IGNOU Solved Assignment 2023–24 & 2024 BECC-106 : INTERMEDIATE MACROECONOMICS - I

 IGNOU Solved assignment 

BECC-106 : INTERMEDIATE MACROECONOMICS - I

1)  How do you derive the AD curve on the basis of IS-LM model? What are the factors that influence the slope and position of the AD curve?

Ans- The IS-LM model lays the groundwork for understanding the Aggregate Demand (AD) curve. Here's how it works:

Deriving the AD Curve from IS-LM:

1. IS-LM Intersection: The IS-LM framework comprises two curves: Investment-Saving (IS) and Liquidity Preference-Money Supply (LM). Their intersection determines the equilibrium level of interest rates and real GDP (output) in the short run, assuming a fixed price level.

2. Price Level Changes: Now, consider changes in the price level (P). If P increases, the real money supply (M/P) decreases. This shift in real money supply moves the LM curve upwards.

3. AD Curve and LM Curve Shifts: For each price level, there's a corresponding LM curve position and an equilibrium point on the IS-LM graph. By tracing these equilibrium points as the price level changes, we get the downward-sloping AD curve.

Factors Affecting the AD Curve:

The slope and position of the AD curve depend on factors that influence the IS curve and LM curve:

• IS Curve Factors:
  • Investment: Higher investment spending due to factors like tax cuts or technological advancements shifts the IS curve right, leading to a higher AD curve.
  • Consumption: Increased consumer confidence or government spending can shift the IS curve right, raising the AD curve.
• LM Curve Factors:
  • Money Supply: An increase in the money supply (M) shifts the LM curve right, lowering interest rates and raising the AD curve.

Slope of the AD Curve:

The slope of the AD curve is generally negative. This reflects the relationship between price level and real GDP demanded. As the price level rises, real money supply falls, pushing the LM curve up and reducing real GDP demanded at each interest rate level. This downward movement in output for higher price levels translates to the downward slope of the AD curve.

In essence, the IS-LM model provides the building blocks for understanding the AD curve, highlighting how changes in various economic factors can influence the level of aggregate demand in the economy.

2)  Bring out the salient features of the Dornbusch’s overshooting model. What are its implications? 

Ans-   

Dornbusch's Overshooting Model: Key Features and Implications

The Dornbusch Overshooting Model, developed by economist Rudiger Dornbusch, tackles the volatility of exchange rates. Here's a breakdown of its salient features and implications:

Features:

• Sticky Prices: The model assumes prices of goods and services adjust slowly in the short run. They're "sticky" and take time to react to changes.
• Flexible Exchange Rates: In contrast, exchange rates are flexible and can react quickly to economic news and events.
• Uncovered Interest Parity (UIP): The model incorporates the concept of uncovered interest parity, which suggests that interest rate differentials between countries are reflected in expected changes in exchange rates.
• Rational Expectations: Market participants form expectations based on all available information and act rationally.

How it Works:

Imagine a situation where there's an unexpected increase in the money supply. According to the model:

1. Initial Overshooting: The exchange rate will depreciate (domestic currency weakens) by more than what's justified by the long-run change in relative inflation (purchasing power parity). This initial depreciation is the "overshooting."
2. Price Adjustments: Gradually, domestic prices will start to rise due to the increased money supply, reducing the competitiveness of domestic goods.
3. Exchange Rate Correction: As domestic prices rise, the initially weakened domestic currency will start to appreciate (gain strength) to reflect the changing relative inflation between countries. This appreciation corrects the overshooting.

Implications:

• Exchange Rate Volatility: The model explains why exchange rates can be quite volatile in the short run due to overshooting and subsequent corrections.
• Monetary Policy and Exchange Rates: It highlights that monetary policy changes can have significant, but temporary, effects on exchange rates.
• Speculation: The model suggests that rational expectations of future exchange rate movements can lead to speculative activity in currency markets.

Criticisms:

• Empirical Evidence: The model's ability to consistently predict the magnitude and duration of overshooting is debated.
• Limited Scope: It primarily focuses on short-term dynamics and may not fully capture long-term exchange rate movements.

Dornbusch's Overshooting Model provides a valuable framework for understanding exchange rate behavior. While it has limitations, it remains an influential theory in international finance.

3) What is Phillips Curve? What is its shape under (i) adaptive expectations, and (ii) rational expectations?

Ans-  The Phillips Curve depicts a relationship between inflation and unemployment. Originally observed by A.W. Phillips, it has become a cornerstone concept in macroeconomics, although with some important nuances depending on how expectations are formed.

The Phillips Curve and Expectations:

The key factor influencing the shape of the Phillips curve is how economic agents (workers, firms) form their expectations about inflation. Let's see how it differs under two assumptions:

(i) Adaptive Expectations:

• Workers and firms base their inflation expectations on past experiences.
• Short-Run: In the short run, if unemployment is high, workers may be willing to accept lower wages to secure jobs. This can lead to a temporary trade-off between inflation and unemployment. A policy that lowers unemployment in the short run may lead to slightly higher inflation as firms compete for a smaller pool of labor, pushing wages (and potentially prices) up. This translates to a downward-sloping Phillips Curve in the short run.
• Long-Run: However, as inflation persists, workers and firms will gradually adjust their expectations upwards. They'll start demanding higher wages to keep pace with inflation, negating the initial short-run benefit of lower unemployment. This ongoing adjustment pushes the Phillips curve upwards over time. In the long run, under adaptive expectations, the Phillips curve becomes a vertical line at the natural rate of unemployment. This natural rate represents the unemployment level that cannot be persistently influenced by monetary or fiscal policy adjustments.

(ii) Rational Expectations:

• Workers and firms are assumed to be forward-looking and use all available information to form expectations.
• No Short-Run Trade-Off: Under rational expectations, economic agents anticipate how government policies might affect inflation. If the government tries to manipulate unemployment by increasing money supply, for example, workers and firms will foresee the resulting inflation and adjust their wage demands accordingly. This eliminates the possibility of a short-run trade-off between inflation and unemployment.
• Vertical Phillips Curve: In this scenario, the Phillips curve is a vertical line at the natural rate of unemployment even in the short run. Any attempt to manipulate unemployment through policy will be immediately priced into inflation expectations, rendering the policy ineffective.

4) What are the major components of the balance of payments (BoP)? Why does the BoP always balances? 

Ans-   Major Components of the BoP:

The BoP is divided into three main accounts:

1. Current Account: This account records the flow of goods, services, investment income, and current transfer payments between a country and the rest of the world.

   • Exports and Imports of Goods and Services: This includes the value of physical goods and intangible services a country sells (exports) and buys (imports) from other countries.
   • Investment Income: This covers income earned on foreign investments (e.g., interest on foreign bonds) and payments made to foreign investors for their investments in the domestic economy (e.g., dividends paid to foreign shareholders).
   • Current Transfer Payments: These are unrequited transfers, such as foreign aid grants or worker remittances sent back home.

2. Capital Account: This account reflects the net change in ownership of foreign assets. It includes:

   • Foreign Direct Investment (FDI): This refers to investments that give investors a controlling interest in a foreign business.
   • Portfolio Investment: This involves buying and selling of foreign stocks, bonds, and other financial assets.
   • Official Transfers: These are government transfers of capital, such as grants for development projects.

3. Financial Account: This account tracks the net change in a country's external financial liabilities (borrowing from abroad) and assets (lending abroad). It includes:

   • Foreign Currency Reserves: This refers to a country's holdings of foreign currencies used for international transactions.
   • Currency Intervention: This reflects government buying or selling of foreign currencies to influence exchange rates.
   • Private Sector Borrowing and Lending: This captures borrowing and lending activities between domestic entities and foreign entities.

Balancing the BoP:

In theory, the Balance of Payments always balances. This means the total debits (outflows of money from the country) in all three accounts must equal the total credits (inflows of money to the country). Here's why:

• Double-Entry System: The BoP follows a double-entry bookkeeping system. Every international transaction has two sides: an export (credit) or import (debit) of goods, services, or financial assets.
• Offsetting Transactions: The components within the BoP accounts often have offsetting effects. For example, a current account deficit (more imports than exports) might be financed by a capital account surplus (foreign investment inflows).

Real-world Discrepancies:

While the BoP should theoretically balance, there may be statistical discrepancies due to factors like:

• Incomplete Data: Capturing all international transactions perfectly is challenging.
• Valuation Differences: Different valuation methods for goods and services can lead to minor discrepancies.
• Transfer Pricing: Multinational corporations may manipulate transfer prices of goods traded between subsidiaries, affecting BoP figures.

5) What are the implications of rational expectations hypothesis? What are its limitations?

Ans- The Rational Expectations Hypothesis (REH) has significant implications for how economists understand economic behavior and design policy. Let's explore both the positive and negative aspects of this theory.

Implications of Rational Expectations:

• Policy Effectiveness: REH challenges the effectiveness of traditional macroeconomic policies, particularly those based on the assumption of limited economic foresight. If individuals have rational expectations, they will anticipate the effects of government policies and adjust their behavior accordingly. For instance, if the government announces an increase in money supply to stimulate the economy, people might expect inflation and raise wages, potentially negating the intended benefits of the policy.
• Credibility Matters: Policy credibility becomes crucial under REH. If policymakers have a history of inconsistency or making unexpected announcements, economic agents won't have accurate expectations. This can lead to policy ineffectiveness and market volatility.
• Focus on Long-Run: REH emphasizes the importance of long-run considerations in policy design. Short-term manipulation of economic variables might be ineffective due to rational anticipation of future adjustments.

Limitations of Rational Expectations:

• Cognitive Limits: REH assumes a level of rationality and access to information that might be unrealistic for some economic agents. People might not have the cognitive ability or resources to perfectly analyze complex economic situations.
• Imperfect Information: Economic information is rarely perfect. There's always some degree of uncertainty and noise in the data. This can lead to formation of inaccurate expectations even amongst rational actors.
• Sticky Prices and Wages: REH often assumes flexible prices and wages that can adjust quickly to changing economic conditions. In reality, prices and wages might be "sticky" and take time to adjust, allowing for short-run policy effects even with rational expectations.

6) Describe the various types of financial markets. 

Ans- Financial markets serve as platforms for trading various financial assets. These assets represent claims on future cash flows or ownership stakes in businesses. Here's a breakdown of some key types of financial markets:

By Asset Type:

• Stock Market: This market facilitates the buying and selling of shares of ownership in publicly traded companies. Investors can purchase stocks (equity) to potentially earn capital gains from price appreciation or receive dividends (a share of the company's profits).
• Bond Market: In the bond market, governments and corporations issue bonds to raise capital. Bonds are essentially loans where investors purchase the bond, essentially lending money to the issuer, and receive interest payments over a fixed term and the return of the principal amount at maturity.
• Commodities Market: This market deals with trading physical commodities like gold, oil, wheat, or agricultural products. Here, contracts are bought and sold for the delivery of these commodities at a future date.
• Derivatives Market: This is a specialized market where financial instruments (derivatives) are traded. These derivatives derive their value from underlying assets like stocks, bonds, commodities, currencies, or even market indexes. Examples include futures contracts, options contracts, and swaps. Derivatives are used for various purposes like hedging risk, speculation, and portfolio diversification.
• Currency Market (Forex Market): This is the largest financial market globally, facilitating the trading of foreign currencies. Individuals, businesses, and governments exchange currencies to conduct international transactions or for speculation on exchange rate movements.
• Cryptocurrency Market: This is a relatively new market where digital assets known as cryptocurrencies are traded. These cryptocurrencies use cryptography for security and operate independently of central banks. The cryptocurrency market is known for its volatility and remains under regulatory development in many countries.

By Maturity and Other Characteristics:

• Money Market: This market deals with short-term debt instruments (usually less than one year) with high liquidity. Examples include Treasury bills, commercial paper, and certificates of deposit (CDs).
• Capital Market: This market focuses on longer-term financing, including stocks, bonds, and long-term loans.

By Trading Mechanism:

• Exchange-Traded Market: In this type of market, securities are traded on a centralized exchange, following established rules and procedures. The New York Stock Exchange (NYSE) is a well-known example.
• Over-the-Counter (OTC) Market: Here, securities are traded directly between two parties, without going through a formal exchange. OTC markets are often less regulated and less transparent compared to exchange-traded markets.

7) Write a short note on the types of financial derivatives.

Ans-  Financial derivatives are contracts that derive their value from an underlying asset, group of assets, or benchmark. They are used for various purposes, including hedging risk, speculation, and portfolio diversification. Here's a quick rundown of the most common types:

• Futures Contracts: These are legally binding agreements to buy or sell an asset at a predetermined price on a specific future date. They are standardized and traded on exchanges, ensuring high liquidity.

• Options Contracts: Options give the buyer the right, but not the obligation, to buy or sell an underlying asset at a certain price by a certain date. Unlike futures, options offer flexibility as the buyer is not obligated to complete the transaction.

• Swaps: Swaps involve exchanging cash flows between two parties based on predetermined formulas. They are often customized contracts traded over-the-counter (OTC). Common types include interest rate swaps and currency swaps.

• Forwards: Similar to futures contracts, forwards obligate both parties to buy or sell an asset at a set price on a future date. However, forwards are customized contracts negotiated directly between two parties, unlike standardized exchange-traded futures.

8) Distinguish between nominal and real exchange rate.

Ans-  The nominal and real exchange rate both represent the value of one currency relative to another, but they capture this value in different ways:

Nominal Exchange Rate:

• The nominal exchange rate is the direct exchange rate between two currencies. It tells you how much of one currency you need to exchange for one unit of another currency.
• For example, if the nominal exchange rate between the US dollar (USD) and the Euro (EUR) is 1.20, it means it takes $1.20 to buy 1 Euro.
• The nominal exchange rate is the figure you see quoted on financial news websites or used in currency exchange booths.

Real Exchange Rate:

• The real exchange rate goes beyond the simple exchange ratio and considers purchasing power. It tells you how much you can actually buy with a unit of currency in another country, relative to what you can buy in your own country.
• It takes into account the relative price levels of goods and services in two countries.
• To calculate the real exchange rate, you typically multiply the nominal exchange rate by the ratio of the price level in the foreign country to the price level in the domestic country.

In essence, the nominal exchange rate is the sticker price, while the real exchange rate reflects the true purchasing power you get for your money.

9) Give a brief account of the IS-LM-BP model.

Ans-  The IS-LM-BP model, also known as the Mundell-Fleming model, is a framework used to analyze the interaction between a nation's goods market (IS), money market (LM), and balance of payments (BP) in a small open economy. Here's  its key components:

• IS Curve:
  • Represents the equilibrium in the goods market.
  • Focuses on the relationship between the real interest rate and real GDP (output).
  • Higher investment or government spending shifts the IS curve right, leading to higher output and potentially lower interest rates.
• LM Curve:
  • Captures the equilibrium in the money market.
  • Reflects the relationship between the real interest rate and money supply.
  • An increase in the money supply shifts the LM curve right, lowering interest rates.
• BP Curve:
  • Represents the equilibrium in the balance of payments (current account and capital account).
  • In a flexible exchange rate system, the BP curve is horizontal at the world interest rate. This implies any changes in domestic interest rates are offset by capital flows to maintain balance.
  • In a fixed exchange rate system, the BP curve is vertical, indicating the government intervenes to maintain a fixed exchange rate.

How it Works:

The IS-LM-BP model helps us understand how various factors like fiscal policy, monetary policy, and exchange rate regimes can influence a small open economy's output, interest rates, and net exports.

• Fiscal Policy: An expansionary fiscal policy (increased government spending) shifts the IS curve right, potentially leading to higher output and a higher interest rate. This higher interest rate can attract capital inflows if exchange rates are flexible, appreciating the currency and reducing net exports.
• Monetary Policy: An expansionary monetary policy (increased money supply) shifts the LM curve right, lowering interest rates. This can stimulate investment and output but might also lead to depreciation of the currency if exchange rates are flexible, improving net exports.

Exchange Rate Regimes:

• Flexible Exchange Rates: Allow for adjustments based on market forces. The BP curve is horizontal, and capital flows play a crucial role in maintaining balance.
• Fixed Exchange Rates: The government intervenes to maintain a fixed exchange rate. The BP curve is vertical, and changes in domestic interest rates are offset by government actions.

The IS-LM-BP model provides a simplified but valuable framework for understanding the complexities of a small open economy and the interplay between domestic and international factors.

10) Explain the interest parity condition for an open economy.

Ans-  The interest parity condition (IPC) in an open economy refers to the relationship between interest rates in two countries and the exchange rate. It suggests that, in a frictionless and efficient market, there won't be any persistent opportunities for risk-free arbitrage based on interest rate differentials.

There are two main types of interest parity conditions:

1. Covered Interest Parity (CIP): This applies when exchange rate risk is eliminated by using forward contracts. Investors can earn the same return by investing in domestic or foreign assets after accounting for the forward premium or discount.

Formula:

(1 + domestic interest rate) = (1 + foreign interest rate) * (forward exchange rate / spot exchange rate)

2. Uncovered Interest Parity (UIP): This applies when investors are willing to take on exchange rate risk and don't hedge their exposure. The expected return on domestic assets should equal the expected return on foreign assets, adjusted for the expected change in the spot exchange rate.

Formula:

(1 + domestic interest rate) = (1 + foreign interest rate) * (expected future spot rate / spot exchange rate)

Key Assumptions:

• Free capital mobility: There are no restrictions on capital flows between countries.
• No transaction costs: There are no fees or charges associated with investing in foreign assets or using forward contracts.
• Perfect information: Investors have all the necessary information to make rational investment decisions.
• Rational expectations: Investors form their expectations about future exchange rates based on all available information.

Implications:

• Arbitrage and Market Efficiency: The interest parity conditions suggest that arbitrage activity will eliminate any significant and persistent deviations from these conditions. This helps maintain efficiency in international financial markets.
• Interest Rate Differentials and Exchange Rates: The IPC can be used to understand how interest rate differentials can influence exchange rates. For example, if the domestic interest rate is higher than the foreign interest rate, the forward exchange rate might be at a discount compared to the spot rate (covered interest parity). This suggests the domestic currency is expected to depreciate in the future.