) under a fractional-
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reserve banking system. It relates to the maximum amount of commercial bank money that can be
created, given a certain amount of central bank money. In a fractional-reserve banking system that
has legal reserve requirements, the total amount of loans that commercial banks are allowed to extend
(the commercial bank money that they can legally create) is equal to a multiple of the amount of
reserves. This multiple is the reciprocal of the reserve ratio minus one, and it is an economic
multiplier. The actual ratio of money to central bank money, also called the money multiplier, is
lower because some funds are held by the non-bank public as currency. Also, in the United States
most banks hold excess reserves (reserves above the amount required by the US central bank, the
Federal Reserve).
Although the money multiplier concept is a traditional portrayal of fractional reserve banking, it has
been criticized as being misleading. The Bank of England, Deutsche Bundesbank, and the Standard &

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Poor's rating agency have issued refutations of the concept together with factual descriptions of
banking operations. Several countries (such as Canada, the UK, Australia and Sweden) set no
legal reserve requirements. Even in those countries that do, the reserve requirement is as a ratio to
deposits held, not a ratio to loans that can be extended. Basel III does stipulate a liquidity requirement
to cover 30 days net cash outflow expected under a modelled stressed scenario (note this is not a ratio
to loans that can be extended); however, liquidity coverage does not need to be held as reserves but
rather as any high-quality liquid assets.

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If banks lend out close to the maximum allowed by their reserves, then the inequality becomes an

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approximate equality, and commercial bank money is central bank money times the multiplier. If
banks instead lend less than the maximum, accumulating excess reserves, then commercial bank
money will be less than central bank money times the theoretical multiplier.
Definition: The money multiplier is defined in various ways. Most simply, it can be defined either as

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the statistic of "commercial bank money"/"central bank money", based on the actual observed

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quantities of various empirical measures of money supply, such as M2 (broad money) over M0 (base
money), or it can be the theoretical "maximum commercial bank money/central bank money" ratio,
defined as the reciprocal of the reserve ratio, 1/RR The multiplier in the first (statistic) sense fluctuates
continuously based on changes in commercial bank money and central bank money (though it is at
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most the theoretical multiplier), while the multiplier in the second (legal) sense depends only on the
reserve ratio, and thus does not change unless the law changes.
For purposes of monetary policy, what is of most interest is the predicted impact of changes in central
bank money on commercial bank money, and in various models of monetary creation, the associated
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multiple (the ratio of these two changes) is called the money multiplier (associated to that model). For
example, if one assumes that people hold a constant fraction of deposits as cash, one may add a
"currency drain" variable (currency–deposit ratio), and obtain a multiplier of (1+CD)/(RR+CD).
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These concepts are not generally distinguished by different names; if one wishes to distinguish them,
one may gloss them by names such as empirical (or observed) multiplier, legal (or theoretical)
multiplier, or model multiplier, but these are not standard usages.
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Similarly, one may distinguish the observed reserve–deposit ratio from the legal (minimum) reserve
ratio, and the observed currency–deposit ratio from an assumed model one. Note that in this case the
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reserve–deposit ratio and currency–deposit ratio are outputs of observations, and fluctuate over time.
If one then uses these observed ratios as model parameters (inputs) for the predictions of effects of
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monetary policy and assumes that they remain constant, computing a constant multiplier, the
resulting predictions are valid only if these ratios do not in fact change. Sometimes this holds, and
sometimes it does not; for example, increases in central bank money may result in increases in
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commercial bank money – and will, if these ratios (and thus multiplier) stay constant – or may result
in increases in excess reserves but little or no change in commercial bank money, in which case the
reserve–deposit ratio will grow and the multiplier will fall.
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Q7. Define marginal propensity to consume (mpc). Why marginal propensity to consume (mpc)
remains between 0 and 1? What is the implication of a higher value of mpc? Is it possible to
explain the mpc through a diagram?
Ans. In economics, the marginal propensity to consume (MPC) is defined as the proportion of an
aggregate raise in pay that a consumer spends on the consumption of goods and services, as opposed
to saving it. Marginal propensity to consume is a component of Keynesian macroeconomic theory and
is calculated as the change in consumption divided by the change in income. MPC is depicted by
a consumption line, which is a sloped line created by plotting the change in consumption on the
vertical "y" axis and the change in income on the horizontal "x" axis.
Understanding Marginal Propensity To Consume (MPC)

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The marginal propensity to consume is equal to ΔC / ΔY, where ΔC is the change in consumption,
and ΔY is the change in income. If consumption increases by 80 cents for each additional dollar of
income, then MPC is equal to 0.8 / 1 = 0.8.

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Suppose you receive a $500 bonus on top of your normal annual earnings. You suddenly have $500
more in income than you did before. If you decide to spend $400 of this marginal increase in income
on a new suit and save the remaining $100, your marginal propensity to consume will be 0.8 ($400
divided by $500).
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The other side of the marginal propensity to consume is the marginal propensity to save, which
shows how much a change in income affects levels of saving. Marginal propensity to consume +
marginal propensity to save = 1. In the suit example, your marginal propensity to save will be 0.2
($100 divided by $500).
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If you decide to save the entire $500, your marginal propensity to consume will be 0 ($0 divided by
500), and your marginal propensity to save will be 1 ($500 divided by 500).
MPC and Economic Policy
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Given data on household income and household spending, economists can calculate households’
MPC by income level. This calculation is important because MPC is not constant; it varies by income
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level. Typically, the higher the income, the lower the MPC because as income increases more of a
person's wants and needs become satisfied; as a result, they save more instead. At low-income levels,
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MPC tends to be much higher as most or all of the person's income must be devoted to subsistence
consumption.
According to Keynesian theory, an increase in investment or government spending increases
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consumers’ income, and they will then spend more. If we know what their marginal propensity to
consume is, then we can calculate how much an increase in production will affect spending. This
additional spending will generate additional production, creating a continuous cycle via a process
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known as the Keynesian multiplier. The larger the proportion of the additional income that gets
devoted to spending rather than saving, the greater the effect. The higher the MPC, the higher the
multiplier—the more the increase in consumption from the increase in investment; so, if economists
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can estimate the MPC, then they can use it to estimate the total impact of a prospective increase in
incomes.

Q8. Explain why income tax is considered as an automatic stabiliser.

Ans. Automatic stabilizers are a type of fiscal policy designed to offset fluctuations in a nation's
economic activity through their normal operation without additional, timely authorization by the
government or policymakers. The best-known automatic stabilizers are progressively graduated
corporate and personal income taxes, and transfer systems such as unemployment insurance and
welfare. Automatic stabilizers are called this because they act to stabilize economic cycles and are
automatically triggered without additional government action.

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Q9. For a three-sector economy the following is given: 𝐶𝐶 = 25 + 0.6𝑌𝑌, I = 30, G = 25
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where C = consumption, I = investment and G = government expenditure. Find out the equilibrium
output level.
Ans. The equilibrium level of income refers to when an economy or business has an equal amount of
production and market demand. The definition is a bit abstract, so let's use a simple example of a
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manufacturing business to explain what it actually means.

The equilibrium level of income is the point at which a business is able to sell all of the goods it
planned to. Pretty simple.
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The company produces its product to that level, and then sells exactly the same amount. The
company's output -- its production -- is equal to the consumer demand to buy the product.
That micro example is pretty easy to understand, and we can use that simplicity to expand our
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understanding to the macroeconomic level. At the national level, gross domestic product, or GDP,
represents the business manufacturing its products. All the businesses, consumers, investors, and
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government spending in the economy represent the consumers buying those products.
An economy is said to be at its equilibrium level of income when aggregate supply and aggregate
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demand are equal. In other words, it is when GDP is equal to total expenditure.
To calculate the equilibrium level of income, you'll need a few economic figures to plug into a
formula. This exercise can quickly become quite complex when factoring in government spending,
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inflation, GDP, and a myriad of other macroeconomic calculations.

Most simply, the formula for the equilibrium level of income is when aggregate supply (AS) is equal
to aggregate demand (AD), where AS = AD.
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The Equilibrium Output Level (Y) = C + I + G, where Y is aggregate income, C is consumption, I is

investment expenditure, and G is government expenditure.
Y= 25+0.6Y +30 + 25
Y= 80 + 0.6Y
0.4Y = 80
Y = 200.
Using this formula, an analyst can observe how a change in any of the factors will impact the level of
income. For example, if government spending increases, and all other expenditures stay constant, the
level of aggregate income must also increase to maintain the equilibrium level of income.

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Q10. In the IS-LM model, explain why the economy always moves towards the equilibrium point.
Ans.

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