MEC

MASTER OF ARTS
(ECONOMICS)

ASSIGNMENTS 2019-20
First Year Courses
(For July 2019 and January 2020 Sessions)

School of Social Sciences

Indira Gandhi National Open University
Maidan Garhi, New Delhi-110 068
 Master of Arts (Economics)
(TMA)

(2019-20)

Dear Student,

As explained in the programme guide for MEC, assignments carry 30 per cent weightage
in a course and it is mandatory that you have to secure at least 40 per cent marks in
assignments to complete a course successfully. Note that you have to submit the
assignments before appearing in Term End Examination of a course.

Before attempting the assignments please read the instructions provided in the
programme guide sent to you separately. In this booklet we have included the
assignments for all the courses pertaining to the second year. In each course there is a
Tutor Marked Assignment (TMA). You have to do the assignment for those courses for
which you have registered. Do remember that you have to prepare and submit the
assignments separately for each course. Make sure that you submit the assignments well
in time for those courses in which you plan to appear in the Term End Examination.

Submission

For July 2019 session, you need to submit the assignments by March 31, 2020, and for
January 2020 session by September 30, 2020 for being eligible to appear in the term-
end examination. Assignments should be submitted to the Coordinator of your Study
Centre. Obtain a receipt from the Study Centre towards submission.

2
 MEC-002: MACROECONOMIC ANALYSIS
Assignment (TMA)

Course Code: MEC-002

Assignment Code: MEC-002/AST/2019-20
Maximum Marks: 100

Note: Answer all the questions. While questions in Section A carry 20 marks each, those in
Section B carry 12 marks each.

Section A

1. Bring out the salient features of the Solow Model. In what respects the golden rule is
different from the steady state growth rate? (Your answer should include the
assumptions, important equations, appropriate diagrams and its interpretation).

2. Consider the overlapping generations model where each member lives for two time
periods ‘t’ and (t+1). Assume that individuals work in time period ‘t’ and earn wage
income, while they do not work in time period (t+1) and survive on interest income.
Explain the impact of an increase in interest rate on consumption during time period ‘t’.

Section B

3. Interpret the IS and the LM curves. What policy implications do they have?

3. Bring out the reasons for rigidity in price and wage rate. What implications do they have?

4. Explain in brief, the decentralized household problem in the Ramsey model.

5. Critically evaluate the endogenous growth theory.

6. What is meant by business cycle? How does the political business cycle model explain it?

7. Write short notes on the following.

a) Ineffectiveness of fiscal policy under flexible exchange rate

b) Lucas Critique

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M.E.C.-2
Macroeconomic Analysis
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 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 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 and solution. Student should must read and refer the official study material provided by the university.

Note : Answer all the questions. While questions in Section A carry 20 marks each, those in Section B
carry 12 marks each.
Section-A
Q. 1. Bring out the salient features of the Solow Model. In what respects the golden rule is different from
the steady state growth rate? (Your answer should include the assumptions, important equations, appropri-
ate diagrams and its interpretation).
Ans. The Solow model is based on following assumptions:
1. The economy produces one composite good which can either be consumed or accumulated as a stock of
capital. No denial to the fact that many goods are produced in the economy but only for simplicity sake, it has been
assumed that one composite or aggregate good is produced.
2. All labour is homogeneous.
3. Constant returns to scale are assumed to prevail, i.e. any given percentage change in inputs brings forth equal
increase in output.
4. MPS is constant. And Savings = sY where s is MPS.
5. Labour force is increasing at a growth rate which is determined externally; i.e. labour growth is exogenous to
the Solow model.
6. It is a closed economy i.e. it has no trading relations with other countries.
7. It is a free market economy with no interference of the government.
8. Steady growth rate would be attained if either all variables are growing at a constant proportional rate or not
at all. But it is not necessary that all resources grow at the same rate.
9. Balanced growth is experienced when all variables are increasing at the same proportional rate. Balanced
growth demands that all variables involved in the model must increase the same constant proportion.
FEATURES OF SOLOW MODEL
In Solow model, aggregate production function has been taken on some assumptions. It is assumed that a
composite goods is produced by using a technology which is same for all firms. It further assumes that factor inputs
of labour and capital are homogeneous. Let us explain in detail how in this model demand for and supply of goods
is determined.

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Supply of Goods: Solow model determines the supply of goods on the basis of production function. The production
function has three inputs (k, l, A) and one output (Y) variables and takes the form
Y (t) = F (k(t), A (t), L (t), ...(i)
where Y refers to income or output
k is capital
L is labour
and t is technology of production. t is time.
Since ‘t’ is not entering the model directly, it implies that over time change in Y will take place only due to
change in inputs k, l and A.
It is important to note that ‘A’ which is referring to technology of production will change over time. It is further
important that labour and effectiveness of labours have been taken as multiplicatively such that AL means effective
labour. It implies that technological progress increases the productivity or efficiency of labour. It means that even if
the quantity of labour remains unchanged, technological progress increases efficiency of labours thereby quntity of
effective labour (AL).
The production function given in eqn. (i) is representing constant returns to scale constant returns to scale are
said to exist when inputs and output change in the same proportion i.e. double the inputs, output will get doubled.
F (a k, aAL) = a F (k, AL) ...(ii)
We can use this assunption to convert the production function given in eqn. – (i) to per-effective labour terms. If
1
a = (i) , eqn. (i) can be written as
AL

k 1
F .| f (k , AL) ...(iii)
AL AL
Such a production function is called production function of intensive form. It helps us to analyse all variables in
the economy relative to the size of effective labour force.
k
Therefore, is capital per effective labour unit. Moreover,,
AL

k Y
F
AL AL

Y
and is output per effective labour unit.
AL

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In the figure above we have taken K/Al i.e. capital per unit of effective labour or x-axis, and Y/AL i.e. output per
unit of effective labour on y-axis.
It is clear from the diagram that if both labour and capital are increased in the same proportion. Constant returns
to scale prevail but if only capital is increased keeping AL constant, we shall get diminishing returns to capital.
The marginal productivity of capital is determined by the slope of production function. MPK is equal to extra
k
output per effective labour produced when is increased by 1 unit
AL
Symbolically,
MPK = f (k + 1) – f (k). ...(iv)
The intensive form of production function given in eqn. (iii) is assumed to satisfy following conditions:
1. at k = 0, f (k) = f (0) = 0
(b) When f' (k) > 0, MPK is positive
(c) When f" (k) < 0, MPK declines.
2. It also satisfies ‘Inada conditions’
(a) lim
k 0 f '(k ) which means that when capital stock is too small the MPK is very large.
(b) lim
k f '( k ) 0 which means that MPK is very small when capital stock is too large.
Demand for Goods: In a solow model, it is assumed that goods are demanded for consumption and investment
purposes.
Therefore,
Y=C+I ...(v)
Y C I
On dividing eqn. (vi) by AL, we get y c i ...(vi)
AL AL Al
For simplification, we have assumed the economy to be a two-sector economy.
Each year people save some proportion of their income (1 – b), then, (1 – b) is the saving rate and it lies between
0 and 1.
Saving per effective labour = (1 – b) y
\ C = (b) y
y = by + i ...(vii)
y – by = i
(1 – b)y = i ...(viii)
The relationship between output and saving is shown with the help of following diagram:

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THE GOLDEN RULE

In this section, we shall consider the effect of change in saving rate on steady state. Let us assume that saving
rate increases while the n, g and d remain to be same. As we know that i = sf(k), there will be higher investment
which will lead to capital accumulation and output growth and the economy will finally reach to a new steady state
with higher capital and output. When rate of savings increase from s1 to s2 then the investment curve also increases
from s1 f(k) to s2f(k). Therefore the economy reaches at new steady state k*2 through the process of capital accumulation
and output growth.
From the above explanation, one may jump to a hurried conclusion that a higher saving is always desirable as
higher savings will lead to higher capital accumulation and thereby increased output in the economy. You may also
misinterpret that the 100% saving rate will lead to highest possible capital accumulation and output in the economy,
but it is not true. At different levels of s, there are different levels of capital accumulation but there is one optimum
level of capital accumulation which is called golden rule level of capital.

At the golden rule level of capital the level of saving is such that consumption per effective labour is maximum
at the steady state. The reason is that individuals are concerned with the amount of output they consume. T = for
them capital stock or total output of the economy is not of much significance. Therefore, that level of saving rate
which maximizes the consumption per effective labour is the most desirable and the optimum. It is known as Golden
rule level of saving rate. we can say that in a two sector economy national income is the sum total of consumption
and investment assuming that saving and investment are equal to each other. Therefore, steady state consumption
can be found by deducting investment from income.
c* = y* – i*
and we know y is a function of capital and i is a function of n, g and d, therefore we can rewrite above equation as:
c* = f (k*) – (n + g + d) k* ...(xiv)
It is interesting to see that this increase in steady state capital has a contrasting effect on steady state consumption.
Increase in steady state capital leads to more output which means increase in consumption and also a higher break-
even investment equal to (n + g + d) k*.
It is shown with the help of following diagram. In the diagram steady state consumption is the difference between
the steady state output and steady state break-even investment. It is maximum at k*gold level of capital per effective
labour. It has been explained in the beginning of this chapter that the slope of the production function is the marginal
product of capital i.e. MPK. It is also clear from the diagram that c*gold level of consumption is the golden rule level
of consumption and at this level of consumption the slope of production function equals the slope of break-even
investment, i.e.

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Marginal productivity of capital, MPK = ((n + g + d)

MPK – d = (n + g) ...(xv)

This golden rule level of steady state is not achieved automatically. It requires a particular rate of saving subscript
as shown in the diagram given below.
In order to attain golden rule steady state of capital k*subscript, a saving rate of subscript is required in such a
way that maximizes c*subscript. If s > subscript then there is dynamic inefficiency in the economy. If we decrease s
to subscript it will lead to increase in consumption. If s < sgold then a rise n saving will decrease consumption in the
short run but lead to a higher consumption in the long-run in the economy.

THE STEADY STATE

According to Solow model, an economy is in equilibrium when investment per unit of effective labour s equal to
savings per unit of effective labour.
I = sY
Where I is investment, s is MPS and Y is income.
Since Y is a function of capital, we can say that
I = sf(k)
Where, k is existing capital stock of an economy.
It implies that
Dk = sf(k)
Where Dk is change in K i.e. existing capital stock of the economy.
This equilibrium condition is true for an economy where,
(a) Depreciation is zero;
(b) Population is constant;
(c) Technology is given and constant.

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Now let us see what happens when we relax these unrealistic assumptions.
The Growth of Capital and Steady State: In Solow model, it is assumed that capital depreciates at a fixed rate.
Let us denote it by d. Therefore, every year dk amount of capital is depreciated.
Investment and depreciation act in opposite directions and the growth in capital stock is net of the two quantities.

k (t) = i (t) d k (t))

Since i = sf (k (t))

k (t) = sf (k (t)) – d k (t)) ...(xi)

From eqn. (xi), we can conclude that
(a) Capital stock increases when df (k (t)) > d k (t)
(b) Captial stock falls when df (k (t)) < d k (t)
(c) And capital stock remains constant when
d k (k (t)) = d k (t)
We can show it with the help of following diagrams:

Population Growth and Steady State: In this section we shall elaborate on the changes in population and
labour force at a constant rate n. When there is a growth of labour force, we need to increase capital; to maintain
same level of k. It is essential that the economy has adequate investment to take care of depreciation (d k) and
population growth (nk). If we introduce n in the equation (xi) above, it will be equal to
k (t) = sf (k(t) – (n + D) k (t) ...(xii)
If we want to maintain steady growth rate we need to cover depreciation which is equal to (dk) and to provide
new workers with capital equal to (nk). In this case, break-even investment will become equal to (d + n) k. The

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economy will attain steady growth rate at a point where investment curve intersects (d + n) k curve. It is shown with
the help of following diagram:

If k1 < k*, this means investment is greater than break-even investment and it will cause capital and output to
rise.
If k2 > k*, then k will decline until it becomes equal to k*.
Population growth gives us an explanation for steady economic growth rate. It is however, assumed that output
per effective labour remains constant. It is also seen that at steady growth rate k and y remain constant. But capital
stock (K) and output (Y) keep increasing at the rate of n so as to keep k and y constant. This feature explains the
cross-country disparities in income. If country one is experiencing population growth @ n1 and country two is
experiencing population growth at n2 such that n1 > n2 and if the saving rates are same in both the countries then (d
+ n2) k with a slope greater than (d + n1) k has been drawn.
A country with higher rate of population growth rate n2 has lower k* (the steady level of capital) and hence lower
y i.e. output per effective labour. And the country with lower rate of population n1 has a higher k* (the steady level of
capital) and hence higher y i.e. output per effective labour.
Technological Progress and Steady State: By introducing technological progress, we can explain growth n
output per effective labour in Solow model. It is assumed that technological growth is labour augmenting i.e. it
increases productivity per efficiency of labour. Therefore, with the technological progress, there will be an increase
in the quantity of effective labour (AL). If we assume that the rate of technological improvement is g then the change
in k over time can be written as:
· k (t) = sf (k(t) – (n + g + d) k (t) ...(xiii)

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Actually eqn. (xiii) is the key equation of the Solow model. We have explained this equation with the help of a
diagram. It is clear from the equation (xiii) that the analysis of steady state remains unaffected with the inclusion of
technological progress but the new break-even investment becomes equal to (n + g + d) k (t). Out of total investment,
dk will be used for recovery of depreciation, and nk amount of capital will be required to maintain capital per
effective labour at a constant rate. But with the result of technological improvement y increases at the rate of g.
Individually, n, d, and g may be positive or negative but their sum total is assume to be positive in the model. Total
output will grow at the rate of (n + g). Therefore, we can conclude that introduction of technological progress leads
to an increase in output per worker.
Solow model claims that persistent rise in standard of living always owe to technological progress.
Q. 2. Consider the overlapping generations model where each member lives for two time periods ‘t’ and
(t+1). Assume that individuals work in time period ‘t’ and earn wage income, while they do not work in time
period (t+1) and survive on interest income. Explain the impact of an increase in interest rate on consumption
during time period ‘t’.
Ans. Overlapping generations’ model is another important framework that considers households’ inter-temporal
consumption decision-making over a finite time horizon. It was first developed by Samuelson in 1954 and since then
it has been widely used in macro dynamics.
In this model, individuals have a finite time horizon and the society is assumed to live forever. The term
“overlapping generations” means that at any given point of time, the life time of two generations overlap. Suppose
an individual is born in time period t. he will be alive for two time periods t and t+1. In time period t, he will be young
and in time period t+1, he will grow old. Now new individuals will get born in time period t+1 who will be young
in t+1 and grow old in t+2. Therefore, during the time period t+1, the two generations will overlap. In this chapter we
shall elaborate a standard case of a two period time horizon.
STRUCTURE OF THE MODEL
The generation which is born at the time period t, will be called generation t. if we look at the activities of a
representative member of generation t, then each person is born with an endowment of one unit of labour. Each
individual works in his initial life when he is young and earns an income. He consumes a part of this income and also
saves apart because which he can utilize for consumption in the next period when he is old. He earns an interest
income on his previous savings which he did out of income that he earned when he was young. He also gets back the
principal amount that he had invested and accordingly the budget constraints for the two periods are given by:
(i) c1t + st = wt;
(ii) c2t = (1+rt+1) st
The representative member aims at maximizing his two period utility function subject to these two budget
constraints. From equation (ii) we can say that st = c2 / (1+rt+1). We can use this value of st to eliminate st from the
two equations. It will give us a single equation which will represent the life-time budget constraint of the agent as
equal to
c1t + c2t/ (1+rt+1) = wt
Maximizing U(c1t, c2t) subject to the life-time budget constraint gives us two first order conditions which are as
follows:
U1 / U2 = (1+rt+1);
c1t + c2t / (1+rt+1) = wt
Since st = c2t / (1+rt+1) therefore, the optimum value of st also becomes a function of c2t and wt.

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Let us assume that all the members of all generations are identical in terms of their tastes and preferences, i.e.
they have similar utility functions.
It has been clarified earlier that in each period there are two generations which are simultaneously alive. Therefore,
at any period t, there are people who belong to t–1 period’s generation. These are currently old people. There are
other set of people who belong to generation t who are currently young. The generation t people are the workers in
period t, each of whom can earn a wage income of wt of which he consumes c1t and and saves st. therefore Ltc 1t = L
(wt–st). on the basis of all this information, we can write the saving-investment equality condition as:
Kt + rt Kt + Lt (wt–st) + K t+1 –Kt = wt Lt +rt K t
It implies that Kt+1/L t+1 = L ts(k t, k t+1)/L t+1 = Lts (w(kt), r(kt+1)/(1+n)L t
K t+1 = st (w(k t), r(k t+1)/(1+n)
It is the basic dynamic equation of this overlapping generation’s model which specifies the relationship between
capital-labour ratio of the present and the capital labour ratio of tomorrow. It tells us how the capital-labour ratio of
the economy changes over time. It is easy to see that this equation is a first order non-linear difference equation in k,
to characterize the solution path we can show it with the help of a diagram. In the diagram K t+1 is shown on the y-axis
and Kt is shown on the x-axis. The intersection of K t+1 with the 45° line shows the steady state. The slope of this line
will be given by the differentiation of Kt+1 with respect to Kt. If we differentiate the equation Kt+1 = st (w(kt), r(kt+1)/
(1+n), with respect to Kt we get
dkt+1 = sw .dwt / dkt.dkt + sr drt+1 /dkt+1 dk t+1 (1+n)
Let us assume that the population in successive generations grows at a constant rate. Let us suppose that L t
denotes the number of people in the present generation and Lt–1 denotes the number of people in the past generation.
Therefore the total population in time period t will be equal to Lt + L t-1.
Under an assumption that consumption in both the periods are of normal goods that is the consumption of the
goods increase with increase in wage rate in both the time periods. Since an increase in rate of interest means that the
relative price of future consumption in terms of present consumption falls which means that with unchanged wage
rate, saving would increase as the current consumption will decrease due to substitution effect. However, a fall in
relative price would also mean that there will be a positive effect on current consumption. Therefore whether with
the increase in rate of interest, current consumption increases or not would depend on the relative strength of income
and substitution effects. If income effect dominates the substitution effect, then consumption in time period t would
increase and therefore sr < 0. On the other hand if substitution effect dominates the income effect, then consumption
in time period t would decrease and therefore sr>0. If we assume that substitution effect dominates the income
effect, then different possibilities are indicated in the figure given below:

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Local stability of a steady state would depend on the fact whether K t+1 is intersecting the 45° line from above or
below. When it intersects the 45° line from above, it is a locally stable equilibrium while when it intersects the 45°
line from below it is a locally unstable equilibrium.
Section B
Q. 3. Interpret the IS and the LM curves. What policy implications do they have?
Ans. Equilibrium in Real Sector–is Curve–An economy is in equilibrium when aggregate demand is just
equal to aggregate supply. In a two sector economy, AD comprises of consumption and investment. While aggregate
supply comprises of consumption and savings. Therefore, at equilibrium level of output, savings is equal invest-
ment. If for simplicity sake, we take investment as autonomous and therefore, a horizontal line parallel to income
axis, then economy is in equilibrium at point E as shown in the diagram. On the right side of point E, unplanned
investment will be positive and on the left hand side, unplanned investment is negative:

Investment is an inverse function of rate of interest and saving is a positive function of income. Both savings and
investment can be integrated to get equilibrium level of income and interest rate. The IS curve shows the equilibrium
in the real sector of the economy. Let us see how IS curve is derived.
In order to understand how IS curve is derived, let us first understand what are we taking on y-axis and x-axis. In
first quadrant, we have taken rate of interest on y-axis and income on x-axis. In second quadrant, we have taken rate
of interest on y-axis and investment on x-axis. In third quadrant, we have taken saving on y-axis and investment on
x-axis. In fourth quadrant, we have taken savings on y-axis and income on x-axis.
Second quadrant is showing that there is an inverse relationship between investment and rate of interest. More is
the rate of interest; less is the level of investment and vice-versa, other things being constant. In the third quadrant,
we have shown a 45° line to exhibit that on this line at all levels saving is equal to investment. In the fourth quadrant
positive relation between savings and investment has been shown. It is showing the different levels of savings at
different levels of income. Hence, by implication that saving is directly related to income and investment is inversely
related to rate of interest and saving is equal to investment at equilibrium level, it is clear that there is an inverse
relation between rate of interest and income. It is shown by IS curve in I quadrant which is the locus of equilibrium
levels of income. In other words, every point on IS curve represents equilibrium level of income and interest rates.
When there is change in the level of investment, there will be a chain of reactions.
Change in investment ® required level of savings will change ® Equilibrium level of income will change
It is implied in IS curve that real sector can be in equilibrium in any combination of lower rate of interest and
higher income or higher rate of interest and lower income.

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EQUILIBRIUM IN MONETARY SECTOR – LM CURVE

LM curve is based on the concept of transaction demand for money and speculative demand for money. According
to Keynes, transaction demand for money is a positive function of income i.e. at higher level of income the transaction
demand for money is more and vice-versa. Speculative demand for money is an inverse function of rate of interest.
At higher rate of interest, the speculative demand for money is less and vice-versa because rate of interest is the
opportunity cost of holding money in the form of cash.
The derivation of LM curve is shown with the help of diagram given below. In this diagram, in first quadrant, we
have taken rate of interest on y-axis and income on x-axis. In second quadrant, we have taken rate of interest on y-
axis and speculative demand for money on x-axis. In third quadrant, we have taken transaction demand for money on
y-axis and speculative demand for money on x-axis. In fourth quadrant, we have taken transaction demand for
money on y-axis and income on x-axis.

In order to explain how LM curve is derived, let us start with second quadrant. Second quadrant is showing the
inverse relationship between rate of interest and speculative demand for money. Third quadrant is showing that
money market is in equilibrium when demand for money (which is sum total of transaction demand for money and
speculative demand for money) is equal to supply of money. Since total demand for money is equal to sum total of

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transaction demand for money and speculative demand for money, equilibrium in money market can be shown by a
straight line which touches y-axis at a point where money supply is equal to transaction demand for money i.e.
speculative demand for money is zero. And it touches x-axis at a point where Money supply is equal to speculative
demand for money i.e. transaction demand for money is zero. It has been explained earlier in this chapter that
transaction demand for money is a constant proportion of income. Therefore, more is the level of income; more will
be the level of transaction demand for money and vice-versa. It is shown in the fourth quadrant of the diagram. On
the basis of second, third and fourth quadrant, LM curve is shown in I quadrant where LM curve is shown as an
upward sloping curve. Each point on LM curve represents equilibrium in money market. Money market is in
equilibrium with lower income and lower rate of interest and higher income with higher rate of interest.
The government can make use of fiscal and monetary policies to bring about changes in IS and LM curves and
thereby changes in the level of income and rate of interest at equilibrium level. In fact, the difference between
classical and Keynesian position can be explained with the help of IS-LM curves,
It is shown with the help of diagram given below that when economy is operating at income level Y1, here LM
curve is perfectly elastic and hence economy is in liquidity trap. In this situation, monetary policy becomes ineffective.
If the government increases expenditures, it will not affect interest rates as there are enough idle cash balances in the
economy. Therefore, in such situations monetary policy becomes ineffective and hence, it is advisable to use fiscal
policy to bring about desirable changes.
If the economy is operating at a very high income like Y3, then LM is perfectly inelastic i.e. rate of interest is too
high and real balances in the economy are very low. When government increases its expenditure by borrowing from
the market, it competes with the private investment and therefore, r-Y does not change. This is known as classical
range.
But usually an economy operates at a moderate level of income where these policies work effectively.

Q. 4. Bring out the reasons for rigidity in price and wage rate. What implications do they have?
Ans. Nominal rigidities are said to exist when prices and wages do not change in spite of change in macro
economic conditions in the economy. It leads to Keynesian kind of unemployment. But it is important to note that
unemployment may emerge as a result of real rigidities also. Such rigidities can exist in commodity market, labour
market or money market.
It is possible that real wage rate in the economy is greater than market-clearing wage rate. It is known as real
rigidities. It will certainly lead to unemployment of some of those who are ready to work at market clearing wage
rate which is less than real wage rate. The point here is not that firms are not changing nominal wages when it needs
to change but the fact that firms do not decide to pay higher wages to their workforce rationally and voluntarily as
they find it advantageous in some way. It will be elaborated further.

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The New Keynesian model stresses on both kinds of rigidities for explaining the causes of boom and depression
in the real world.
NOMINAL RIGIDITIES AND MENU COSTS
A simplified New Keynesian model has been presented to understand the reasons for the profit maximizing
rational firms being unwilling to change prices when macroeconomic policies are calling for such a change. For
example, when there is an increase in money supply, firms know that there would be an increase in prices subsequently
but still their prices are rigid.
These models came into picture due to the work of economists like N. Gregory Mankiw who wrote a paper titled
“Small Menu Costs and Large Business Cycles: A Macro Economic Model of Monopoly”, published in Journal of
Economics in 1985 and George A. Akerlof and Janet L. Yellen in a paper titled “A Near Rational Model of Business
Cycle, With Wage and Price Inertia” published in quarterly Journal of Economics in 1985. These papers used the
analytical tools of New Classical model to reach at Keynesian conclusions. As the title suggest, before we understand
Mankiw model of nominal rigidities, it is important to understand menu costs.
Menu Costs: Firms do not change their prices frequently because the cost of changing prices at such small
intervals are to be compared with the marginal benefit that will be obtained from such a change. Certainly latter has
to be greater than former, only then it is profitable for the firm. Firms preferably change prices only after some time
in relatively large amounts and in the mean time; they keep on bearing losses that they suffer by keeping the prices
rigid. It is implicit in this that it is assumed that firms have some control over the prices of their products or they have
some monopoly power in price determination. When he talked of losses, he also meant the loss of profits which the
firm could make if it would have increased the price and not only out of pocket losses.
Menu cost can be understood with the help of an example of restaurants competing with each other. The prices
of grocery items and vegetables change very frequently. If with every increase in the prices of inputs, the firms
decide to change their prices, they will have to get new menu cards printed which may be a negligible cost but there
is also a cost of negative effect on the psychology of the customers who get irritated by so frequent changes. Therefore,
the restaurants would preferably continue to absorb losses for short time and change prices only after an interval.
Another example can be taken of automatic dispensers like coffee machines or telephones operating on coins.
Certainly, with these machines, the cost of adjusting every small change in price would involve a high cost. The
firms would prefer not to change their prices to bear the cost. It is so because the cost of changing prices is more than
the benefit expected from it. Mankiw model explains this idea of weighing the costs of changing prices against the
benefits obtained from such a change.
Mankiw Model of Nominal Rigidities: There are two reasons due to which firms do not change their prices
frequently.
(a) The cost of changing prices at such small intervals are to be compared with the marginal benefit that will be
obtained from such a change. If the former is more than the latter, it is better not to change prices.
(b) The benefits to be reckoned from changing the prices are not so much in the private realm as in the social
realm. Price rigidity causes unemployment. It implies that social cost of price rigidity is much higher than
private costs reckoned by the firms in terms of menu costs. These models have shown that private benefits
of changing a price can be far less than social benefits if there is substantial monopoly power in the economy.
Dornbusch, Fischer and Startz model of 2004 has been used to present a simplified version of the Mankiw
Model. It is assumed in the model that firms have some monopoly power in the market and therefore, the demand
curve is downward sloping and firm can set a price which is not profit optimizing price. It is impossible in perfectly

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competitive market in which a small deviation from the optimizing price will lead to fall in demand to zero and
therefore, even if a perfectly competitive firm has equal menu cost as imperfectly competitive, the loss of profits by
not changing the prices be big enough to outweigh the menu costs. A competitive firm is not a price- maker.
But in case of a imperfectly competitive firm, Mankiw showed that the profits that the firm expects to get from
increased prices could be much less especially when elasticity of demand for the product of the firm is less than unity
i.e. the monopoly power of the firm is more and if the deviation of the actual price from the profit optimizing price
is small. In this case, the menu cost of increasing price could be higher than the potential profits and therefore, being
rational, the firm does not change its price. Same applies to all firm sin the industry and therefore, nominal price
level remains unchanged.
It can be used to explain the Keynesian conclusion of an increase in money supply on output rather than on
prices is based on it. Prices remaining same, an increase in money supply leads to increase in real money supply
which in turn increases real aggregate output either through a decrease in rate of interest or through a real balanced
effect. In classical model, there would have been no effect on output if prices were flexible. Therefore, it established
a major difference between classical and Keynesian models.
Q. 5. Explain in brief, the decentralized household problem in the Ramsey model.
Ans. The Household in the Ramsey Model
Assumptions:
One infinitely-lived household the maximizes intertemporal utility.
The household receives wage income in exchanges for its labour services and interest income for its
accumulated assets.
Population growth rate is constant (equal to n) and at time t = 0 there is only one individual in the economy
(i.e. L0 = 1), so that total population any time t is given by Lt = ent
Budget constraint (The change in assets the sum of labour and interest income less consumption):
g
B = wt Lt + r1 Bt – Ct
Bt : assets
wt : wages rate and
rt : interest rate
g
In per capita terms: b = wt + rtbt – nbt – ct where
Bt Ct
bt = ct .
Lt Lt
One important constraint: Households cannot borrow unlimited amounts to finance arbitrarily high levels of
consumption.
Þ The persent value of current and future assets must be asymptotically non-negative.
Û households cannot borrow infinitely until the end of their economic life-cycle
Û the households’ debt cannot increase at a rate asymptotically than the interest rate
t
– ( rs – n ) ds
lim bt e 0 ³0
t

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Effect of a Permanent Change in Government Purchases:

Effect of a Permanent Change in Government Purchases:

Types of variables: Consumption is a ‘jump’ variable (i.e. it is allowed to take any value), whereas capital is a
‘state’ or ‘predetermined’ variable (i.e.) its current state is determined by the past level).
Type of equilibrium: For any capital stock level, there is a unique consumption level that drives the economy
to equilibrium (Saddle Data)
Q. 6. Critically evaluate the endogenous growth theory.
Ans. Endogenous growth theory began with the efforts of Paul Romer in 186 and Robert Lucas in 1988. Endog-
enous growth models originated in two sources: one, to give a coherent explanation of convergence controversy, and
the other, to go beyond an unrealistic simple world of perfect competition and constant returns to scale in growth
models. Their work differs from Neo Classical economists who took economic growth is caused by factors that are
exogenous. The endogenous growth theory is an extension of Solow Model in the sense that the latter introduced
increasing and diminishing returns to the theories of economic growth but the latter also included technical change
as an endogenous variable i.e. a variable which is being measured internally, in growth models.
The Endogenous Growth Theory gives a great emphasis on accumulation of human capital even more than
physical capital. They laid a great stress on knowledge capital. Secondly, since knowledge capital can be acquired
by transfer of technology, developing nations would do well if they open up their economies for developed economies.
It would increase the sharing of technology. Thirdly, the theory also recognizes the role of policies and government
in promoting the rate of knowledge capital and thereby human capital formation. Government need to formulate
favourable policies to promote the rate of human capital formation. And most importantly, the Theory also suggests
that automatic convergence in the growth rate does not occur and therefore, a planned effort is required. Rather it

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explained logically that in spite of same saving rate, population we can see different countries growing at different
rates due to difference in their level of human capital. And hence, government needs to formulate favourable policies
to promote the rate of human capital formation. It is a way to break vicious circle of poverty.
Endogenous theory is called new growth theory because it came into picture later than exogenous growth theory.
Endogenous theory is modern as it explains technology as an endogenous variable. Exogenous theory was outdated
with the introduction of endogenous growth models. The idea of the fact that technology is and must be incorporated
as an endogenous variable in growth models was also recognized by the economists like Marx and Schumpeter.
Exogenous theories claimed that economies converge towards equal growth rates but endogenous theory expanded
the notion of capital to include human capital ad claimed that different countries diverge from each other depending
upon the level of human capital formation.
CRITICAL ASSESSMENT OF THE NEW GROWTH THEORY
The new growth theory has been criticized on the following grounds:
(a) It is just an expansion of Neo-classical theory. It is based on some of the traditional neo-classical theory that
is inappropriate for developing countries. Therefore, all the limitations of those theories are automatically incorporated
into this theory.
(b) The New growth theory does not consider the factors that lead to inefficiencies in the economy like poor
infrastructure, inadequate institutional structures, and imperfection in capital as well as commodity markets and so
on.
Q. 7. What is meant by business cycle? How does the political business cycle model explain it?
Ans. when we are referring to business cycle, we mean the irregular periodic movement brought about by a first-
order difference of differential equation.
There are three important moments in the evolution of thought on business cycles associated with landmarks in
the subject:
(a) Seminal contribution of Richard Goodwin who explained the tools and techniques of dynamic economic
analysis. He is the first economist who presented modern work in complex economic dynamics. He presented
his models in absolute real terms.
(b) The work of Michal Kalecki was developed in the framework of monopoly capitalism of his time. Kalecki
who is an economist, Mathematician, Statistician is amongst the founding fathers of modern macro economics.
(c) The work of Hyman Minsky totally removed the veil of money together. He claimed that a capitalist economy
is a financially layered entity prone to fluctuations in connected financial and real activities.
However, there is a long list of economists who have contributed to the subject in their own ways.
The Political Business Cycle: Kalecki explained that in a parliamentary democratic form of government, the
government is sensitive to the electoral process. The elections are the outcomes of the voters who are either businessmen
or working class or other group interest. Kalecki has tried to answer of whose interests the government considers in
making policy choices.
A government spending programme could either lead to full employment level of equilibrium or wage control
etc. But it may be averse by the business class. It is not always so because increase in employment level will also
increase profits of the businessmen. Moreover, the threat of strengthening of workers’ voice and inflationary pressure
is over powering. However, the working class will be happy with these policies. But in a capitalist economy,
generally speaking, the business class has an influence over the government policies if the government settles itself
as an employer of last resort, then it need bother for the pessimism or optimism of the investor. Therefore, capitalist
class considers budget deficits negatively but there is no complaint against policies which increase their profits like
protectionist’ tariffs, trade union activities etc. Short lived and moderate cycles will emerge when government would

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stimulate the economy in case it observes a downfall in the economy and re-enter when the rate of unemployment
increases to a very high level. Therefore, the economy will dwindle between combating employment and inflation.
Suppose a party which was in opposition earlier has been elected. It promised to reduce inflation. Therefore, it
introduces deflationary package of policies. But it leads to increase in unemployment. With a fear of losing election
in the next turn, it reverses the policy. It results in overacting too late or doing too little earlier.
Initially, the government intervene those areas that are not entrusted to private sector like economic and social
infrastructure. Businessmen will also not protest to it because it will not affect returns on their investments. But the
capitalist class may face a fear that the government might nationalize certain fields in which so far they had been
enjoying monopoly like transportation. Similarly, businessmen do not mind if the government supports to weaker
section through subsidies, family allowances, social security benefits etc. it will not affect private enterprises. However,
a regime of permanent full employment would be resisted because profits will increase. But the capitalists are ready
to sacrifice profits but they do not want a transfer of power in favour of working class. A purposeful stance towards
full employment might entail a redistribution of income. In such a case, income policies will be energetically opposed
by the capitalist class.
Kalecki rejected the idea that an economy can be brought out of recession through optimism. It is possible to
blunt the situation and amplitude of the cycle through pro-cyclical interest rate policies but even in boom the full
employment will not be attained only the level of employment will fluctuate less. If such measures are repeated
period after period, then a situation will emerge in which the rate of interest is negative and corporate income tax
gets transformed into a subsidy. The capitalist class would not resist public investment financed through borrowing
but they would resist is output generation by subsidizing consumption and a regime of full employment.
Q. 8. Write short notes on the following.
(a) Ineffectiveness of fiscal policy under flexible exchange rate
Ans. If instead of monetary policy, the government makes use of fiscal policy to address the cyclical fluctua-
tions, then the process of adjustment will be as follows:
If the government is using expansionary fiscal policy, there will be a shift in IS curve from IS to IS 1. With this
shift in IS curve, there will be an increase in domestic rate of interest which will increase capital inflow in the
domestic economy. It will improve balances on capital account. It will improve BOP condition and BOP surplus will
appreciate the domestic currency. With the appreciation of currency, the net exports will fall. It will lead to shift in
IS curve from IS1 to IS. Therefore, fiscal policy is ineffective when a country is following flexible exchange rate. it
is shown with the help of a diagram given below:

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(b) Lucas Critique

Ans. In many cases, we rely on any macroeconomic model on the basis of past data. Such models, however,
implicitly assume that the past trend is expected to continue in future also. When the economy is in transition stage,
then estimates of macro-econometric models may not give accurate results. Robert Lucas pointed out the limitations
of traditional macro-economic models as their inadequacy for policy evaluation.
Robert Lucas pointed out some limitations of deterministic models.
The most important one is that a deterministic model is generally used to isolate the most important determining
factors for the variables of interest, like Y in the above example. Second, these models are used to represent the
relationships between the variable sin the model in a simple and clear manner. These models are over simplified
versions of reality and do ignore many factors that can affect the variables of interest.
An important implication of his critique is that any macro-economic policy should not be evaluated as one time
change in the value of policy variables but as part of policy rules which also explains how future policy would be
determined.

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