To calculate GDP using the expenditure method, we sum up:

Personal consumption expenditure: 200

Government purchases: 50

Gross private domestic investment: 40

Net exports (Exports - Imports): 30 - 40 = -10

GDP = 200 + 50 + 40 + (-10) = 280 billion Rs.

Net Domestic Product (NDP) is GDP minus depreciation:

NDP = 280 - 10 = 270 billion Rs.

Gross National Product (GNP) is GDP plus net factor income from abroad:

GNP = 280 + 60 = 340 billion Rs.

Government revenue (personal taxes) = 50 billion Rs.

Government expenditure = Government purchases + Government transfer payments

= 50 + 20 = 70 billion Rs.

Fiscal deficit = Government expenditure - Government revenue

= 70 - 50 = 20 billion Rs.

With 10% inflation, nominal GDP = real GDP * (1 + inflation rate)

Nominal GDP = 280 * 1.10 = 308 billion Rs.

Real interest rate = Nominal interest rate - Inflation rate

= 12% - 10% = 2%

_________________________________

Keynesian multiplier = 1 / (1 - MPC)

Where MPC (Marginal Propensity to Consume) = 0.8

Multiplier = 1 / (1 - 0.8) = 1 / 0.2 = 5

Output gap = Full employment output - Current output

= 220 - 190 = 30 billion USD

Stimulus package size = Output gap / Multiplier

= 30 / 5 = 6 billion USD

c. The fiscal prudence lobby argument is valid. The government should balance its budget to avoid increasing debt. The
stimulus should be 6 billion USD, financed by reallocating existing resources rather than additional spending.

Money multiplier = 1 / Cash reserve ratio

= 1 / 0.05 = 20

Current stock of money = Price level * Real GDP / Velocity of money

= Price level * 190 / 2 = 95 * Price level

High-powered money needed = (Desired money supply - Current money supply) / Money multiplier
= (220 - 190) / 20 = 1.5 billion USD

This injection of high-powered money would increase the money supply to match the full employment output level.

I'll address both questions in detail, including a diagram for question 3a.

Calculate the GDP using the expenditure approach:

The expenditure approach calculates GDP using the following formula:

GDP=C+I+G+(X−M)

Where:

• CC= Consumption

• I = Investment

• G = Government Spending

• X−M = Net Exports (Exports - Imports)

From the data provided:

• C=5,000

• I=2,000

• G=3,000

• Net Exports = 500

Now, plug in the values:

GDP=5,000+2,000+3,000+500=10,500

So, GDP = 10,500.

Determine the GDP using the income approach:

The income approach calculates GDP as the sum of all incomes earned in the economy. The formula is:

GDP=Compensation of Employees+Rents+Interest+Corporate Profits+Taxes on Production and Imports−Subsidies

From the data provided:

• Compensation of Employees = 4,000

• Rents = 500

• Interest = 800

• Corporate Profits = 2,000

• Taxes on Production and Imports = 600

• Subsidies = 300

Now, plug in the values:

GDP=4,000+500+800+2,000+600−300=7,600

So, GDP = 7,600.

Using the simple Keynesian multiplier, explain how an increase in government spending by $500 affects GDP,
assuming a marginal propensity to consume (MPC) of 0.8.
Balanced budget multiplier. From your answers to parts a and b, deduce the value of the balanced budget multiplier.

The balanced budget multiplier refers to the situation where an equal increase in government spending and taxes leads to
a change in GDP. Even though both taxes and spending rise by the same amount, the impact on GDP will be positive.

The balanced budget multiplier (BBM) is always 1. This is because the increase in government spending has a direct effect
on GDP, while the increase in taxes has a smaller, indirect effect (since only part of the tax increase affects consumption).

In this case:

• The increase in government spending increased GDP by $2,500 (from part a).

• The increase in taxes reduced GDP by $2,000 (from part b).

Thus, the net effect on GDP is :

Net Change in GDP=2,500−2,000=500

FORMULAS

Formula for GDP using the Income Method:

GDP=Compensation of Employees + Rent + Interest + Profits + Taxes on Production and

Imports−Subsidies + Depreciation

Formula for GDP using the Expenditure Method:

GDP=C+I+G+(X−M)

Where:

• C = Consumption
• I = Investment
• G = Government Spending
• X = Exports
• M = Imports

1. From Factor Cost to Market Price:

Market Price (MP) = Factor Cost (FC) + Indirect Taxes−Subsidies

2. From Market Price to Factor Cost:

Factor Cost (FC)= Market Price (MP)− Indirect Taxes + Subsidies

NNPfc – National Income

Formula for GDP using the Production Method:

GDP = ∑(Gross Value of Output−Intermediate Consumption)

Expanded Formula:

GDP= Value Added by Primary Sector + Value Added by Secondary Sector + Value Added by Tertiary Sector
the demand curve in microeconomics is downward sloping because a decrease in the price level of a good is necessary to
induce greater consumption because of diminishing marginal utility.
in macroeconomic theory, the consumption demand depends only on real income levels. Therefore, a reduction in price
levels has no immediate effect on consumption. The impact on consumption happens after a fall in interest rates leads to
increased investment and income thereby triggering multiple rounds of consumption expenditure. And through the wealth
effect.

Shifts in the aggregate demand curve

Two causes :

boosting aggregate demand by fiscal policy, i.e. increased government expenditure, or reduced taxes

AD curve shifts rightward, interest rates increase bringing about reduction in the interest rates through expansionary
monetary policy, AD curve shifts rightward, interest rates decrease

Crowding in effect

Increase in government spending financed by borrowing boosts output due to increase in aggregate demand, despite
increase in real interest rate

Increase in government spending financed by money printing boosts output due to increase in aggregate demand resulting
from increased government spending, increase in real interest rate muted or absent

Keynesian

AS curve flat as supply increases without price level increases at high unemployment levels

Monetary policy ineffective on account of liquidity trap

AD curve shifts outward through expansionary fiscal policy

Classical

AS curve vertical as labour market in equilibrium, hence full employment

Monetary policy changes price level, not output Monetarist

Monetary expansion can increase aggregate demand and restore full employment

Fiscal policy unnecessary

In long run, the central bank should ensure stable monetary conditions – inflation, interest rate, and exchange rate

----------------------------------------------------------------------------------------------------------------

Classical Theory: economy at full employment, permanent decrease in money wage, outcome on output and prices

In case of a classical macroeconomic theory, when the economy is in full employment level, a decrease in money wage
will cause a decline in money supply in the economy, causing a leftward shift in the aggregate demand curve, due to
concept of quantity theory of money.

As per quantity theory of money:

MV=PY

Where M is quantity of money, V is velocity of transaction P is the price index for items traded and Y is the output.

The velocity of money in QTM, as argued by Fisher is determined by payment habits and payment technology of society i.e
the equilibrium of velocity was determined by such institutional factors and could be regarded as fixed in the short run.

On the other hands, in classical macroeconomics, the output (Y) is determined by the supply side factors, therefore fixed.

Hence, the equation now expresses a relationship of proportionality between given money supply and price level.
In the graph above, output (Y) is taken on X axis and aggregate price level is taken on Y axis. Y s curve is the vertical
aggregate supply curve which illustrates the supply determined nature of output in the classical model.

Y1d Y2d are the aggregate demand curves. P1 and Y1 are price and output level at initial level of equilibriunm where Ys = Y 1d

Now due to a permanent reduction in wages, the income in the economy would fall for the workers, causing a reduction in
the consumption, due to which the AD curve would shift to the left (Y 1d to Y2d). Also as explained by quantity theory of
money, decrease in money supply would shift the AD curve downward.

Now, because the supply curve is vertical, decrease in demand do not affect output and output remains the same (Y1=Y2).
Only the price level decreased from P1 to P2 due to shift in AD curve.

Keynesian Theory: economy at full employment, and decrease in price levels, outcome on output and prices

In the graph above, labor is taken on OX axis and wages in taken on OY axis, NS is the labor supply curve and MPN
(Nd) is the labor demand curve.

NO is the point of the full employnment

Due to a fall in price the wages goes up, increasing the cost of labor for the company in a period of global pandemic, which
causes a leftword shift in the ND curve from ND1 TO ND2

Causing involuntary unemploynment in the economy and a fall in money wage

Due to a fall in the price level in the economy, the demand for labor falls, causing a fall in the output in the economy, The
AD curve shifts downwards and output falls and prices falls from Po to P1
Inflation expectations increase,

Effect on aggregate supply curve

Impact on equilibrium price levels, interest rates and real GDP

In the above graph output is taken is taken on Y axis, Price is taken on axis. AS and AS’ are the aggregate supply curves. AD
is the aggregate demand curve and P reflects the output and price level in the economy.

Due to inflation the cost input rises as the price increases causing a leftward shift in the supply curve due to cost push and
the supply curve shifts from AS to AS’

Due to leftward shift in the supply curve , the eq price level rises and the real GDP falls due to a fall in employment due to
this price rise.
Additionally inflation will create a situation where the monehy supply in the economy will fall and to restore that the govt
will increase the interest rates to increase money supply. Therefore interest rates would rise in inflationary case.

Conditions under which monetary stimulus may fail to increase real output of economy

Liquidity Trap - A liquidity trap is an economic situation where monetary policy becomes ineffective because interest
rates are already very low (close to zero or even negative) and people prefer to hold cash rather than invest or spend. This
phenomenon often occurs during periods of economic downturn or stagnation, when consumers and businesses are too
pessimistic about future prospects to increase spending, regardless of how much money is available or how low
borrowing costs are. A liquidity trap may develop when consumers and investors keep their cash in checking and savings
accounts because they believe interest rates will soon rise. That would make bond prices fall, and make them a less
attractive option.

Cost-Push Inflation : If the economy is experiencing cost-push inflation (e.g., due to rising commodity prices or wage
pressures), increasing the money supply may exacerbate inflation rather than stimulate real output. Higher inflation
without corresponding increases in productivity can erode purchasing power and potentially lower real output, despite
monetary easing.

High Levels of Debt (Debt Overhang): When consumers, businesses, or governments are already burdened with high levels
of debt, they may be reluctant to take on additional debt, even if interest rates are low. In this case, monetary stimulus
might lead to increased savings or paying down debt rather than stimulating spending and investment, reducing its
effectiveness in boosting real output.

Low Confidence or Economic Uncertainty: If businesses and consumers have low confidence in the economy's future or if
there is significant uncertainty (e.g., political instability, global crises), they may refrain from spending or investing,
regardless of favorable monetary conditions. A lack of confidence can mean that even with increased money supply or
lower interest rates, economic agents might choose to save more rather than spend, leading to minimal impact on real
output.

Expectations of Future Tightening (Forward Guidance): If people expect that the central bank’s monetary easing is
temporary and will be followed by future tightening (higher interest rates), they might not change their behavior in response
to current stimulus. This can lead to subdued spending and investment, as households and firms may anticipate future
interest rate hikes and maintain a conservative financial stance.

Additional Notes

1. Liquidity Trap:

A liquidity trap occurs when interest rates are very low or close to zero, and savings rates are high, making monetary
policy (such as lowering interest rates) ineffective in stimulating economic growth. In this situation, people prefer holding
onto cash rather than investing or spending, so even with an increase in the money supply, demand doesn't rise, and the
economy remains stagnant.

2. Twin Deficit Problem:

The twin deficit problem refers to a situation where a country experiences both a fiscal deficit (government spending
exceeds revenues) and a current account deficit (the value of imports exceeds the value of exports). This theory suggests
that high fiscal deficits can lead to current account deficits because increased government borrowing may lead to higher
interest rates, attracting foreign capital and strengthening the currency, which makes exports more expensive and imports
cheaper.

3. Multiplier Effect:

The multiplier effect refers to the phenomenon where an initial change in spending (such as government expenditure or
investment) leads to a larger overall increase in national income or output. This happens because one person’s spending
becomes another person’s income, which they then spend, leading to a chain reaction of economic activity. The
magnitude of the effect depends on the marginal propensity to consume (MPC).

4. Fiscal Multiplier:

The fiscal multiplier measures the effect that an increase in government spending or a change in taxation has on overall
economic output. It reflects how much national income changes in response to a change in fiscal policy. For example, if
the fiscal multiplier is 1.5, then a $1 billion increase in government spending would lead to a $1.5 billion increase in GDP.

5. Tax Multiplier:

The tax multiplier shows how changes in taxation affect overall economic output. A decrease in taxes raises disposable
income, leading to higher consumption and economic growth, while an increase in taxes has the opposite effect. The tax
multiplier is typically smaller than the government spending multiplier because not all of the tax savings will be spent. The
formula is:

Tax Multiplier=−MPC1−MPC\text{Tax Multiplier} = -\frac{MPC}{1 - MPC}Tax Multiplier=−1−MPCMPC

Where MPC is the marginal propensity to consume.

6. Balanced Budget Multiplier:

The balanced budget multiplier occurs when an increase in government spending is matched by an equal increase in
taxes, and the resulting increase in national income is equal to the amount of government spending. In other words, a
balanced budget where both taxes and spending rise by the same amount still leads to a positive impact on economic
output, typically with a multiplier effect of 1.

7. Quantity Theory of Money:

The quantity theory of money is an economic theory that links the money supply in an economy to the price level and the
amount of economic activity. It is often expressed using the equation:

M×V=P×YM \times V = P \times YM×V=P×Y

Where:

• M = Money supply; V = Velocity of money (how often money is spent)

• P = Price level

• Y = Real output (quantity of goods and services produced)

The theory suggests that, assuming the velocity of money (V) and output (Y) are constant, any increase in the money
supply (M) leads to a proportional increase in the price level (P), which results in inflation.