ALLAMA IQBAL OPEN UNIVERSITY ISLAMABAD

NAME : ARIF

STUDENT ID : 0000507172

COURSE CODE : 9335 (ECONOMICS)

SEMESTER : SPRING 2024

LEVEL : BS (ISLAMIC STUDIES)

ASSIGNMENT: NO :3
Q.1 What is Gross National Product (GNP)? Give a detailed discussion
on GNP, keeping in view its measurement and resultant benefits, the
items left uncounted, its ingredients and its role in determining
economic activities. Also differentiate between GNP and NNP.

ANSWER:

Gross National Product (GNP)

Gross National Product (GNP) is a measure of the total economic output
produced by the residents of a country, both domestically and abroad, within
a specific time, typically a year. It includes all goods and services produced
by the citizens of a country, regardless of where they are located globally.
GNP considers not only the domestic production within a country's borders
but also the income earned by its residents from investments or work abroad.

Measuring GNP involves aggregating the market value of all final goods and
services produced by nationals of a country, whether the production occurs
within the country or abroad. This includes personal consumption
expenditures, gross private domestic investment, government spending, and
net exports (exports minus imports). By capturing income earned abroad by
residents, GNP provides a comprehensive view of a country's economic
performance and the contribution of its citizens to the global economy.

Despite its comprehensive scope, GNP has limitations and leaves certain
items uncounted or undervalued. It does not account for non-market activities
such as unpaid household work or volunteer services, which can be
significant contributors to well-being but are not monetarily valued. Moreover,
it does not always accurately reflect income distribution within a country, as
it aggregates all income earned by nationals regardless of how it is distributed
among individuals.
GNP consists of several components: personal consumption expenditures
(consumer spending on goods and services), gross private domestic
investment (investment by businesses in capital goods), government
spending on goods and services, and net exports (exports minus imports).
These components collectively illustrate the major drivers of economic
activity within a country and provide insights into consumer behavior,
business investment decisions, government policies, and international trade
dynamics.

Differentiating between GNP and Net National Product (NNP), the latter
adjusts GNP by subtracting depreciation or the consumption of fixed capital.
NNP

represents the net output produced by nationals of a country after accounting

for depreciation of capital goods. It provides a more accurate measure of the
actual economic output available for consumption or future investment within
the country, reflecting the sustainability of economic growth over time.

In summary, GNP is a crucial economic indicator that measures the total

economic output produced by a country's residents, encompassing both
domestic and international activities. It serves as a key metric for assessing
a country's economic health, influencing policy decisions, and understanding
its global economic footprint. However, it is important to recognize its
limitations in fully capturing all economic activities and the distribution of
income within a society.
Q.2 Discuss Keynes point of view about the relationship between
income and consumption or law of consumption and its assumptions.
Also discuss the effects of objective and subjective factors on
consumption function.

ANSWER:

John Maynard Keynes,

John Maynard Keynes, a prominent economist of the 20th century, proposed
a theory on the relationship between income and consumption known as the
"psychological law of consumption." According to Keynes, consumption is a
function of income, meaning that as income increases, consumption also
increases but by a smaller proportion. This principle suggests that individuals
tend to save a portion of any additional income rather than spending it all on
consumption immediately.

Keynes outlined several key points regarding the relationship between

income and consumption:

Propensity to Consume: Keynes introduced the concept of the propensity

to consume (C/Y), where C represents consumption and Y represents
income. This is the fraction of total income that households choose to spend
on consumption goods and services rather than saving or investing.

Marginal Propensity to Consume (MPC): This refers to the change in

consumption resulting from a change in income. It is the slope of the
consumption
function and indicates the proportion of additional income that is spent on
consumption rather than saved.
Psychological Law of Consumption: Keynes argued that as income
increases, consumption increases, but not by as much as the increase in
income itself. This is because households tend to save a portion of their
additional income, leading to a lower marginal propensity to consume as
income rises.
Assumptions underlying Keynes' theory include:
Income as the Primary Determinant: Keynes assumed that income is the
main determinant of consumption levels. Changes in income lead to changes
in consumption, with other factors remaining relatively constant in the short
run.

Stable Expectations: Keynes assumed that individuals have stable

expectations about future income and economic conditions, influencing their
current consumption decisions.

Factors influencing the consumption function can be broadly categorized

into objective and subjective factors:
Objective Factors: These include income levels, wealth, interest rates, and
prices of goods and services. Higher income and wealth generally lead to
higher consumption levels, as individuals have more disposable income to
spend. Lower interest rates can encourage borrowing and consumption
rather than saving. Changes in prices can also affect consumption decisions,
as higher prices may discourage spending on certain goods.

Subjective Factors: These include consumer confidence, expectations

about future income and prices, and cultural or social factors. Consumer
confidence plays a significant role; if consumers are optimistic about future
economic conditions, they may increase their current consumption levels.
Conversely, pessimism can lead to higher savings and lower consumption.

In conclusion, Keynes' theory of consumption emphasizes the role of income

as a primary determinant of consumption behavior, with the propensity to
consume reflecting the fraction of income spent rather than saved. Objective
factors such as income, wealth, and interest rates, as well as subjective
factors including consumer confidence and expectations, collectively
influence consumption decisions and shape the consumption function in an
economy. Understanding these factors is crucial for policymakers and
economists in predicting and managing economic trends and consumer
behavior.
Q.3 (a) Differentiate between supply and stock of money. Also discuss
ingredients of supply of money in detail.
ANSWER:
Supply of money and stock of money are concepts related to the quantity
and availability of money in an economy, but they refer to different aspects:
Supply of Money:
The supply of money refers to the total amount of money circulating in the
economy at a given point in time. It includes all forms of money that are
readily available for transactions and other economic activities. The supply of
money is influenced by the actions of central banks, commercial banks, and
sometimes the government. It is crucial because it affects the overall level of
economic activity, inflation, and interest rates.

Stock of Money:
The stock of money, on the other hand, refers to the total amount of money
in existence within an economy over a period. It represents the cumulative
supply of money that has been created and is available for use. The stock of
money includes money held by the public (currency in circulation) and money
held by banks (demand deposits and other forms of deposits).
Ingredients of Supply of Money:
The supply of money is composed of various components that collectively
determine the total amount of money available in the economy.

These components include:

Currency in Circulation: This refers to physical currency (notes and coins)

held by individuals, businesses, and non-bank institutions. It represents the
most liquid form of money because it can be used for transactions directly.

Demand Deposits: These are deposits held by individuals and businesses

in commercial banks that can be withdrawn on demand without any notice.
Demand deposits are part of the broader category of checking accounts
and are a key component of the money supply because they are used for
everyday transactions.
Savings Deposits: Savings deposits are deposits held in savings accounts
in banks. Although they are part of the broader money supply, they are less
liquid than demand deposits because there may be restrictions on
withdrawals or transactions.

Time Deposits: Time deposits, such as certificates of deposit (CDs), are

deposits held for a fixed period at a specified interest rate. They are less liquid
than savings deposits because early withdrawal may incur penalties.
Money Market Mutual Funds: These are mutual funds that invest in short-
term, high-quality securities such as Treasury bills and commercial paper.
They are included in the broader definition of the money supply because they
are highly liquid and can be easily converted into cash.

Repurchase Agreements (Repos): Repos are short-term loans where

financial institutions sell securities to each other with an agreement to
repurchase them later. They are used by banks and other financial institutions
to manage their liquidity needs and are considered part of the money supply.

Central Bank Reserves: Reserves held by commercial banks at the central

bank play a crucial role in determining the overall money supply through the
process of fractional reserve banking. Changes in reserve requirements and
open market operations conducted by the central bank can influence the
availability of money in the economy.

In summary, while the supply of money refers to the total amount of money
available at a specific time, the stock of money represents the cumulative
amount of money in existence over time. The ingredients of the supply of
money encompass various forms of money, deposits, and financial
instruments that contribute to the overall liquidity and functioning of the
economy. Understanding these components is essential for policymakers
and economists in managing monetary policy, regulating financial markets,
and assessing economic stability.
(b) Discuss Fischer’s equation of exchange with a suitable example.

ANSWER
The Fisher's equation of exchange, formulated by American economist Irving
Fischer, is a fundamental concept in monetary economics that expresses the
relationship between the quantity of money and its velocity, and their effect
on the price level and real output in an economy.
The equation is represented as:
 Q.4 Discuss the historical evolution of present-day modern banking
system. What is the difference between the functions of a central bank
and those of commercial ones.

ANSWER
The modern banking system has evolved significantly over centuries, shaped
by historical events, economic needs, and technological advancements. The
roots of banking can be traced back to ancient civilizations such as
Mesopotamia and Egypt, where temples and royal palaces served as places
to store valuables and assets. However, the modern banking system as we
know it today began to take shape in the late Middle Ages and Renaissance
period in Europe.

During the Renaissance, banking activities expanded with the rise of

merchant trade and exploration. Italian city-states like Florence and Venice
became hubs of banking, facilitating international trade through instruments
like bills of exchange and letters
of credit. Banking families such as the Medici in Florence played crucial
roles in providing financial services and fostering economic growth.

The establishment of the Bank of England in 1694 marked a pivotal moment

in the evolution of modern banking. It was the first central bank to be
chartered with the purpose of financing the government's debt and stabilizing
the currency. Central banks emerged in various countries over the following
centuries, each tasked with managing monetary policy, regulating
commercial banks, and maintaining financial stability.

Difference between Central Banks and Commercial Banks:

Role and Function:
Central Bank: The central bank is the apex monetary authority in a country
responsible for formulating and implementing monetary policy. It regulates
the money supply and interest rates to achieve macroeconomic objectives
such as price stability, full employment, and economic growth. Central banks
also act as lenders of last resort to provide liquidity to the banking system
during times of financial stress.
Commercial Bank: Commercial banks are financial institutions that provide
services to the public and businesses. They accept deposits, make loans,
issue credit cards, and facilitate payment systems. Commercial banks earn
profits primarily through lending and investment activities, and they play a
crucial role in allocating capital within the economy.

Regulation:
Central Bank: Central banks regulate and supervise commercial banks to
ensure their stability and adherence to financial regulations. They set capital
requirements, conduct stress tests, and oversee systemic risks to safeguard
the overall financial system.
Commercial Bank: Commercial banks are subject to regulations and
supervision by central banks and other regulatory authorities. They must
comply with rules on capital adequacy, liquidity, risk management, and
consumer protection.

Monetary Policy:
Central Bank: Formulating and executing monetary policy is the primary
function of central banks. They adjust interest rates, conduct open market
operations (buying or selling government securities), and set reserve
requirements to influence the money supply, inflation rates, and economic
growth.
Commercial Bank: Commercial banks do not have the authority to set
monetary policy. Instead, they implement the policies set by the central bank
through their lending, deposit, and investment activities.

Role in the Economy:

Central Bank: Central banks play a pivotal role in maintaining overall
economic stability and financial system resilience. They act as custodians of
the national currency and promote efficient payment systems to facilitate
economic transactions.
Commercial Bank: Commercial banks contribute to economic growth by
mobilizing savings and channeling them into productive investments. They
provide essential financial services that support individual consumers,
businesses, and the broader economy.
Q.5 Write notes on the following
(I) Ricardo’s theory of comparative advantage.
(ii) Modern theory of international trade.
ANSWER
(I) Ricardo’s Theory of Comparative Advantage:
David Ricardo's theory of comparative advantage, developed in the early
19th century, remains a cornerstone of international trade theory and
highlights the
benefits of specialization and trade between countries. The theory is based
on the principle that even if one country can produce all goods more efficiently
(absolute advantage), both countries can still benefit from trade if they
specialize in producing goods where they have a comparative advantage.

Key points of Ricardo's theory include:

Comparative Advantage: Ricardo argued that countries should specialize
in producing goods in which they have a lower opportunity cost relative to
other countries. Opportunity cost refers to the value of the next best
alternative forgone when a choice is made.
Trade and Efficiency: By specializing in goods where they have a
comparative advantage and trading for other goods, countries can achieve
higher levels of efficiency and maximize their total output. This leads to
overall economic gains and higher standards of living.
Mutual Benefits: Comparative advantage implies that both trading partners
can benefit from trade, even if one country is less efficient in producing all
goods compared to another. This counters the notion that trade only benefits
the more efficient country.

Long-Run Growth: Ricardo's theory suggests that countries can achieve

sustained economic growth by specializing in production based on their
comparative advantages and participating in international trade. This
specialization encourages innovation, technological advancement, and
capital accumulation over time.
Ricardo's theory of comparative advantage provides a theoretical foundation
for understanding why countries engage in trade, how specialization can lead
to efficiency gains, and why protectionist policies restricting trade may result
in suboptimal outcomes for all parties involved.

(ii) Modern Theory of International Trade:

ANSWER:
The modern theory of international trade builds upon Ricardo's insights and
incorporates additional factors and complexities that affect global trade
patterns in the contemporary world. Key elements of modern international
trade theory include:

Factor Endowments and Heckscher-Ohlin Model: Developed by Eli

Heckscher and Bertil Ohlin, this model emphasizes that countries tend to
export goods that intensively use their abundant factors of production (land,
labor, capital) and import goods that use their scarce factors. It predicts trade
patterns based on differences in factor endowments between countries.

New Trade Theory: Introduced by Paul Krugman and others, this theory
explains trade patterns through economies of scale, product differentiation,
and increasing returns to scale. It argues that countries may specialize in
particular industries not only due to comparative advantage but also because
of factors such as first-mover advantages and network effects.

Trade and Economic Growth: Modern theories emphasize that

international trade contributes to economic growth by promoting
specialization, innovation, and the efficient allocation of resources. Countries
can benefit from trade not only through increased consumption possibilities
but also through technological spillovers and knowledge transfer.

Trade Policies and Globalization: The modern theory also addresses the
impact of trade policies, such as tariffs, quotas, and trade agreements, on
international trade flows and economic welfare. It highlights the importance
of trade liberalization and the reduction of barriers to trade in maximizing
global economic efficiency and welfare.

“THE END”