www.daniyalstudio9.

com

Advanced
Course name: Level: MA / MSC
Macroeconomics
Course Code: 806 Semester: Spring 2022
Assignment: 2 Due Date: 02-10-2022
Total Assignment: 2 Late Date: 02-10-2022

‫اجنےساتکںیبںیہنآریہںیہ۔وہہبلط مہاریرسوسےکذرےعیاسنمنئاوراحتمناتیکیتریےکےیلیک ببرھگےھٹیب‬‫نجہبلطیکویوینریٹسیک ب‬

‫ے‬ ‫ٹٹ‬ ‫ے‬
‫ادارکےکآرڈررکواتکسںیہ۔زیناہھتےسیھکلوہیئاورالیامیاسییک‬180‫رپنتمیقےکالعوہمزیڈڈاکخزہچ‬
‫احلصرکتکسںیہ۔بتکیک ڈ‬
‫ئم ٹ‬
03096696159‫ان‬ ‫وسٹفاس نٹسآرڈررپدایتسبںیہ۔واسٹ پ‬

Assignment no. 2

Q.1 Explain the difference between classical and Keynesian theory of interest
rate.

1. The classical theory of interest is a special theory because it presumes full

employment of resources. On the other hand, Keynes theory of interest is a
general theory, as it is based on the assumption that income and employment
fluctuate constantly.

2. Classical regard rate of interest to be equilibrating mechanism between saving

and invest-ment. Keynes regards changes in income to be the equilibrating
mechanism between them. According to Keynes, savings depend on income.
Classicals regarded savings as fixed corresponding to full employment
income, whereas for Keynes for every level of employ-ment, there will be a
different level of income and for different levels of income there will be
corresponding savings (curves).

3. According to classicals, more savings will flow at a higher rate of interest, but
according to Keynes savings will fall because the level of income will fall,
for the investment will be less when the rate of interest goes up, leading to a
decline in income and hence savings.

4. The element of hoarding occupies a central position in Keynes’ liquidity

preference theory of interest because he considers money as a store of value
also; whereas the classicals gave little importance to the element of hoarding
and considered money only as a medium of exchange.
 www.daniyalstudio9.com

5. Classicals gave more attention to interest on bank loans, whereas Keynes was
concerned with the entire loan and interest rate structure in the market and
the complex of rates of interest that exist. In his theory, long-term rate of
interest on loans, bonds and securities occupies greater significance as they
influence long-term investment.

6. Classicals always held that savings automatically flow into investment.

Keynes held just the reverse, that is, it is investment that automatically leads
to saving out of current income. Further, classicals held that investment
could be increased by saving more but Keynes held that investment could
increase income and out of the increased income, increased savings flow.

7. An increase in thrift, which according to classicals, was a great virtue, may

according to Keynes, cause income to fall reducing the volume of savings.
Hence, the classical position is falsified. It is one of the great merits of
“General Theory” and the Keynesian approach of liquidity preference that it
once for all cleared the thinking which confused the amount saved with the
propensity to save. Thus, whereas classicals were keen to retain saving to
investment as determining factors, Keynes omitted them completely from his
theory of interest.

Q.2 Differentiate between the Fisherian and Cambridge versions of the

quantity theory of money.

The Fisherian approach emphasises the medium of exchange function of money,

whereas the Cambridge approach stresses the store of value function of money.

3. Flow and Stock Concepts:

The Fisherian approach regards money as a flow concept; money is considered in

terms of flow of money expenditures. The Cambridge version regards money as a
stock concept; money supply refers to a given stock at a particular point of time.

4. Transaction and Income Velocities:

Fisherian approach emphasises the importance of the transaction velocity of

circulation (i.e., V). The Cambridge Version, on the contrary, lays stress on the
income velocity of the part of income which is held in the cash balance (i.e., K).

5. Nature of P:
 www.daniyalstudio9.com

In both approaches, the price level (P) is not used identically. In Fisher’s version,
P is the average price level of all goods. On the contrary, in Cambridge version.
P refers to the price of consumer goods.

6. Factors Affecting V and K:

Fisher is concerned about the institutional and technological factors governing

how fast individuals can spend their money (i.e., V). The Cambridge School, on
the other hand, is concerned about the economic factors determining what
portion of their wealth the public desires to hold in the form of money (i.e., K).

7. Relationship between M and P:

The Fisherian approach maintains that any change in the money supply produces
proportional changes in the price level. This is because Fisher believes that both
velocity and real income are in the long run independent of each other and of
supply of money.

In the Cambridge approach, the price level may change by more or less than the
money supply; it depends upon what happens to the stock of non-monetary assets
and their expected yields on which the Cambridge economists believed the
desired cash balances depend.

8. Different Approaches to Monetary Theory:

Both Fisher and Cambridge School led to the development of two different
approaches to the monetary theory. Fisher’s approach has given rise to an
inventory theory of money holding largely for transactions purposes. On the
other hand, the Cambridge approach has been developed into portfolio, or capital
theoretic approach to monetary demand.

Superiority of Cash Balance Approach:

The Cambridge version is superior to the Fisherian version on the following

grounds:

1. Realistic Theory:

The Fisherian approach is mechanical in the sense that it maintains a mechanical,

i.e., direct and proportional relationship between the supply of money and the
price level. The Cambridge approach, on the contrary, provides a realistic
 www.daniyalstudio9.com

analysis. By emphasising K, it introduced the role of human motives in the

determination of the price level.

2. Complete Theory:

Fisher’s approach is one-sided because it considers quantity of money to be the

only determinant of the value of money or the price level. In the Cambridge
approach, both the demand for and the supply of money are recognised as real
determinants of the value of money.

3. Broader Theory:

The Cambridge approach is broader and comprehensive because it takes into

account income level as well as changes in it as important determinant of the
price level. The Fisherian approach ignored income level and makes the price
level dependent upon the quantity of money and the total number of transactions.

4. More Useful:

According to Kurihara, the Cambridge equation, P = M/KT, is analytically more

useful than the Fisherian equation, P = MV/T, in explaining money value. It is
easier to know the amount of cash balances of an individual than to know his
expenditure on various types of transactions.

5. Causal Process:

According to Fisher, changes in the price level are caused by the changes in the
quantity of money. But according to the Cambridge economists, the price level
may change even without a change in the quantity of money, if K changes. Given
the quantity of money, a desire to keep less money balances will raise the price
level and vice versa.

6. Explanation of Cyclical Fluctuations:

The variable K in the Cambridge equation is more significant in explaining the

trade cycles than the variable V in Fisher’s equation. During inflation, people
decrease their cash balances (K) and as a result, the value of money falls and the
price level rises. On the contrary, during depression, the desire to hold money
(K) rises and, as a consequence, the value of money rises and the price level falls.

7. Basis of Liquidity Preference Theory:

 www.daniyalstudio9.com

The Cambridge approach, by stressing on the motives for the demand for holding
money, provided a foundation for the development of Keynes ‘liquidity
preference theory of interest, Liquidity preference theory is a significant
constituent of the modem theory of income and employment and its emergence
has raised the importance of fiscal policy in controlling business cycles.

8. Nature of Variables:

Various variables in the Cambridge equation are defined in a better and more
realistic manner than those in the Fisherian equation. T in Fisher’s version refers
to the total transactions, whereas in the Cambridge equation, T refers to only the
final goods and services. Similarly, P in Fisher’s version stands for the average
price level of all goods transacted in a period of time, but in Cambridge version,
P is the general price level of only final goods.

9. General Demand Analysis:

The Cambridge approach is preferred by the economists because it applies the

general demand analysis to the special case of money. It enquires into the utility
of money, the nature of the budget constraint facing the individual and the
opportunity cost of holding money as against the other assets.

Q.3 Why do many economists think that large cross-country income

differences are hard to settle with implications of neoclassical growth
model?

Neoclassical growth theory is an economic theory that outlines how a

steady economic growth rate results from a combination of three driving
forces—labor, capital, and technology. The National Bureau of Economic
Research names Robert Solow and Trevor Swan as having the credit of
developing and introducing the model of long-run economic growth in 1956.
The model first considered exogenous population increases to set the growth rate
but, in 1957, Solow incorporated technology change into the model. The theory
states that short-term equilibrium results from varying amounts of labor and
capital in the production function. The theory also argues that technological
change has a major influence on an economy, and economic growth cannot
continue without technological advances.
 www.daniyalstudio9.com

Neoclassical growth theory outlines the three factors necessary for a growing
economy. These are labor, capital, and technology. However, neoclassical
growth theory clarifies that temporary equilibrium is different from long-term
equilibrium, which does not require any of these three factors.

Special Consideration

This growth theory posits that the accumulation of capital within an economy,
and how people use that capital, is important for economic growth. Further, the
relationship between the capital and labor of an economy determines its output.
Finally, technology is thought to augment labor productivity and increase the
output capabilities of labor.

Therefore, the production function of neoclassical growth theory is used to

measure the growth and equilibrium of an economy. That function is Y = AF (K,
L).
• Y denotes an economy's gross domestic product (GDP)

• K represents its share of capital

• L describes the amount of unskilled labor in an economy

• A represents a determinant level of technology

However, because of the relationship between labor and technology, an

economy's production function is often re-written as Y = F (K, AL).

Increasing any one of the inputs shows the effect on GDP and, therefore, the
equilibrium of an economy. However, if the three factors of neoclassical growth
theory are not all equal, the returns of both unskilled labor and capital on an
economy diminish. These diminished returns imply that increases in these two
inputs have exponentially decreasing returns while technology is boundless in its
contribution to growth and the resulting output it can produce.

Example of the Neoclassical Growth Theory

A 2016 study published in Economic Themes by Dragoslava Sredojević,

Slobodan Cvetanović, and Gorica Bošković titled "Technological Changes in
Economic Growth Theory: Neoclassical, Endogenous, and Evolutionary-
Institutional Approach" examined the role of technology specifically and its role
in the neoclassical growth theory.
 www.daniyalstudio9.com

The authors find a consensus among different economic perspectives all points
to technological change as a key generator of economic growth. For example,
neoclassicists have historically pressured some governments to invest in
scientific and research development toward innovation.2

Endogenous theory supporters emphasize factors such as technological spillover

and research and development as catalysts for innovation and economic growth.
Lastly, evolutionary and institutional economists consider the economic and
social environment in their models for technological innovation and economic
growth.

Q.4 Explain endogenous growth. How does endogenous growth model differ
from the neoclassical models of growth?

What is Endogenous Growth Theory?

Endogenous growth theory is an economic theory which argues that economic

growth is generated from within a system as a direct result of internal processes.
More specifically, the theory notes that the enhancement of a nation's human
capital will lead to economic growth by means of the development of new forms
of technology and efficient and effective means of production.

Understanding Endogenous Growth Theory

The endogenous growth theory offered a fresh perspective on what engineers

economic growth. It argued that a persistent rate of prosperity is influenced by
internal processes such as human capital, innovation, and investment capital,
rather than external, uncontrollable forces, challenging the view of neoclassical
economics.

Endogenous growth economists believe that improvements in productivity can be

tied directly to faster innovation and more investments in human capital. As
such, they advocate for government and private sector institutions to nurture
innovation initiatives and offer incentives for individuals and businesses to be
more creative, such as research and development (R&D) funding and intellectual
property rights.

The idea is that in a knowledge-based economy, the spillover effects from

investment in technology and people keep generating returns. Influential
 www.daniyalstudio9.com

knowledge-based sectors, such as telecommunications, software, and other high-

tech industries, play a particularly important role here.

Central tenets to endogenous growth theory include:

• Government policy's ability to raise a country’s growth rate if they lead to

more intense competition in markets and help to stimulate product and
process innovation.
• There are increasing returns to scale from capital investment, especially in
infrastructure and investment in education, health, and telecommunications.
• Private sector investment in R&D is a crucial source of technological
progress.
• The protection of property rights and patents is essential to providing
incentives for businesses and entrepreneurs to engage in R&D.
• Investment in human capital is a vital component of growth.

Government policy should encourage entrepreneurship as a means of creating

new businesses and ultimately as an important source of new jobs, investment,
and further innovation.

History of Endogenous Growth Theory

Endogenous growth theory emerged in the 1980s as an alternative to the

neoclassical growth theory. It questioned how gaps in wealth between developed
and underdeveloped countries could persist if investment in physical capital like
infrastructure is subject to diminishing returns.

Economist Paul Romer put forward the argument that technological change is not
just an exogenous byproduct of independent scientific developments. He sought
to prove that government policies, including investment in R&D and intellectual
property laws, helped foster endogenous innovation and fuel persistent economic
growth.

Romer previously complained that his findings hadn’t been taken seriously
enough. However, he was awarded the 2018 Nobel Prize in Economics for his
studies on long-term economic growth and its relationship with technological
innovation. His concepts are also regularly discussed by politicians when they
debate ways to stimulate economies.
 www.daniyalstudio9.com

Criticism of Endogenous Growth Theory

One of the biggest criticisms aimed at the endogenous growth theory is that it is
impossible to validate with empirical evidence. The theory has been accused of
being based on assumptions that cannot be accurately measured.

Key Policy Implications of Endogenous Growth Theory

• Governmental policies can raise an economy’s growth rate if the policies
are directed toward enforcing more market competition and helping
stimulate innovation in products and processes.
• There are increasing returns to scale from capital investment in the
“knowledge industries” of education, health, and telecommunications.
• Private sector investment in R&D is a vital source of technological progress
for the economy.

Q.5 What factors determine the growth rate of steady- state per capita output?
Are there other factors that could affect the growth rate of output in the
short run?

The Solow Growth Model is an exogenous model of economic growth that

analyzes changes in the level of output in an economy over time as a result of
changes in the population growth rate, the savings rate, and the rate of
technological progress.

The Solow Growth Model, developed by Nobel Prize-winning economist Robert

Solow, was the first neoclassical growth model and was built upon the Keynesian
Harrod-Domar model. The Solow model is the basis for the modern theory of
economic growth.

Simplified Representation of the Solow Growth Model

Below is a simplified representation of the Solow Model.

Assumptions:

1. The population grows at a constant rate g. Therefore, the current population

(represented by N) and future population (represented by N’) are linked through
the population growth equation N’ = N(1+g). If the current population is 100 and
its growth rate is 2%, the future population is 102.
 www.daniyalstudio9.com

2. All consumers in the economy save a constant proportion, ‘s’, of their incomes
and consume the rest. Therefore, consumption (represented by C) and output
(represented by Y) are linked through the consumption equation C= (1-s)Y. If a
consumer earns 100 units of output as income and the savings rate is 40%, then
the consumer consumes 60 units and saves 40 units.

3. All firms in the economy produce output using the same production
technology that takes in capital and labor as inputs. Therefore, the level of output
(represented by Y), the level of capital (represented by K), and the level of labor
(represented by L) are all linked through the production function equation Y =
aF(K,L).

The Solow Growth Model assumes that the production function exhibits
constant-returns-to-scale (CRS). Under such an assumption, if we double the
level of capital stock and double the level of labor, we exactly double the level of
output. As a result, much of the mathematical analysis of the Solow model
focuses on output per worker and capital per worker instead of aggregate output
and aggregate capital stock.

4. Present capital stock (represented by K), future capital stock (represented by

K’), the rate of capital depreciation (represented by d), and level of capital
investment (represented by I) are linked through the capital accumulation
equation K’= K(1-d) + I.

Solving the Solow Growth Model

1. In our analysis, we assume that the production function takes the following
form: Y = aKbL1-b where 0 < b < 1. The production function is known as the
Cobb-Douglas Production function, which is the most widely used neoclassical
production function. Together with the assumption that firms are competitive,
i.e., they are price-taking firms, the coefficient b is the capital share (the share of
income that capital receives).

2. Therefore, output per worker is given through the following equation: y =

akb where y = Y/L (output per worker and k = K/L (capital stock per worker)

3. Under the assumption of competitive equilibrium, we get the following:

The income-expenditure identity holds as an equilibrium condition: Y = C + I

 www.daniyalstudio9.com

Consumer’s budget constraint: Y = C + S

Therefore, in equilibrium: I = S = sY.

4. The capital accumulation equation becomes: K’ = (1–d)K + sY

The capital accumulation equation in per worker times is given through the
following equation: (1 + g)k’ = (1 – d)k + sy = (1 – d)k + saf(k) = (1 – d)k + sakb

5. The solution concept used is that of a steady state. The steady state is a state
where the level of capital per worker does not change. Consider the graph below:

6. The steady state is found by solving the following equation: k’ = k => (1 + g)k
= (1 – d)k + sakb

7. Therefore, the steady state value of capital per worker and the steady state
value of output per worker are the following:

Implications of the Solow Growth Model

There is no growth in the long term. If countries have the same g (population
growth rate), s (savings rate), and d (capital depreciation rate), then they have the
same steady state, so they will converge, i.e., the Solow Growth Model predicts
conditional convergence. Along this convergence path, a poorer country grows
faster.

Countries with different saving rates have different steady states, and they will
not converge, i.e. the Solow Growth Model does not predict absolute
convergence. When saving rates are different, growth is not always higher in a
country with lower initial capital stock.