Name:

Roll#:
Course: Advanced
Macroeconomics
Code:(806)
Level:MSC Economics
Semester: Spring, 2021
ASSIGNMENT No. 2
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Q.1 Examine the similarities and dissimilarities between accelerator theory and flexible
accelerator theory.
The accelerator principle states that an increase in the rate of output of a firm will require a
proportionate increase in its capital stock. The capital stock refers to the desired or optimum
capital stock, K. Assuming that capital-output ratio is some fixed constant, v, the optimum
capital stock is a constant proportion of output so that in any period t,
Kt =vYt
Where Kt is the optimal capital stock in period t, v (the accelerator) is a positive constant,
and Y is output in period t.
Any change in output will lead to a change in the capital stock. Thus
Kt – Kt-1 = v (Yt – Yt-1)
and Int = v (Yt – Yt-1) [Int=Kt– Kt-1
= v∆Yt
Where ∆Yt = Yt – Yt-1, and Int is net investment.
This equation represents the naive accelerator.
In the above equation, the level of net investment is proportional to change in output. If the
level of output remains constant (∆Y = 0), net investment would be zero. For net investment
to be a positive constant, output must increase.
This is illustrated in Figure 1 where in the upper portion, the total output curve Y increases at
an increasing rate up to t + 4 periods, then at a decreasing rate up to period t + 6. After this, it
starts diminishing. The curve In in the lower part of the figure, shows that the rising output
leads to increased net investment up to t + 4 period because output is increasing at an
increasing rate.
But when output increases at a decreasing rate between t + 4 and t + 6 periods, net
investment declines. When output starts declining in period t + 7, net investment becomes
negative. The above explanation is based on the assumption that there is symmetrical
reaction for increases and decreases of output.

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In the simple acceleration principle, the proportionality of the optimum capital stock to
output is based on the assumption of fixed technical coefficients of production. This is
illustrated in Figure 2 where Y and Y1 are the two isoquants.
The firm produces T output with K optimal capital stock. If it wants to produce Y 1 output, it
must increase its optimal capital stock to K1. The ray OR shows constant returns to scale. It
follows that if the firm wants to double its output, it must increase its optimal capital stock
by two-fold.
Eckaus has shown that under the assumption of constant returns to scale, if the factor-price
ratios remain constant, the simple accelerator would be constant. Suppose the firm’s
production involves the use of only two factors, capital and labour whose factor-price ratios
are constant.

In Figure 3, Y, Y1 and Y2 are the firms’ isoquants and C, C1 and C2 are the isocost lines
which are parallel to each other, thereby showing constant costs. If the firm decides to
increase its output from Y to Y1, it will have to increase the units of labour from L to L 1 and
of capital from K to K1 and so on.

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The line OR joining the points of tangency e, e 1 and e2 is the firms’ expansion path which
shows investment to be proportional to the change in output when capital is optimally
adjusted between the iosquants and isocosts.

The flexible accelerator theory removes one of the major weaknesses of the simple
acceleration principle that the capital stock is optimally adjusted without any time lag. In the
flexible accelerator, there are lags in the adjustment process between the level of output and
the level of capital stock.
This theory is also known as the capital stock adjustment model. The theory of flexible
accelerator has been developed in various forms by Chenery, Goodwin, Koyck and Junankar.
But the most accepted approach is by Koyck.
Junankar has discussed the lags in the adjustment between output and capital stock. He
explains them at the firm level and extends them to the aggregate level. Suppose there is an
increase in the demand for output. To meet it, first the firm will use its inventories and then
utilise its capital stock more intensively.
If the increase in the demand for output is large and persists for some time, the firm would
increase its demand for capital stock. This is the decision-making lag. There may be the
administrative lag of ordering the capital.
As capital is not easily available and in abundance in the financial capital market, there is the
financial lag in raising finance to buy capital. Finally, there is the delivery lag between the
ordering of capital and its delivery.
Assuming “that different firms have different decision and delivery lags then in aggregate
the effect of an increase in demand on the capital stock is distributed over time. This implies
that the capital stock at time t is dependent on all the previous levels of output, i.e.
Kt = f ( Yt, Yt-1……., Yt-n).
This is illustrated in Figure 4 where initially in period t 0, there is a fixed relation between the
capital stock and the level of output. When the demand for output increases, the capital stock
increases gradually after the decision and delivery lags, as shown by the K curve, depending
on the previous levels of output. The increase in output is shown by the curve T. The dotted
line K is the optimal capital stock which equals the actual capital stock K in period t.

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Q.2 Discuss the macroeconomic variables that affect the aggregate demand for money.
Aggregate demand (AD) is the total demand for final goods and services in a given economy
at a given time and price level.
There are four components of Aggregate Demand (AD); Consumption (C), Investment (I),
Government Spending (G) and Net Exports (X-M). Aggregate Demand shows the
relationship between Real GNP and the Price Level.
1. Net Export Effect
When domestic prices increase, then demand for imports increases (since domestic goods
become relatively expensive) and demand for export decreases.
2. Real Balances
When inflation increases, real spending decreases as the value of money decreases.
This change in inflation shifts Aggregate Demand to the left/decreases.
3. Interest Rate Effect
Real Interest is the nominal interest rate adjusted to the inflation rate. When inflation
increases, nominal interest rates increase to maintain real interest rates. Lower real interest
rates will lower the costs of major products such as cars, large appliances, and houses; they
will increase business capital project spending because long-term costs of investment
projects are reduced.
4. Inflation Expectations
If consumers expect inflation to go up in the future, they will tend to buy now causing
aggregate demand to increase or shift to the right.
Any increase in any of the four components of aggregate demand leads to an increase or shift
in the aggregate demand curve as seen in the diagram above.
Aggregate Demand = C + I + G + (X-M)

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Consumption
This is made by households, and sometimes consumption accounts for the larger portion of
aggregate demand. An increase in consumption shifts the AD curve to the right.
1. Consumer Confidence
If consumers are confident about their future income, job stability, and the economy is
growing and stable, consumer spending is likely to increase. However, any job insecurity
and uncertainty over income is likely to delay spending. An increase in consumer
confidence shifts AD to the right.
2. Interest Rates
Lower interest rates tend to increase consumption because consumers purchase larger goods
on credit. If interest rates are low, then it’s cheaper to borrow. Consumers mostly borrow to
buy houses, which is one of the biggest purchases and lower interest rates mean lower
mortgage payments so that households can spend more on other goods. Some Economists
argue that lower interest rates also make saving less attractive, but there is no real evidence.
So, lower interest rates increase Aggregate Demand.
3. Consumer Debt
If a consumer has a lot of debt, he is unlikely to buy more since he would have to pay his
debt off first. Low consumer debt increases consumption and aggregate demand.
4. Wealth
Wealth is assets held by a household, such as property or stocks. An increase in property
value is likely to increase consumption.
Investment, second of the four components of aggregate demand, is spending by firms on
capital, not households. However, investment is also the most volatile component of AD. An
increase in investment shifts AD to the right in the short run and helps improve the quality
and quantity of factors of production in the long run.
1. Interest Rates
Firms borrow from banks to make large capital intensive purchases, and if the interest rate
decreases, it becomes cheaper for firms to invest and provides an incentive for firms to take
on risk.
2. Business Confidence
If firms are confident about the economy and its future growth, they are more likely to invest
in capital, new projects, and buildings/machinery.

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3. Investment Policy
If governments provide incentives such as tax breaks, subsidies, loans at lower interest rates
then investment can increase. However, corruption and bureaucracy deter investment.
4. National Income
As firms increase output, they would need to invest in new machines. This relationship is
known as The Accelerator. The assumption behind the accelerator is that firms will want to
main a fixed capital to output ratio, meaning that if a factory uses one machine to produce
1000 goods, and the firms needs to produce 3000 goods more, then the firm will buy 3 more
machines.
Q.3 Compare Friedman’s on monetary policy in the short-run and in the long run.
The immediate effect of Friedman's 1968 AEA presidential address on the economics
profession was the introduction of an adaptive term in the Phillips curve that shifted the
curve, as Friedman proposed, based on expected inflation. Initial formulations suggested that
the shift was less than point-for-point, but later thinking, based on the emerging idea of
rational expectations, together with the experience of the 1970s, came to agree with
Friedman that the shift was by the full amount. The profession also recognized that
Friedman's point was deeper---real outcomes are invariant to the monetary policy rule, not
just to the trend in inflation. The presidential address made an important contribution to the
conduct of monetary policy around the world. It ushered in low and stable inflation rates in
all advanced countries, and in many less advanced ones.
The centerpiece of Milton Friedman's (1968) presidential address to the American Economic
Association, delivered in Washington, DC, on December 29, 1967, was the striking
proposition that monetary policy has no longer-run effects on the real economy. Friedman
focused on two real measures, the unemployment rate and the real interest rate, but the
message was broader—in the longer run, monetary policy controls only the price level. We
call this the monetary-policy invariance hypothesis. By 1968, macroeconomics had adopted
the basic Phillips curve as the favored model of correlations between inflation and
unemployment, and Friedman used the Phillips curve in the exposition of the invariance
hypothesis. Friedman's presidential address was commonly interpreted as a recommendation
to add a previously omitted variable, the rate of inflation anticipated by the public, to the
right-hand side of what then became an augmented Phillips curve. We believe that
Friedman's main message, the invariance hypothesis about long-term outcomes, has
prevailed over the last half-century based on the broad sweep of evidence from many
economies over many years. Subsequent research has not been kind to the Phillips curve, but
we will argue that Friedman's exposition of the invariance hypothesis in terms of a 1960s-
style Phillips curve is incidental to his main message.
Today, monetarism is mainly associated with Nobel Prize–winning economist Milton
Friedman. In his seminal work A Monetary History of the United States, 1867–1960,
which he wrote with fellow economist Anna Schwartz in 1963, Friedman argued that poor
monetary policy by the U.S. central bank, the Federal Reserve, was the primary cause of
the Great Depression in the United States in the 1930s. In their view, the failure of the Fed

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(as it is usually called) to offset forces that were putting downward pressure on the money
supply and its actions to reduce the stock of money were the opposite of what should have
been done. They also argued that because markets naturally move toward a stable center,
an incorrectly set money supply caused markets to behave erratically.
Monetarism gained prominence in the 1970s. In 1979, with U.S. inflation peaking at 20
percent, the Fed switched its operating strategy to reflect monetarist theory. But
monetarism faded in the following decades as its ability to explain the U.S. economy
seemed to wane. Nevertheless, some of the insights monetarists brought to economic
analysis have been adopted by nonmonetarist economists.
The foundation of monetarism is the Quantity Theory of Money. The theory is an
accounting identity—that is, it must be true. It says that the money supply multiplied by
velocity (the rate at which money changes hands) equals nominal expenditures in the
economy (the number of goods and services sold multiplied by the average price paid for
them). As an accounting identity, this equation is uncontroversial. What is controversial is
velocity. Monetarist theory views velocity as generally stable, which implies that nominal
income is largely a function of the money supply. Variations in nominal income reflect
changes in real economic activity (the number of goods and services sold) and inflation
(the average price paid for them). The quantity theory is the basis for several key tenets
and prescriptions of monetarism:
Long-run monetary neutrality: An increase in the money stock would be followed by an
increase in the general price level in the long run, with no effects on real factors such as
consumption or output.
Short-run monetary nonneutrality: An increase in the stock of money has temporary
effects on real output (GDP) and employment in the short run because wages and prices
take time to adjust (they are sticky, in economic parlance).
Constant money growth rule: Friedman, who died in 2006, proposed a fixed monetary
rule, which states that the Fed should be required to target the growth rate of money to
equal the growth rate of real GDP, leaving the price level unchanged. If the economy is
expected to grow at 2 percent in a given year, the Fed should allow the money supply to
increase by 2 percent. The Fed should be bound to fixed rules in conducting monetary
policy because discretionary power can destabilize the economy.
Interest rate flexibility: The money growth rule was intended to allow interest rates,
which affect the cost of credit, to be flexible to enable borrowers and lenders to take
account of expected inflation as well as the variations in real interest rates.
Although monetarism gained in importance in the 1970s, it was critiqued by the school of
thought that it sought to supplant—Keynesianism. Keynesians, who took their inspiration
from the great British economist John Maynard Keynes, believe that demand for goods
and services is the key to economic output. They contend that monetarism falters as an
adequate explanation of the economy because velocity is inherently unstable and attach
little or no significance to the quantity theory of money and the monetarist call for rules.
Because the economy is subject to deep swings and periodic instability, it is dangerous to

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make the Fed slave to a preordained money target, they believe—the Fed should have
some leeway or “discretion” in conducting policy. Keynesians also do not believe that
markets adjust to disruptions and quickly return to a full employment level of output.
Keynesianism held sway for the first quarter century after World War II. But the
monetarist challenge to the traditional Keynesian theory strengthened during the 1970s, a
decade characterized by high and rising inflation and slow economic growth. Keynesian
theory had no appropriate policy responses, while Friedman and other monetarists argued
convincingly that the high rates of inflation were due to rapid increases in the money
supply, making control of the money supply the key to good policy.
Q.4 Is Harrod-Domar model relevant for countries like Pakistan?
The Harrod–Domar model is a Keynesian model of economic growth. It is used
in development economics to explain an economy's growth rate in terms of the level of
saving and of capital. It suggests that there is no natural reason for an economy to have
balanced growth. The model was developed independently by Roy F. Harrod in 1939,
and Evsey Domar in 1946, although a similar model had been proposed by Gustav Cassel in
1924. The Harrod–Domar model was the precursor to the exogenous growth model.
Neoclassical economists claimed shortcomings in the Harrod–Domar model—in particular
the instability of its solution—and, by the late 1950s, started an academic dialogue that led to
the development of the Solow–Swan model.
According to the Harrod–Domar model there are three kinds of growth: warranted growth,
actual growth and natural rate of growth.
Warranted growth rate is the rate of growth at which the economy does not expand
indefinitely or go into recession. Actual growth is the real rate increase in a country's GDP
per year. (See also: Gross domestic product and Natural gross domestic product). Natural
growth is the growth an economy requires to maintain full employment. For example, If the
labor force grows at 3 percent per year, then to maintain full employment, the economy’s
annual growth rate must be 3 percent.
Let Y represent output, which equals income, and let K equal the capital stock. S is total
saving, s is the savings rate, and I is investment. δ stands for the rate of depreciation of the
capital stock. The Harrod–Domar model makes the following a priori assumptions:

1: Output is a function of capital stock

2: The marginal product of capital is constant; the production function exhibits constant
returns to scale. This implies capital's marginal and average products are equal.

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3: Capital is necessary for output.
4: The product of the savings rate and output equals saving, which equals investment
5: The change in the capital stock equals investment less the depreciation of the capital stock

First, assumptions (1)–(3) imply that output and capital are linearly related (for readers with
an economics background, this proportionality implies a capital-elasticity of output equal to
unity). These assumptions thus generate equal growth rates between the two variables. That
is,

In summation, the savings rate times the marginal product of capital minus the depreciation
rate equals the output growth rate. Increasing the savings rate, increasing the marginal
product of capital, or decreasing the depreciation rate will increase the growth rate of output;
these are the means to achieve growth in the Harrod–Domar model.

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Q.5 Suppose the saving rate were increased from 6 to 12 percent in Pakistan. What
predictions does the neoclassical growth model have for the effect this would have
on per capita income in Pakistan over the next 30 years?
Economists have had an enormous impact on trade policy, and they provide a strong
rationale for free trade and for removal of trade barriers.  Although the objective of a trade
agreement is to liberalize trade, the actual provisions are heavily shaped by domestic and
international political realities. The world has changed enormously from the time when
David Ricardo proposed the law of comparative advantage, and in recent decades economists
have modified their theories to account for trade in factors of production, such as capital and
labor, the growth of supply chains that today dominate much of world trade, and the success
of neomercantilist countries in achieving rapid growth.
The law of comparative advantage also holds equally well for many factors of production. In
addition to labor and capital, other factors of production include natural resources such as
land and technology, and these can be subdivided. For example, land can be land for mining
or land for farming, or technology for making cars or computer chips, or skilled and
unskilled labor. Additionally, over time factor endowments may change. For example,
natural resources, such as coal reserves, may be used up, or a country’s educational system
may be improved, thereby providing a more highly skilled labor force.
Furthermore, some products do not utilize the same factors of production over their life
cycle.[6] For example, when computers were first introduced, they were incredibly capital
intensive and required highly skilled labor. Over time, as volume increased, costs came
down and computers could be mass produced. Initially, the United States had a comparative
advantage in production; but today, when computers are mass produced by relatively
unskilled labor, the comparative advantage has shifted to countries with abundant cheap
labor. And still other products may use different factors of production in different countries.
For example, cotton production is highly mechanized in the United States but is very labor
intensive in Africa. The fact that factors of production may change does not nullify the
theory of comparative advantage; it just means that the mix of products that a nation can
produce relatively more efficiently than its trade partners may change.
Traditional economic theories expounded by Ricardo and Heckscher-Ohlin are based on a
number of important assumptions, such as perfect competition with no artificial barriers
imposed by governments. A second assumption is that production occurs under diminishing
or constant returns to scale, that is, the costs of producing each additional unit are the same
or higher as production increases. For example, to increase his wheat crop, a farmer may be
forced to use less-fertile land or pay more for laborers to harvest the wheat, thereby
increasing the cost of each additional unit produced.
Another key assumption of traditional economic theory is that basic factors of production—
such as land, labor, and capital—are not traded across borders. Although Ohlin believed that
such basic factors of production were not traded, he argued that the relative returns to factors
of production between countries would tend to be equalized as goods are traded between the
countries. Subsequently, Samuelson argued that factor prices would in fact be equalized

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under free trade conditions, and this is known in economics as the factor price equalization
theorem. This might mean, for example, that international trade would cause wage rates for
unskilled workers to fall in the high-wage country in relation to the rents available from
capital and to the same level as wages in the low wage country, and for wages to rise in
relation to the rents available from capital in the low-wage country and equal to the level of
the country where labor was less abundant. (The implications of this are important and are
explored further in chapter 8.)
In static terms, the law of comparative advantage holds that all nations can benefit from free
trade because of the increased output available for consumers as a result of more efficient
production. James Jackson of the Congressional Research Service describes the benefits as
follows: Trade liberalization, “by reducing foreign barriers to U.S. exports and by removing
U.S. barriers to foreign goods and services, helps to strengthen those industries that are the
most competitive and productive and to reinforce the shifting of labor and capital from less
productive endeavors to more productive economic activities.”
Many economists, however, believe that the dynamic benefits of free trade may be greater
than the static benefits. Dynamic benefits, for example, include the pressure on companies to
be more efficient to meet foreign competition, the transfer of skills and knowledge, the
introduction of new products, and the potential positive impact of the greater adoption of
commercial law. Thus trade can affect both what is produced (static effects) and how it is
produced (dynamic effects).
Economists have developed a number of sophisticated models designed to simulate the
changes in economic conditions that could be expected from a trade agreement. These
models, which are based on modern economic theories of trade, are helpful where the
barriers to trade are quantifiable, although the results are highly sensitive to the assumptions
used in establishing the parameters of the model.
One type of model used extensively by economists to estimate the economy-wide effects of
trade policy changes, such as the results of a multilateral trade round, is the Applied General
Equilibrium Model, also called the Computable General Equilibrium (CGE) Model. James
Jackson of the Congressional Research Service notes: “These models incorporate
assumptions about consumer behavior, market structure and organization, production
technology, investment, and capital flows in the form of foreign direct investment.”
CGE models may be used to estimate the impact of a trade agreement on trade flows, labor,
production, economic welfare, or even the environment.  They may consider the effects of
the agreement on all countries involved, and are ex ante; that is, they attempt to forecast
changes that would result from a trade agreement. General equilibrium models are based on
input-output models, which track how the output of one industry is an input to other
industries. General equilibrium models use enormous data inputs that reflect all the elements
to be considered.
One of the great strengths of these models is that they can show how the effects on industries
flow through the entire economy. One of their disadvantages is that because of their
complexity, the assumptions behind their projections are not always transparent. Economic

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models are useful to give a sense of what might happen as a result of a trade agreement. 
They give the appearance of being authoritative, but users need to be aware that economic
models are not predictive of what will actually happen and that they have significant
weaknesses.
First, the results of any model depend on the assumptions underlying it, such as the degree to
which imported products and domestically produced products can be substituted for one
another, or whether or not there is perfect or imperfect competition. Differing assumptions
can produce a wide range of results, not only in magnitude but also sometimes even in the
direction of projected changes.
Consider, for example, a country that starts off with a GDP per capita of $40,000, which
would roughly represent a typical high-income country today, and another country that starts
out at $4,000, which is roughly the level in low-income but not impoverished countries like
Indonesia, Guatemala, or Egypt. Say that the rich country chugs along at a 2% annual growth
rate of GDP per capita, while the poorer country grows at the aggressive rate of 7% per year.
After 30 years, GDP per capita in the rich country will be $72,450 (that is, $40,000 (1 +
0.02)30) while in the poor country it will be $30,450 (that is, $4,000 (1 + 0.07) 30).
Convergence has occurred; the rich country used to be 10 times as wealthy as the poor one,
and now it is only about 2.4 times as wealthy. Even after 30 consecutive years of very rapid
growth, however, people in the low-income country are still likely to feel quite poor
compared to people in the rich country. Moreover, as the poor country catches up, its
opportunities for catch-up growth are reduced, and its growth rate may slow down
somewhat.

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