Course: Advanced Macroeconomics (806)

Semester: Autumn, 2021

ASSIGNMENT No. 1
Q.1 Explain in words how and why the income and interest sensitivity of the demand for real balance
affect the slope of the LM curve?
The resulting slope of the IS plot will be vertical. This is an investment trap - this is a situation in which the
demand for investments is completely inelastic to the interest rate, so the graph of the investment function
becomes vertical. IS curve shows the goods market equilibrium combinations of interest rates and output. It is a
downward-sloping curve which shows the inverse relationship between interest rates and investment spending.
The slope of the IS curve depends on the interest elasticity of investment demand and the slope of saving curve
(MPS).
In other words, in Keynes’ simple model the level of national income is shown to be determined by the goods
market equilibrium. In this simple analysis of equilibrium in the goods market Keynes considers investment to
be determined by the rate of interest along with the marginal efficiency of capital and is shown to be
independent of the level of national income.
The rate of interest, according to Keynes, is determined by money market equilibrium by the demand for and
supply of money. In this Keynes’ model, changes in rate of interest either due to change in money supply or
change in demand for money will affect the determination of national income and output in the goods market
through causing changes in the level of investment.
In this way changes in money market equilibrium influence the determination of national income and output in
the goods market. However, there is apparently one flaw in the Keynesian analysis which has been pointed out
by some economists and has been a subject of a good deal of controversy.
It has been asserted that in the Keynesian model whereas the changes in rate of interest in the money market
affect investment and therefore the level of income and output in the goods market, there is seemingly no
inverse influence of changes in goods market i.e., (investment and income) on the money market equilibrium.
It has been shown by J.R. Hicks and others that with greater insights into the Keynesian theory one finds that
the changes in income caused by changes in investment or propensity to consume in the goods market also
influence the determination of interest in the money market.
According to him, the level of income which depends on the investment and consumption demand determines
the transactions demand for money which affects the rate of interest. Hicks, Hansen, Lerner and Johnson have
put forward a complete and integrated model based on the Keynesian framework wherein the variables such as
investment, national income, rate of interest, demand for and supply of money are interrelated and mutually
interdependent and can be represented by the two curves called the IS and LM curves.
This extended Keynesian model is therefore known as IS-LM curve model. In this model they have shown how
the level of national income and rate of interest are jointly determined by the simultaneous equilibrium in the
two interdependent goods and money markets. Now, this IS-LM curve model has become a standard tool of

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 Course: Advanced Macroeconomics (806)
Semester: Autumn, 2021
macroeconomics and the effects of monetary and fiscal policies are discussed using this IS and LM curves
model.
Q.2 Suppose the government cuts income that show in the IS-LM model the impact of the tax cut under
two assumptions.
a) The government keeps interest rates constant through an accommodating monetary policy.
Beyond education, geographic dispersion is an important factor to consider. Even among households with
similar income levels, blacks are more likely to live in economically depressed areas than whites, 1 which would
drive up their unemployment rate compared to whites. Additionally, evidence suggests that Hispanic
immigrants may be more likely to remain near their country of origin, whereas Asian immigrants might pick
locations based on economic opportunity.2
So while both populations tend to be heavily concentrated in specific areas, it could be that Hispanics, like
blacks, tend to live in areas with worse economic prospects, while Asians congregate in areas with more
plentiful opportunities. If true, this would help account for Hispanics’ relatively high unemployment rate
compared to Asians’ relatively low one.
b) The money stock remains unchanged. Explain the difference in results.
1. Boost public sector employment: The public sector often offers a path to middle-class incomes for
African-American workers. A one percentage-point increase in state and local government employment
decreases the African-American unemployment rate by 0.5 percentage points. In addition, every $1 million
spent in Cook County on state and local government workers creates 6 net jobs. Efforts to cut state and local
government employment have a disproportionately negative impact on African-American workers.
2. Increase public transportation ridership: A one-percentage point increase in the public transit commuters
decreases the African-American unemployment rate by 0.1 percentage point. In addition, every $1 million spent
in Cook County on local government passenger transit creates 24 net jobs. Increasing investment in public
transportation systems improves connectivity, economic efficiency, and lowers the costs of going to work.
3. Raise the number of African-Americans with bachelor’s degrees: A well-educated workforce raises
wages and builds a foundation for shared economic prosperity. A one-percentage point increase in the share
of African Americans with at least a bachelor’s degree decreases the African-American unemployment rate by
0.5 percentage points. In addition, every $1 million spent in Cook County on public universities creates 3 net
jobs. Increasing investment in higher education and reducing tuition costs for all residents benefits African-
American communities.
4. Lower the costs of homeownership: A one-percent decrease in homeownership costs decreases the African-
American unemployment rate by about 0.1 percentage point. In most Chicago neighborhoods, it is illegal to
build anything other than single-family homes. By relaxing zoning laws, especially in high-demand
neighborhoods, developers can build new high-rises and units. This increase in supply lowers the price of
homes, making monthly mortgages more affordable for all families. Every $1 million spent in Cook County on

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 Course: Advanced Macroeconomics (806)
Semester: Autumn, 2021
multifamily residential structures creates 10 net jobs. A $15 minimum wage would also lower the relative cost
of homeownership for the lowest-earning African Americans because the average wage needed to afford a
modest one-bedroom apartment at the fair market rent in the Chicago area is $16.36 per hour for a full-time
worker.
5. Reduce the reliance on local property taxes to fund an adequate and equitable public education:
Unequal education funding contributes to an inequitable education for people of color, leading to lower rates of
high school completion, lower rates of college attendance and completion, and higher unemployment.
Replacing the state’s current Foundation Level scheme for funding schools with an Evidence-Based
Education Funding model would improve the chances of African-American students earning the minimum
requirements to enter the labor market or to enter college.
6. Enforce prohibitions against racial discrimination in employment and apply a racial justice lens to
employment practices: In addition to enforcing anti-discrimination laws, states and local governments should
help employers develop tools to understand the equity effects of employment decisions. Illinois’ Human
Relations Commission should assist employers in developing a Racial Equity Impact Assessment to
determine how different racial and ethnic groups will likely be affected by a proposed employment decision.
7. Enhance local market conditions: A low overall unemployment rate and high rents are generally
byproducts of a strong local economy. The best way to improve local market conditions is to invest in both
physical infrastructure and human capital. Corporate executives list the availability of skilled labor and
highway accessibility as the two most important factors in moving to a community or state. Investing in
transportation infrastructure and investing in higher education are appropriate policies to boost the
employment of all workers, including African Americans.
Q.3 In the friction less neoclassical model assumes that labour becomes less productive, with the labour
demand curve shifting downward and to the left.
a) What is the effect of this change on the full employment levels of employment and output.
Months before the pandemic, in July 2019, Pakistan was forced to seek an Extended Fund Facility
(EFF) programme with the International Monetary Fund (IMF) due to its twin deficit problem, i.e.
fiscal and current account. With aggressive curbs on imports and massive devaluation, the country
managed to reduce the current account deficit (CAD) by over 70 percent in the first seven months of
Financial Year (FY) 2019-20. However, this came at the expense of economic growth, which fell from
5.6 percent in 2018 to 3.3 percent in 2019. In 2020, it was being projected to fall further to 2.4 percent,
without accounting for the pandemic. Meanwhile, the fiscal deficit problem continued unchecked—
partly because the revenue collections fell drastically short of the targets and because the government
slashed developmental expenditure to demonstrate a positive primary balance, which was one of the
conditionalities of the IMF programme.

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 Course: Advanced Macroeconomics (806)
Semester: Autumn, 2021
Amidst the ongoing COVID-19 pandemic, both these deficits are likely to re-emerge, with a drastic
decline in exports and foreign remittances. Pressure will also mount on the expenditure front. In 2019,
Pakistan’s military had voluntarily foregone any increase in the defence budget. Now, it is likely to
demand a substantial increase. Further, the government will be forced to reverse the trend of cutting
expenditure on health, education and other social service sectors. These issues are compounded by
Pakistan’s growing public debt, the servicing of which constitutes a substantial part of the government
expenditure.
The pandemic has forced most countries to break with the past and initiate deep reforms, not only in
the economy but also in politics and foreign and security policy. However, being a national security
state, Pakistan continues to adhere to its existing model, since changing its foreign and security policy
will require upending the power dynamics between the dominant military and the civilian political
establishment. Consequently, Pakistan is treating COVID-19 as an opportunity to obtain concessions,
bailouts and debt relief, to avoid undertaking the reforms it had accepted as part of the 2019 IMF
bailout. The country is also seeking bailouts from China and Saudi Arabia. While helpful, these
measures cannot replace the underlying need for deep structural reform in Pakistan.
On 2 January 2020, PM Imran Khan claimed that the government had stabilised the economy, declaring
this to be the year of growth, development and wealth creation.  A week later, the finance ministry
issued a press release asserting that the economy was moving “progressively along the adjustment path
and stabilization process and economic recovery is expected towards the end of FY2020.” The
statement noted several achievements in the first five months of FY2020: the CAD dropped by nearly
73 percent; the fiscal deficit was at 1.6 percent of GDP; the “primary balance” was positive, at 0.3
percent of the GDP; the credit rating had improved from negative to stable; and the country’s rank on
the Ease of Doing Business Index had improved from 136 to 108.
b) What is the effect on the full employment real ways?
Foreign banks and ratings agencies, too, have endorsed Pakistan’s management of the economy. In
December 2019, Moody’s upgraded Pakistan’s credit outlook from negative to stable,  and Citibank’s
top management in Pakistan commended the Khan government’s economic policies.  As late as the last
week of February 2020, Credit Suisse released a report titled “Pakistan: On the Path to Recovery,”
noting that the “fundamentals” of the economy had improved significantly as a result of the IMF
package, fiscal consolidation and the necessary reforms being undertaken by the government. In its
second-quarter report on the state of the country’s economy, the State Bank of Pakistan (SBP) claimed
that the “cumulative effect of stabilization and regulatory measures taken during the past one year” had
led to “notable improvements” in the economy. Additionally, there was an increase in foreign
investment, tax and non-tax revenues and exports; currency had stabilised; inflation had started to ease;

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 Course: Advanced Macroeconomics (806)
Semester: Autumn, 2021
and large-scale manufacturing showed “some positive signs.” While the SBP tempered its optimism
with several caveats, on the whole, it seemed to suggest that the economy was on the right track.
However, a closer look at Pakistan’s pre-COVID-19 economic landscape reveals a very different
picture. The 70 percent reduction in the CAD was a result of import compression and steep depreciation
of the Pakistani Rupee, which came at the cost of economic growth.  From around 5.5 percent in FY18,
Pakistan’s GDP growth came down to 3.3 percent in FY19, and was further projected by the IMF to fall
to 2.4 percent in FY20. The unofficial estimate by independent economists was bleaker, at 1.9 percent
in FY19 and 1.2 percent in FY20. While most international organisations were projecting Pakistan’s
growth to be around 2.4 percent in FY20, renowned Pakistani economist, Dr. Hafiz Pasha, estimated
that the 3.3 percent growth claimed by the government and multilateral institutions in FY19 was
actually 1.9 percent, set to fall further to 1.2 percent in FY20.  Moreover, Dr. Pasha predicted a fall in
per capita income in light of the population growth rate of 2.4 percent.  Thus, Pakistan’s economy was
faltering on virtually every economic parameter.
The increase in foreign exchange reserves (after the IMF approved the EFF programme in 2019) was
largely based on borrowed money, such as bailout loans from China, Saudi Arabia and the
UAE. Despite a nearly 30 percent depreciation in the value of the Pakistani Rupee, exports increased
only marginally. In the first nine months of the current fiscal year, exports rose by only 2.2 percent in
dollar terms. Meanwhile, there was a steady rise in inflation. The data released by the Pakistan Bureau
of Statistics shows that the year-on-year inflation in January 2019 was 5.6 percent, with food inflation
at 2.6 percent and 1.8 percent in urban and rural areas, respectively. However, by January 2020, the
percentage had spiked to 14.6 percent, with food inflation at 19.5 percent in urban areas and 24 percent
in rural areas. In March 2020, the inflation number did fall to 10.2 percent, with food inflation at 13
percent and 15.5 percent (urban and rural, respectively),  but this was largely due to the disruption and
dislocation caused by the pandemic.
As part of the IMF agreement and to control inflation, the SBP had been steadily raising interest rates.
From 6.5 percent at the time when the Pakistan Muslim League-Nawaz (PML-N) government demitted
office in May 2018, the SBP’s benchmark interest rate increased to 13.25 percent in July 2019.  The
high interest rate was also meant to attract ‘hot money’ into Pakistan. Around US$ 3 billion flowed into
Pakistan in the form of purchases of short-term treasury bonds, but it started to flow back as soon as the
COVID-19 crisis started to unfold in the West.
Q.4 In the classical model how will and increased desire by the public to hold money balances affect
prices, income and employment?
Voluntary Unemployment - Voluntary unemployment refers to a situation where a person who is able to work
remains unemployed due to his/her own willingness. Under this situation, the person remains unemployed
despite jobs being available in the market. Involuntary Unemployment - Involuntary unemployment refers to a

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 Course: Advanced Macroeconomics (806)
Semester: Autumn, 2021
situation where a person who is willing and is able to work does not get work at the existing wage rate. Under
this situation, the person remains is unemployed due to non-availability of jobs in the market.
An involuntary unemployment means a situation in which all able persons who are willing to work at the
prevailing wage rate do not get work.
Such people are (i) physically and mentally fit to work and are also (ii) willing to work at the going rate but are
out of Job.
Thus, their unemployment is involuntary (i.e., not voluntary) because they are rendered unemployed against
their wishes.
This type of unemployment is due to deficiency of aggregate demand sufficient to ensure full employment. It
indicates excess supply of labour which the rigid wage-rate has failed to eliminate. In short, if involuntary
unemployment exists, the economy cannot be said to be at the level of full employment equilibrium. It will
indicate under-employment equilibrium in the economy.
It needs to be understood that involuntary unemployment is different from voluntary unemployment. Voluntary
unemployment refers to a situation when persons who are able to work but are not willing to work although
suitable work is available for them. In other words, they are voluntarily unemployed, i.e., unemployed of their
own will.
Such persons are not included in labour force of the country. On the contrary, involuntary unemployment occurs
when those who are able and willing to work at the going wage rate do not get work. Hence, they are
unemployed against their wishes.
Significance of distinction is that the magnitude of unemployment in an economy, is reflected by the magnitude
of involuntary unemployment since the former includes only involuntary unemployment. According to Keynes,
involuntary unemployment arises due to insufficiency of effective demand which can be solved by stepping up
aggregate demand through government intervention.
Voluntary unemployment refers to the situation where people who are able to work, but are not willing to work at the
existing wage rate remain unemployed. While, involuntary unemployment refers to the situation where people who
are able to work and are willing to work at the existing wage rate do not get employment opportunities.
Voluntary unemployment refers to a situation when a person is unemployment because he is not willing to work
at the existing wage rate. On the other hand, Involuntary unemployment refers to an unemployment in which all
those people, who are willing and able to work at the existing wage rate, do not get work.
The distinction is significant to determine the total unemployment in an economy. Voluntary unemployment is
not counted while estimating the size of unemployment. While involuntary unemployment is considered while
estimating the total unemployment in an economy.
Q.5 Compare and contrast the absolute income hypothesis and permanent income hypothesis.
The consumption function, or Keynesian consumption function, is an economic formula that represents the
functional relationship between total consumption and gross national income. It was introduced by British

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 Course: Advanced Macroeconomics (806)
Semester: Autumn, 2021
economist John Maynard Keynes, who argued the function could be used to track and predict total aggregate
consumption expenditures.
The classic consumption function suggests consumer spending is wholly determined by income and the changes
in income. If true, aggregate savings should increase proportionally as gross domestic product (GDP) grows
over time. The idea is to create a mathematical relationship between disposable income and consumer spending,
but only on aggregate levels.
The stability of the consumption function, based in part on Keynes' Psychological Law of Consumption,
especially when contrasted with the volatility of investment, is a cornerstone of Keynesian macroeconomic
theory. Most post-Keynesians admit the consumption function is not stable in the long run since consumption
patterns change as income rises.
The consumption function is represented as:
C = A + MD
Where:
C=consumer spending
A=autonomous consumption
M=marginal propensity to consume
D=real disposable income
Much of the Keynesian doctrine centers around the frequency with which a given population spends or saves
new income. The multiplier, the consumption function, and the marginal propensity to consume are each crucial
to Keynes’ focus on spending and aggregate demand.
The consumption function is assumed stable and static; all expenditures are passively determined by the level of
national income. The same is not true of savings, which Keynes called “investment,” not to be confused with
government spending, another concept Keynes often defined as investment.
For the model to be valid, the consumption function and independent investment must remain constant long
enough for national income to reach equilibrium. At equilibrium, business expectations and consumer
expectations match up. One potential problem is that the consumption function cannot handle changes in the
distribution of income and wealth. When these change, so too might autonomous consumption and the marginal
propensity to consume.
Over time, other economists have made adjustments to the Keynesian consumption function. Variables such as
employment uncertainty, borrowing limits, or even life expectancy can be incorporated to modify the older,
cruder function.
For example, many standard models stem from the so-called “life cycle” theory of consumer behavior as
pioneered by Franco Modigliani. His model made adjustments based on how income and liquid cash balances
affect an individual's marginal propensity to consume. This hypothesis stipulated that poorer individuals likely
spend new income at a higher rate than wealthy individuals.

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 Course: Advanced Macroeconomics (806)
Semester: Autumn, 2021
Milton Friedman offered his own simple version of the consumption function, which he called the “permanent
income hypothesis.” Notably, the Friedman model distinguished between permanent and temporary income. It
also extended Modigliani’s use of life expectancy to infinity.
More sophisticated functions may even substitute disposable income, which takes into account taxes, transfers,
and other sources of income. Still, most empirical tests fail to match up with the consumption function’s
predictions. Statistics show frequent and sometimes dramatic adjustments in the consumption function.
b) Give that S= -25+0.6Yd derive the consumption function and illustrate the result on a curve.
British economist John Maynard Keynes created the consumption function formula, which calculates
consumer spending based on income and the changes in income – spending rises or falls in proportion to
income. The consumption function determines consumer spending based on three factors. The
consumption function is calculated by first multiplying the marginal propensity to consume by disposable
income. The resulting product is then added to autonomous consumption to get total spending. As an equation
in which C = consumer spending; A = autonomous consumption; M = marginal propensity to consume; D =
real disposable income, it is: C = A + MD.
S= -25 + 0.6Yd
a = -25 c = 0.6
Consumption function C = a + cYd
C = -25 + 0.6 Yd