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IGNOU MEC-002 Solved Assignment 2012

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(Assignment Code: MEC-002/AST/2011-12) Section: A Q.1 What is meant by steady state in the Solow Model? Explain how Golden Rule is different from steady state.

Ans The Steady State is a condition when the economy does not have to change its capitallabour ratio. Investment per unit of effective labour equals saving per unit of effective labour i.e i = sy {since, y = f(k)}, then i = sf(k) The rate of growth capital stock is equal to the rate of investment. In per effective labour term, written as = sf(k), where refers to growth rate in k. Growth of Capital and Steady State The Solow model assumes that existing capital depreciates at the rate . Thus each year K amount of capital is depreciated. Investment and depreciation act in opposite directions and the growth in capital stock is net of the two quantities. (t) = i(t) - k(t) {since i= sf(k(t)), then (t) = sf(k(t)) - k(t) Capital stock rises when sf(k(t)) > k(t); falls when sf(k(t)) < k(t) and remain constant when sf(k(t)) = k(t). Population Growth and Steady State Consider the case where population and the labour force grow at a constant rate n. (t) = sf(k(t)) (n+)k(t) For steady state the amount of investment required must not only cover depreciation (k) but also provide new workers with capital (nk). Break-even investment now would be (n+)k. The steady state is achieved at the point of intersection of investment and (n+)k curves. Capital Stock(K) and output (Y) keeps on growing at the rate n to keep k and y constant. At steady state both k and y are constant. Technological Progress and Steady State The technological progress in the Solow model indicates the quantity of effective labour (AL). The rate of technological progress is g. The change in k over time is now modified as (t) = sf(k(t)) (n+g+)k(t)

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The analysis of steady state does not change with the inclusion of technological progress. But the break-even investment now is (n+g+)k. Out of total investment sf(k), k is needed to cover depreciation and nk to maintain capital per effective labour constant. However, as a result of technological progress y grown at a rate of g.

The Golden Rule

In economics, we generally assume that the more people consume, the happier they are. So if we want people to be as happy as possible, our aim is to maximize consumption per worker c. The steady state associated with that particular outcome is called the Golden Rule (GR) steady state. Steady State consumption is output net of investment. Thus c* = y* - i* {since y* = f(k*) and investment (i*) = depreciation ((n+g+)k*) } or c* = f(k*) - (n+g+)k* As increase in steady state capital has contrasting effect on steady state consumption more capital leads to more output which contributes positively to consumption, but it also means higher bread even investment (n+g+)k. Steady state consumption is the gap between the steady state output and steady state breakeven investment, which maximized at k*gold level of capital per effective labour. While higher levels of capital mean higher levels of output, they also mean more capital is being removed from the economy each year. If the capital stock is below the GR level, the slope of the production function is greater than that of the capital stock curve, and an increase in capital per worker has a greater impact on f(k) than on (n+g+)k giving us an increase in consumption. The opposite will hold true when we are above the GR level. The GR steady state occurs when MPK = (n+g+) or (MPK - ) = (n+g) At the golden rule level of capital, the MPK net of depreciation is equal to the rate of growth of total output (n+g). A planner trying to maximize long-run consumption would then aim to get a savings rate that corresponded with that particular steady state level of capital. Note that in the transition to the GR point, there will be initial effects and long-run effects. Say were below the GR. As we increase savings, there will be a temporary decrease in consumption, and then a long run increase. Why? Because an increase in savings means less consumption right away (c = y sy). However, as capital accumulates, output increases, and thus so does consumption. This situation gives us a look into why its called the Golden Rule . . . because we sacrifice consumption now for higher consumption for the people of the future. As Mankiw puts it, the welfare of all generations is given equal weight, so sacrifice by this generation is outweighed by the gains of future generations.

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Q.2 Explain how the permanent income hypothesis reconciles the difference between long-run and short-run consumption functions? Ans. According to the life cycle hypothesis the short-run consumption function shows a decline average propensity to consume (APC) while the long-run consumption function exhibits constant average propensity to consume due to increase in asset base. On the other hand permanent income hypothesis explains the discrepancy in terms of permanent income and transitory income. Friedmans permanent income hypothesis provides an alternative explanation to the apparent discrepancy between cross-sectional and time series data on consumption. Unlike the life-cycle hypothesis, Friedman does not postulate that incomes follow a regular pattern over the life cycle of an individual; he instead argues that individuals experience random and temporary changes in their income from time to time. Accordingly, Friedman views the current income in any period (Yt) as consisting of two components: permanent income (YtP) and transitory income (YtT). Permanent income is that part of the income which prevails over the long run. Friedman interprets this as the long run average income of the individual, i.e. YtP t) Transitory income is any random deviation from this average, i.e YtT t) A positive transitory income implies that the current income exceeds the permanent income; a negative income implies that the current income is less than the permanent income. Since P Ct = A0/T + 1/T ( t) = A0/T + Yt , i.e current consumption of the household depends only on the permanent income, any increase in the transitory part of the current income, which leaves the permanent income unchanged, will have no impact on the level of current consumption. Friedmans permanent income hypothesis solves the apparent puzzle in the consumption data. According to Friedmans hypothesis, the average propensity to consume (Ct / Yt) depends on the ratio of permanent to current income YtP /Yt. Thus when current income temporarily rises above the permanent income the average propensity to consume falls; the opposite happens when current income temporarily falls below the permanent income. The high income group will contain some people with a high transitory income, who will have a lower propensity to consume than the average. Similarly the low income group will contain some people with a low transitory income, who will have a higher propensity to consume that the average. Thus average propensity to consume will fall from lower to the higher income group. Any increase in the long run reflects a permanent increase in the average income level.

Section B Q.3 Policy makers should stick to rules instead of pursuing discretionary policies. Do you agree with the above statement? Substantiate your answer. Ans Yes, policy makers should stick to rules instead of pursuing discretionary policies. This is because the greater the deviation from rules that a government displays in undertaking discretionary action even in circumstances where intervention is unanimously demanded, the less will be the credibility of policy rules announced by the government in the future. The

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credibility of an announced policy rules depends not only on past experience regarding a governments ability to adhere to commitments but also on a rational evaluation about the future possibility of a government adhering to a policy rule. If the governments have the discretion to change policy at future points in time then an announced policy rule will not be credible unless it is time-consistent, at some point in time it will not be optimal for the government to follow the policy dictated by the rule. A problem might arise because the policy rule which is optimal over the entire time horizon may not be time-consistent. An obvious way by which the government can commit to a particular policy rule is to enact legislation making it costly to deviate from the rule in the future. However, it might be difficult and time-consuming to amend the legislation if there arises unanticipated eventualities which urgently require deviation from the rule or if it is found that important assumptions make in faming the rule are erroneous. An alternative way by which an optimal policy rule may be made credible without losing the flexibility for using discretion in emergencies if for the government to delegate responsibility for this policy to some autonomous agency which the public perceives as having a different objective function. In practice policy formulation needs to be based on certain rules or procedures. However, there is a need for revision of policy rules against unanticipated developments which may be time-taking and costly. In order to tackle such eventualities the government can delegate the responsibility to some autonomous body. The possibility of following a sub-optimal policy over time cannot be ruled out.

Q.4 Explain in brief the salient features of real business cycle theory. In what respects is it different from other theories of business cycle? Ans. In real business cycle theory emphasis in given on real shocks such as technological change which shifts the production function. A productivity shock changes the level of output produced by given amount of inputs. The basic tenets of real business cycle theory are as follows: (a) An economy is considered as a sea with islands of local markets.

(b) Buyers and sellers have perfect information about the prices of goods and services on their islands but cannot sample the prices on other islands except by rowing there, a costly activity. But, they form estimates of the general price level, the average of all prices. Thus, an increase in the general price level will be misperceived as an increase in the price of goods on the island, a (small) subset and therefore sub optimal decisions about consumption; production and investment will be taken. (c) Each household produces goods and sells them on one and only one of the arrays of these markets. (d) Goods differ according to location, physical characteristics and so on.

(e) Fluctuations in output by means of exogenous shocks. These shocks can originate on the demand side as well as on the supply side. (f) A monetary shock leads to an increase in the general price level and a fall in the expected interest rate.

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(g) The greater the uncertainty about money and the general price level, the less prices become useful as the conveyor of information par excellence. Thus, the economy becomes less responsive to changes in fundamentals, shifts in tastes and technology that require optimizing and efficient allocation of resources. The Real Business Theory emphasizes on relative prices rather than absolute price level, and believes that money is neutral, and also because it lays emphasis on supply side forces. Real business cycles are fluctuations generated by shock which might not reflect the rhythms of ebb and flow of classical cycles. New Classical Business Cycle research is oriented towards explaining the familiar pattern of boom and slump, one following the other in regular succession. The role of money and finance in both approaches are distinguished. In the former, shocks referred to are changes in technology and taster. Money is a veil. On the other hand, money and finance are part of the model of expansion and contraction developed by New Classical Business Cycle theorists.

================================================================== Q.5 Explain why firms may offer a higher wage to workers than the equilibrium wate rate. Ans. The efficiency wage theories rationalize the existence of higher than market clearing real wages. Firms pay higher than market-clearing real wages because the benefits accruing from higher wages are more than the cost of paying higher wages. The higher benefits accrue for the following reasons: (a) The benefits come from increased efficiency of workers. The increased efficiency due to increased physical efficiency of workers obtaining higher wages enable higher consumption including higher nutrition. (b) A higher than market wage build loyalty and belonging among workers and induce higher effort. Whereas in the context of the opposite situation of a lower wage, which is expected to have affects like generating anger and a desire for revenge, thereby leading even to a sabotage by the workers. (c) A higher wage generates incentives for workers to avoid work shirking behavior in situations where the firms cannot monitor the work effort perfectly. Workers will have fear of losing high paying jobs if caught shirking. (d) Higher wages get into the pool of workers with a higher reservation wage i.e the minimum wage that should be offered to a worker to induce him to supply his labour on the market. Workers with a higher reservation wage are expected to have superior abilities along directions that cannot be directly observed and duly compensated for on the market. These higher abilities in the pool o employed workers are expected to benefit the firm. The efficiency wage model not only rationalizes the existence of persistent unemployment, but also produces a larger effect on employment in the short run. The shortcoming of an efficiency wage model using a simple version of the effort function is that it implies that there is no increasing trend in the real wage in the long run.

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================================================================== Q.6 Bring out the important issues on which Lucas criticizes Keynesian macroeconomics. To what extent the New-Keynesian economists have accepted these criticisms? Ans. One of the most influential economists since the 1970s, he challenged the foundations of macroeconomic theory (previously dominated by the Keynesian economics approach), arguing that a macroeconomic model should be built as an aggregated version of microeconomic models (while noting that aggregation in the theoretical sense may not be possible within a given model). He developed the "Lucas critique" of economic policymaking, which holds that relationships that appear to hold in the economy, such as an apparent relationship between inflation and unemployment, could change in response to changes in economic policy. This led to the development of neoclassical and New Keynesian economics and the drive towards microeconomic foundations for macroeconomic theory. The development of macroeconomic theory since the 1970s was significantly influenced by the Lucas critique. This critique implies that we cannot apply econometrics using macroeconomic models, which directly assumed certain behavioural relations between macroeconomic variables, in order to check the effects of alternative policies. The Lucas critique, named for Robert Lucas work on macroeconomic policymaking, argues that it is nave to try to predict the effects of a change in economic policy entirely on the basis of relationships observed in historical data, especially highly aggregated historical data. The Lucas critique suggests that if we want to predict the effect of a policy experiment, we should model the "deep parameters" (relating to preferences, technology and resource constraints) that govern individual behavior. We can then predict what individuals will do, taking into account the change in policy, and then aggregate the individual decisions to calculate the macroeconomic effects of the policy change. The Lucas critique was influential not only because it cast doubt on many existing models, but also because it encouraged macroeconomists to build microfoundations for their models. Microfoundations had always been thought to be desirable; Lucas convinced many economists they were essential. One important application of the critique is its implication that the historical negative correlation between inflation and unemployment, known as the Phillips Curve, could break down if the monetary authorities attempted to exploit it. Permanently raising inflation in hopes that this would permanently lower unemployment would eventually cause firms' inflation forecasts to rise, altering their employment decisions. ================================================================== Q.7 Write short notes on (a) Rational expectation and adaptive expectation

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Ans Expectations are said to be rational when they are formed on the basis of all available information. Under this assumption, expectations are never biased. Economic-behavior observation according to which: (1) On average, people can quite correctly predict future conditions and take actions accordingly, even if they do not fully understand the cause-and-effect (causal) relationships underlying the events and their own thinking. Thus, while they do not have perfect foresights, they construct their expectations in a rational manner that, more often than not, turn out to be correct. Any error that creeps in is usually due to random (non-systemic) and unforeseeable causes. (2) In efficient markets with perfect or near perfect information (such as in modern open-market economies) people will anticipate government's actions to stimulate or restrain the economy, and will adjust their response accordingly. For example, if the government attempts to increase the money supply, people will raise their prices and wage demands to compensate for the inflationary impact of the increase. Similarly, during periods of accelerating inflation, they will anticipate stricter credit controls accompanied by high interest rates. Therefore they will attempt to borrow up to their credit capability, thus largely nullifying the controls. This theory was proposed not as a plausible explanation of human behavior, but to serve as a model against which extreme forms of behavior could be compared. It was developed by the US economist Robert Lucas (born 1937) who won the 1955 Nobel Prize for this insight. Expectations are said to be adaptive when people form their expectations on the basis of past behavior. Economic-behavior observation that people form their expectations of economic trends solely on the basis of what was the past magnitude and direction of those trends. If these expectations turn out to be wrong then, depending on the degree of the error, people revise (adapt) their future estimates accordingly. (b) Non-accelerating Inflation Rate of Unemployment (NAIRU).

Ans It is an unemployment rate that is consistent with a constant inflation rate. The NAIRU is the unemployment rate at which the long-run Phillips curve is vertical. When unemployment is equal to NAIRU there will be stability in the rate of inflation. When unemployment departs from NAIRU, there is acceleration or deceleration in inflation rate. Thus if actual unemployment is less than u*, inflation will continue to accelerate higher and higher in subsequent years. Unless unemployment returns to its natural rate inflation spiral will keep on accelerating. When unemployment is more than u*, inflation will tend to fall as long as unemployment is above u*.




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U*1 Unemployment Shifts in Phillips Curve

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