1.

GDP deflator/CPI ***

a. Math
b. Discuss the problems of measuring CPI.
c. What are the differences between GDP deflator and CPI?
2. How does government policies offering savings incentives affect the market of
loanable funds? Explain with graph.***
Policy 1- Saving Incentives (3)
Now, we know that the government in order to earn revenue, imposes tax on
income, including interest and dividend income. A tax imposed on interest income
reduces the future pay off from current savings which reduces the incentive of
people to save. This is why economists often suggest tax codes that encourage
savings. Government for example, can shelter some of the savings of people from
taxation. Let us see the effect of the saving incentive on the market of loanable
funds.
Firstly, as the tax change affects the incentive of household to save at an given
interest rate, it will affect the supply of loanable funds at each interest rate.
(Sheet graph)
Supply of loanable funds will shift and demand will remain unchanged as it does not
directly affect the amount a borrower wants to borrow at a given interest rate.
Secondly, as saving will be taxed less heavily, households will raise its savings. This
increased supply of loanable funds will shift the supply curve to right.
Finally, the increased supply of loanable funds will reduce the interest rate. This
reduced rate will raise the demand of loanable funds. With a lower interest rate, cost
of borrowing falls, which encourages borrowing, investment rises. So a reform of tax
laws that encourage greater saving, reduces interest rate and increases investment.

3. How does government policies offering investment incentives affect the market of
loanable funds? Explain with graph.***
Policy 2- Investment Incentives(4)
Suppose in order to make investment more attractive, government offers
investment tax credit, which gives a tax advantage to any firm building anew firm or
buying anew equipment. What will be the effect of such policy?
Firstly, this policy will reward the firms that borrow and invests in new capital, the
investment level will be altered at any given interest rate, and the demand for
loanable funds will change. As it does not affect the savings of households, supply of
loanable funds remain unchanged.
 Secondly, as the policy offers incentives to raise investment at given interest rate,
demand of loanable fund rises at the given interest rtae and the demand curve shifts
to the right.

4. Define structural unemployment. Discuss how “Minimum Wage Law” gives rise to
structural unemployment. ***
5. Discuss how “Unions and collective bargaining” results in structural unemployment.
Are unions good or bad for the economy? ***

6. Define efficiency wage. Discuss prominent efficiency wage theories explaining why
firms want to pay high wages.***
The Theory of Efficiency Wages(9,10,11)
The fourth reason why there always exists some unemployment, can be explained
using the theory of efficiency wage.
What is efficiency wage?
An above-equilibrium wage paid by firms to increase the productivity of workers.
According to this theory, firms operate more efficiently if wages are above the
equilibrium level.
Why should firms want to keep wages high?
We know that any profit maximizing firm wants to keep its cost low. As wages are a
large part of the cost firms bear, firms are expected to keep wages as low as
possible. The novel insight of the efficiency wage theory is- paying high wages might
be profitable as it might raise the efficiency of a firm’s workers.
There are several types of efficiency wage theory each type suggesting a different
explanation for why firms want to pay high wages. We will now consider four of these types.
➢ Worker Health
There lies a link between wages and workers health. Better paid workers eat a more
nutritious diet, and thus, become healthier and more productive. A firm may find it
profitable to pay high wages and have healthy and productive workers than pay lower wage
and have less healthy, less productive workers.
This type of efficiency wage theory is more relevant for explaining unemployment in less
developed countries where inadequate nutrition is a problem. Firms fear that cutting wages
might adversely affect the workers heath and productivity. Such explanation are less
relevant in rich countries where the equilibrium wage for most workers are well above the
level needed for an adequate diet.
The Theory of Efficiency Wages
➢ Worker Turnover
There lies a link between wage and workers turnover. Workers quit jobs for many reasons-
to take job in other firms, to move to other parts of countries, to leave the labor force etc.
The frequency with which they quit depends on the incentives they face- including the
benefits of leaving and the benefits of staying. The more a firm pays, the less its workers will
choose to leave. So a firm can reduce turnover among workers by paying high wages.
Why do firms care about turnovers?
It is costly for firms to hire and train new workers. Even after they are trained, new workers
are less productive as they have lack of experience. So a higher turnover implies a higher
production cost for a firm. So firms find it profitable to pay a wage higher than equilibrium
level, to reduce turnover. The Theory of Efficiency Wages
➢ Worker Quality
There lies a link between wages and worker quality. All firms want the most talented
workers and they try to pick the best applicants to fill job openings. Now, firms cannot
perfectly gauge the quality of the applicants. If a firm offers high wage, it attracts a better
pool of applicants and thus increases the quality of the workforce. If the firm offered low
wages, the better applicants who are more likely to have better alternatives than the less
competent applicants- may choose not to apply. So it is profitable for a firm to offer a above
equilibrium wage if the effect of wage on worker quality is very strong.
The Theory of Efficiency Wages
➢ Worker Effort
Efficiency wage theory emphasizes on the link between wages and worker effort. In many
jobs, workers have some discretion over how hard to work. So firms monitors the workers
and if someone is caught shirking, they are fired. But monitoring is costly and imperfect so
not all shirkers get caught. A way to deter shirking is to pay an above equilibrium wage. High
wages make workers more eager to keep their jobs, so they have the incentive to give their
best effort. At the equilibrium wage, workers have less reason to work hard as, if they are
fired due to shirking, they might be able to find an alternative job quickly at the same wage
level. So firms offer above equilibrium wage to offer an incentive to workers to deter
shirking.
7. Define efficiency wage. Discuss how a firm can reduce workers turnover by paying an
above equilibrium efficiency wage.
8. Define efficiency wage. Discuss how a firm can ensure workers effort by paying an
above equilibrium efficiency wage.
9. Define commodity money and fiat money. ***
Commodity Money(12)
Money that takes the form of a commodity with intrinsic value. Intrinsic value means
that the item will have some value even if it were not used as money. Gold is an example
of commodity money. Although we no longer use gold as money, historically gold has
been a common form of money as it was easy to carry, measure, and verify for
impurities. Gold has some intrinsic value as it is used in industry and in making of
jewelry.
Fiat Money(12)
Money without intrinsic value that is used as money because of government decree. A
fiat is an order or a decree and fiat money is established as money by government
decree. Let’s compare you taka (printed by Bangladesh Government) and paper money
from the game monopoly. You can use taka to pay your bills, but not the monopoly cash,
as taka has been decreed by government to be valid as money.

10.Discuss how open market operations of the central bank influences the
quantity of reserves. ***
Open Market Operations:(14)
Open market operation is the purchase and sale of government bonds by the central
banks to increase the money supply in the economy. The central bank buys bonds
from the public in the nation’s bond market. The money the central bank pays for
the bonds increases the supply of money in the economy. On the other hand, to
reduces the money supply in the economy, the central bank does the opposite. It
sales government bonds to the public in the bond market. The public pays for the
bonds, directly reducing the amount of money in circulation.

11. Explain how the banking system creates money supply under X% fractional reserve
banking with an initial deposit of Tk. Y. ***
 12. Discuss the velocity and quantity equation of money. ***
]

The number of mes money changes hand. n

economics the velocity of money refers to the speed at which money travels
around the economy from wallet to wallet.
To calculate the velocity of money we divide the nominal GD by the
uan ty of money. f is the price level (the GD de ator) the uan ty of
output (real GD ) and M the uan ty of money then velocity is

To see why this makes sense imagine a simple economy that produces only
pi a. uppose that the economy produces pi as in a year that a pi a
sells for Tk. and that the uan ty of money in the economy is . Then
the velocity of money is

( ) . n this economy people spend a total of Tk. per

year on pi a. or this Tk. of spending to take place with only Tk. of
money each dollar bill must change hands on average mes per year.

With slight algebraic rearrangement this e ua on can be rewri en as

This e ua on states that the uan ty of money (M) mes the velocity of
money ( ) e uals the price of output ( ) mes the amount of output ( ). t is
called the uan ty e ua on because it relates the uan ty of money (M) to
the nominal value of output ( ). The uan ty e ua on shows that an
increase in the uan ty of money in an economy must be re ected in one of
the other three variables The price level must rise the uan ty of output
must rise or the velocity of money must fall.
 t has been observed that the velocity of money is rela vely stable. o the
assump on of constant velocity is a good appro ima on. We now have all the
elements necessary to e plain the e uilibrium price level and in a on rate.
They are as follows
. The velocity of money is rela vely stable over me.
. Because velocity is stable when the central bank changes the uan ty of
money (M) it causes propor onate changes in the nominal value of output
( ).
. The economy s output of goods and services ( ) is primarily determined by
factor supplies (labor physical capital human capital and natural resources)
and the available produc on technology. n par cular because money is
neutral money does not a ect output.

. With output ( ) determined by factor supplies and technology when the

central bank alters the money supply (M) and induces propor onal changes
in the nominal value of output ( ) these changes are re ected in
changes in the price level ( ).
. Therefore when the central bank increases the money supply rapidly the
result is a high rate of in a on. These ve steps are the essence of the
uan ty theory of money.

13. Discuss the inflation tax. ***

ncreased supply of money results in in a on. Then why do the central banks choose to
print so much money that its value is certain to fall rapidly over me
The answer is that the governments of these countries are using money crea on as a way
to pay for their spending. When the government wants to build roads pay salaries to its
soldiers or give transfer payments to the poor or elderly it rst has to raise the necessary
funds. ormally the government does this by levying ta es such as income and sales
ta es and by borrowing from the public by selling governmentbonds. et the government
can also pay for spending simply by prin ng the money it needs. When the government
raises revenue by prin ng money it is said to levy an .
The in a on ta is not e actly like other ta es however because no one receives a bill
from the government for this ta . nstead the in a on ta is subtler. When the
government prints money the price level rises and the dollars in your wallet become less
valuable. Thus the in a on ta is like a ta on everyone who holds money.
14. Discuss the Fisher effect. ***

To understand the rela onship between money in a on and interest rates

recall the dis nc on between the nominal interest rate and the real interest
rate. The nominal interest rate is the interest rate you hear about at your
bank. The real interest rate corrects the nominal interest rate for the e ect
of in a on to tell you how fast the purchasing power of your savings account
will rise over me.
.
We can rewrite this e ua on to show that the nominal interest rate is the
sum of the real interest rate and the in a on rate
.

Let s now consider how growth in the money supply a ects interest rates. n
the long run over which money is neutral a change in money growth should
not a ect the real interest rate. The real interest rate is a er all a real
variable. or the real interest rate not to be a ected the nominal interest
rate must ad ust one for one to changes in the in a on rate. Thus when the
B increases the rate of money growth the long run result is both a higher
in a on rate and a higher nominal interest rate. This ad ustment of the
nominal interest rate to the in a on rate is called the a er
( ) the economist who rst studied it.
15. Discuss the shoe leather cost of inflation. ***

Because in a on erodes the real value of the money in your wallet you can
avoid the in a on ta by holding less money. ne way to do this is to go to
the bank more o en. or e ample rather than withdrawing Tk. every
four weeks you might withdraw Tk. once a week. By making more
fre uent trips to the bank you can keep more of your wealth in your
interest bearing savings account and less in your wallet where in a on
erodes its value. The cost of reducing your money holdings is called the
of in a on because making more fre uent trips to the bank
causes your shoes to wear out more uickly. f course this term is not to be
taken literally The actual cost of reducing your money holdings is not the
wear and tear on your shoes but the me and convenience you must
sacri ce to keep less money on hand than you would if there were no
in a on.

16. Discuss the menu cost of inflation.***

irms change prices infre uently because there are costs to changing prices.
osts of price ad ustment are called a term derived from a
restaurant s cost of prin ng a new menu. Menu costs include the costs of
deciding on new prices prin ng new price lists and catalogs sending these
new price lists and catalogs to dealers and customers adver sing the new
prices and even dealing with customer annoyance over price changes. When
high in a on makes rms costs rise rapidly annual price ad ustment is
imprac cal. During hyperin a ons for e ample rms must change their
prices daily or even more o en ust to keep up with all the other prices in
the economy.

17. Discuss how unexpected inflation arbitrarily redistributes wealth.***