Exercise 1

PART A:
Introduction:

The circular flow model demonstrates how money moves through society. Money flows from producers
to workers as wages and flows back to producers as payment for products. In short, an economy is an
endless circular flow of money.

The basic purpose of the circular flow model is to understand how money moves within an economy. It
breaks the economy down into two primary players: households and corporations. It separates the
markets that these participants operate in as markets for goods and services and the markets for the
factors of production.

Demand Side Components of Circular Flow:

Consumption expenditure by households is the largest component of GDP, accounting for about two-
thirds of the GDP in any year. This tells us that consumers’ spending decisions are a major driver of the
economy.

Investment expenditure refers to purchases of physical plant and equipment, primarily by businesses. If
Starbucks builds a new store, or Amazon buys robots, these expenditures are counted under business
investment. Investment demand is far smaller than consumption demand.

Government expenditure is largely a policy variable. It responds partly to economic conditions and is
partly influenced by non-economic factors. When the economy is depressed, the government may
deliberately increase its expenditure on goods and services to provide a stimulus for economic activity.
Conversely when the economy is overheated discretionary expenditure may be curtailed though some
items of mandatory expenditure such as salaries cannot be easily contracted.

Net exports are a measure of a nation's total trade. The formula for net exports is a simple one: The
value of a nation's total export goods and services minus the value of all the goods and services it
imports equal its net exports.

Based on these four components of demand, GDP can be measured as:

GDP= Consumption + Investment + Government + Trade balance

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PART B:

Fiscal policy is a government's decisions regarding spending and taxing. If a government wants to
stimulate growth in the economy, it will increase spending for goods and services

Both fiscal policy and monetary policy can impact aggregate demand because they can influence the
factors used to calculate it: consumer spending on goods and services, investment spending on business
capital goods, government spending on public goods and services, exports, and imports. It is often the
cause of multiple trilemmas.
Fiscal policy affects aggregate demand through changes in government spending and taxation. Those
factors influence employment and household income, which then impact consumer spending and
investment.

Monetary policy impacts the money supply in an economy, which influences interest rates and the
inflation rate. It also impacts business expansion, net exports, employment, the cost of debt, and the
relative cost of consumption versus saving—all of which directly or indirectly impact aggregate demand.

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PART C

Covid-19 has given an economic shock to countries across the globe with its alarming speed and gigantic
magnitude. This led to steep recessions in many industries across countries. Despite the global policy
support, the pandemic is estimated to impact the global economy in the form of a 5.2% dip in the GDP in
2020, the highest in eight decades. The per capita incomes of emerging and developing economies have
been contracted by far this year. The impact on the global economy would worsen if the pandemic took
longer to get controlled and financial stress persists.

Monetary and fiscal policy measures can mitigate the short-term impact of the pandemic on the
economy and productivity while comprehensive reforms would be required to minimize the long-term
impact of the pandemic on the growth of the nation by improving governance, public health policies,
and general business environment. The Covid-19 outbreak has led to a collapse in demand for oil, an
upwelling oil inventories and the lowest decline in oil prices. In the initial stage of the pandemic, with all
the lockdown restriction, oil prices cannot buffer the impact of Covid-19, but it can certainly help the
economy to recover once the restrictions are lifted. The fiscal positions of energy-exporting emerging
economies have been strained for a while now, and the pandemic has resulted in a collapse in their oil
revenues. Thus, fiscal policy needs to be implemented for a sustainable economic position in a country.
Recently, a sharp rise in the number of virus patients has been witnessed even in the developed
economies let alone emerging and developing economies. The second wave of infection has resulted in
the loss of income, trade, and investments. In these scenarios, the government fiscal policies and central
bank's monetary policies are likely to renew the collapsed consumption of households. The low income
restrained the borrowing capacity of households, and therefore, they could not maintain the
consumption. The loose monetary policy would provide liquidity and purchasing power to the
households to maintain their basic level of consumption despite a low level of savings. The ability of
monetary policy and welfare systems to reduce income losses differ from country to country and is
generally lower in low-income countries. The domestic investment comes to a halt during uncertainty
like pandemics, and the outputs worsen. Restrictions imposed due to COVID-19 reduce the ability of
fiscal and monetary policies to limit the consequences of the pandemic.

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PART D:

Case 1:

The final cost of borrowing money often involves much more than just the interest rate. A variety of
other monetary and nonmonetary costs should be considered in determining the real cost of borrowing.
Assessing the direct financial costs

It goes without saying that the financial costs of a loan are important considerations in shopping for a
lender or negotiating with a bank. But you may not be aware of everything that fulls under the umbrella
of "direct financial costs."

Negotiating a fair interest rate percentage

Any interest rate that exceeds the bank's prime rate should be considered negotiable. Now, that
negotiable range is likely to be very small, but even an eighth of a point in interest can be a meaningful
amount to your business. You should expect to pay a point or two over the bank's prime lending rate.
Generally, the longer the term of the loan, the higher the interest rate.

Protecting your variable interest rate

Banks often prefer floating interest rates in making small commercial loans to minimize the already
significant risks of lending to a small business.

As a borrower, you should try to negotiate a maximum interest rate cap on any variable rate. That way
you have some idea of your maximum exposure on the loan.

Buying a fixed interest rate

In some instances, you might also consider "buying" a fixed rate from the lender. Many banks will offer a
fixed interest rate for a rate slightly higher than the current floating rate, e.g., an additional 1/2 percent.
Both you and the bank are speculating whether the prime rate will rise or fall and how quickly the rate
may move.

Case 2

A real interest rate is an interest rate that has been adjusted to remove the effects of inflation to reflect
the real cost of funds to the borrower and the real yield to the lender or to an investor. The real interest
rate reflects the rate of time-preference for current goods over future goods. The real interest rate of an
investment is calculated as the difference between the nominal interest rate and the inflation rate:

The nominal rate of interest is the rate that is actually agreed and paid. For example, it’s the rate
homeowners pay on their mortgage or the return savers receive on their deposits. Borrowers pay the
nominal rate and savers receive it.

In a stable economy that is growing at a moderate pace, the inflation rate is usually low. With a low
inflation rate, a simplified version of the Fisher equation can be implemented. It states that the nominal
interest rate is approximately equal to the real interest rate plus the inflation rate (i = R + h).

For example, a bond investor is expecting a real interest rate of 5%, when the market shows an expected
inflation rate of 3%. Therefore, the investor should look for a bond with a stated (nominal) interest rate
of 8% (5% + 3%).

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PART E

The GDP deflator is a measurement of the difference between nominal (not adjusted for inflation) and
real (adjusted for inflation) GDP. Using the statistics on real GDP and nominal GDP, one can calculate an
implicit index of the price level for the year.

GDP Deflator = (Nominal GDP / Real GDP) x 100

Nominal GDP is 100 and Real GDP is 20.

GDP Deflator = (100 / 20) x 100 = 0.9090 = 90.90

Therefore, the GDP Deflator is 90.90.

Nominal GDP is GDP evaluated at current market prices. Therefore, nominal GDP will include all of the
changes in market prices that have occurred during the current year due to inflation or deflation.
Inflation is defined as a rise in the overall price level, and deflation is defined as a fall in the overall price
level. In order to abstract from changes in the overall price level, another measure of GDP called real
GDP is often used.

The GDP deflator can be viewed as a conversion factor that transforms real GDP into nominal GDP. Note
that in the base year, real GDP is by definition equal to nominal GDP so that the GDP deflator in the base
year is always equal to 100.

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PART F:

Real GDP measures the economic output of a country which accounts for the effects of inflation and
deflation. Real GDP provides a more realistic assessment of the economy than the Nominal GDP. If real
GDP is not considered then it would look like the country is producing more when the prices are gone up

It is also known as an inflation-adjusted gross domestic product. It uses constant base-year prices for
measuring the value of final goods and services

Real GDP = Nominal GDP / Deflator

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 EXERCISE 2

PART A

Net borrower and Net lender:

A country is said to be net borrower or net lender if there is over all change in the account is the total
increase in assets minus the total increase in total liabilities.

Net Borrower or net Lender= total increase in assets- total increase in liabilities

This is so simple to examine as we study already if a country is in the condition of better off like if we see
in the economic perspective the country is growing its indicators shows that economy is growing the
country is said to be net lender

And the totally opposite condition which we say is the condition in a country is going to worse off
conditions as explained earlier is said to be net borrower.

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PART B

let’s take an example of a public sector (a government) of a country which is net borrower and looking
their GDP examine the case.

A Country named Pakistan is net borrower and its always borrow from institutions Like IMF,World Bank
and other net lender countries or neighbors countries.

Let’s look at Pakistan GDP:

 Pakistan GDP for 2020 was $263.69B, a 5.22% decline from 2019.

 Pakistan GDP for 2019 was $278.22B, a 11.55% decline from 2018.

 Pakistan GDP for 2018 was $314.57B, a 3.28% increase from 2017.

 Pakistan GDP for 2017 was $304.57B, a 9.3% increase from 2016.

There is both increase and decrease trend shown in GDP of Pakistan. But if we see the country’s debt is
internal and external. In the major scene country borrow from both sides whether it borrow from
external sources and also from internal sources. But the country’s major debt is external.

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PART C

In my examination in the most of the cases the private sector is net lender where public borrowing rise
public sector savings, but it can vary with others.

Let’s take a graphical GDP data and see what the numbers tell us.
This is the graphical example of the condition given in question. If we see the illustration of net lending
by private sector it shows the upward trend till 2004 and then it decreases back to 2005 which means
the net lending is decreased in 2005 and if we see the net borrowing case by government sector the
trend is normal and the it suddenly increases the line in minus here it means that borrowing increase in
2010 and them back to decrease.

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PART D

Yes, if we see the data there are several years data is mentioned. This data tells us that country is net
borrower somehow it maintains to last years in stabilization and if we see the data for private sector
lending it is continuously lending and it is a condition where lending decrease the borrowing is also
decrease.

As a whole if we see the country, is net Borrower.

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PART E

let’s solve this by taking Germany real exchange rate example

An increase denotes real effective appreciation for Germany. ULC denotes the real effective exchange
rate based on relative unit labor costs in manufacturing, and CPI denotes the real effective exchange
rate based on relative consumer price indices.

To address these questions, this section explores the conceptual basis for conventional measures of
competitiveness. Underlying the analysis is the presumption that an indicator of competitiveness should
possess one critical property: when it points to a loss of competitiveness by a country, the producers of
traded goods in that country should see an erosion of their shares in both domestic and foreign markets.
This criterion is used to assess two measures of competitiveness--one based on labor costs in traded
goods’ activities and the other on aggregate price indices.

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PART F:

Purchasing power parity (PPP):

We can define purchasing power parity as it is a theoretical exchange rate that allows you to buy the
same amount of goods and services in every country.

Government agencies use it to compare the output of countries that use different exchange rates.

The conclusion we get from above data is simply we can express this like if there is when there is
increase in completeness in exchange rate the things will be more complex to understand like if there is
unbiasing of exchange rate there is more difficult to get result of getting competition in exchange rate

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 EXERCISE 3

PART A

People do not obtain utility just from products they purchase. They also obtain utility from leisure time.
Leisure time is time not spent at work. The decision-making process of a utility-maximizing household
applies to what quantity of hours to work in much the same way that it applies to purchases of goods
and services. Choices made along the labor-leisure budget constraint, as wages shift, provide the logical
underpinning for the labor supply curve. The discussion also offers some insights about the range of
possible reactions when people receive higher wages, and specifically about the claim that if people are
paid higher wages, they will work a greater quantity of hours.

The Labor-Leisure Budget Constraint

How do workers make decisions about the number of hours to work? Again, let’s proceed with a
concrete example. The economic logic is precisely the same as in the case of a consumption choice
budget constraint, but the labels are different on a labor-leisure budget constraint.

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PART B

Vivian has 70 hours per week that she could devote either to work or to leisure, and her wage is
$10/hour. The lower budget constraint in Figure 1 shows Vivian’s possible choices. The horizontal axis of
this diagram measures both leisure and labor, by showing how Vivian’s time is divided between leisure
and labor. Hours of leisure are measured from left to right on the horizontal axis, while hours of labor
are measured from right to left. Vivian will compare choices along this budget constraint, ranging from
70 hours of leisure and no income at point S to zero hours of leisure and $700 of income at point L. She
will choose the point that provides her with the highest total utility. For this example, let’s assume that
Vivian’s utility-maximizing choice occurs at O, with 30 hours of leisure, 40 hours of work, and $400 in
weekly income. Any point not lying on his utility maximizing choice will not be optimal
For Vivian to discover the labor-leisure choice that will maximize her utility, she does not have to place
numerical values on the total and marginal utility that she would receive from every level of income and
leisure. All that really matters is that Vivian can compare, in her own mind, whether she would prefer
more leisure or more income, given the tradeoffs she faces. If Vivian can say to herself: “I’d really rather
work a little less and have more leisure, even if it means less income,” or “I’d be willing to work more
hours to make some extra income,” then as she gradually moves in the direction of her preferences, she
will seek out the utility-maximizing choice on her labor-leisure budget constraint.

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PART C

Now imagine that Vivian’s wage level increases to $12/hour. A higher wage will mean a new budget
constraint that tilts up more steeply; conversely, a lower wage would have led to a new budget
constraint that was flatter. How will a change in the wage and the corresponding shift in the budget
constraint affect Vivian’s decisions about how many hours to work?

Vivian’s choices of quantity of hours to work and income along her new budget constraint can be
divided into several categories, using the dashed horizontal and vertical lines in Figure 1 that go through
her original choice (O). One set of choices in the upper-left portion of the new budget constraint
involves more hours of work (that is, less leisure) and more income, at a point like A with 20 hours of
leisure, 50 hours of work, and $600 of income (that is, 50 hours of work multiplied by the new wage of
$12 per hour). A second choice would be to work exactly the same 40 hours, and to take the benefits of
the higher wage in the form of income that would now be $480, at choice B. A third choice would
involve more leisure and the same income at point C (that is, 33-1/3 hours of work multiplied by the
new wage of $12 per hour equals $400 of total income). A fourth choice would involve less income and
much more leisure at a point like D, with a choice like 50 hours of leisure, 20 hours of work, and $240 in
income.

In effect, Vivian can choose whether to receive the benefits of her wage increase in the form of more
income, or more leisure, or some mixture of these two. With this range of possibilities, it would be
unwise to assume that Vivian (or anyone else) will necessarily react to a wage increase by working
substantially more hours. Maybe they will; maybe they will not

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PART D

An involuntary unemployment means a situation in which all able persons who are willing to work at the
prevailing wage rate do not get work.

Such people are (i) physically and mentally fit to work and are also (ii) willing to work at the going rate
but are out of Job.

Thus, their unemployment is involuntary (i.e., not voluntary) because they are rendered unemployed
against their wishes.

This type of unemployment is due to deficiency of aggregate demand sufficient to ensure full
employment. It indicates excess supply of labour which the rigid wage-rate has failed to eliminate. In
short, if involuntary unemployment exists, the economy cannot be said to be at the level of full
employment equilibrium. It will indicate under-employment equilibrium in the economy.

It needs to be understood that involuntary unemployment is different from voluntary unemployment.

Voluntary unemployment refers to a situation when persons who are able to work but are not willing to
work although suitable work is available for them. In other words, they are voluntarily unemployed, i.e.,
unemployed of their own will.

Such persons are not included in labour force of the country. On the contrary, involuntary
unemployment occurs when those who are able and willing to work at the going wage rate do not get
work. Hence, they are unemployed against their wishes.

Significance of distinction is that the magnitude of unemployment in an economy, is reflected by the

magnitude of involuntary unemployment since the former includes only involuntary unemployment.
According to Keynes, involuntary unemployment arises due to insufficiency of effective demand which
can be solved by stepping up aggregate demand through government intervention.

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EXERCISE 4

PART A

The government influences investment, employment, output and income in the economy through fiscal
policy. For an expansionary fiscal policy, the government increases its expenditure or/and reduces taxes.
This shifts the IS curve to the right.

The government follows a contractionary fiscal policy by reducing its expenditure or/and increasing
taxes. This shifts the IS curve to the left.
Graph illustrates an expansionary fiscal policy with given IS and TR curves. Suppose the economy is in
equilibrium at point E with OR interest rate and OY income. An increase in government spending or a
decrease in taxes shifts the IS curve upwards to IS which intersects the TR curve at E1 .This raises the
national income from OY to OY1. The rise in the national income increases the demand for money, given
the fixed money supply. This, in turn, raises the interest rate from OR to OR1.The increase in the interest
rate tends to reduce private investment expenditure at the same time when the government
expenditure is being increased.

If the interest rate had not changed with the increase in government expenditure, income would have
risen to OY1 level. But the actual increase in income has been less by Y2Y1 due to the increase in the
interest rate to OR1 which has reduced private investment expenditure. The opposite happens in a
contractionary fiscal policy.

Fiscal policy is completely ineffective, if the IS curve is horizontal. A horizontal IS curve means that
investment expenditure is perfectly interest elastic. This is depicted in the graph where the LM curve
intersects the TR curve at E. An increase in government expenditure has no effect on the interest rate
OR and hence on the income level OY. Such a situation is not likely to be in practice.
KEYNESIAN MULTIPLIER:

Output is the product of multiplier and autonomous spending.

Multiplier: 1/(1 ‐ c(1‐t)) ≈ 2

Autonomous Spending: [C0 + cTr + I0 + G0]

“Induced” spending leads to non‐trivial trivial multiplier.

Multiplier answers the question “If autonomous expenditures rise for some exogenous reason, how
much does total real income rise in equilibrium?”
PART B:

Subpart i:

Under Flexible Inflation Targeting (FIT), the overriding objective of Monetary Authorities (MA) across the
world is to achieve price stability. At the same time, MA also minimizes the undesirable fluctuations in
other key macroeconomic variables such as economic growth. To achieve this objective, central banks
choose appropriate intermediate and operational targets. Typically, the intermediate target is the
variable which helps in predicting the path of ultimate targets while the operational target is the
variable that the central bank can control on a daily basis.

The theoretical approach, where the central bank minimizes a squared loss function with inflation and
resource utilization has been in the monetary policy toolbox for a long time, and it has been useful in
developing flexible inflation targeting. It captures in an illustrative and relatively simple way the essence
of inflation targeting and it has helped to structure our thinking. The mean squared gap analysis makes it
easier for the central bank to explain why it chooses a particular monetary policy – what it means more
specifically by a “well-balanced” policy. It can also provide support when assessing monetary policy.

Subpart ii:

Pandemic Scenarios:

It is easy to imagine that this final mix of the two policy instruments is not optimal from the perspective
of the economy as a whole. The means of control for monetary policy and risk have been used much
more aggressively than is beneficial for the economy and also more aggressively than either the central
bank or the financial supervisory authority would wish. Of course, one can discuss how realistic this
particular example is. But I nevertheless believe that it illustrates the importance of formulating the
authorities’ mandate and powers of authority wisely. It also shows that monetary policy and regulation
are connected. Each regulation creates a form of “shadow interest rate”. So how can we avoid policy
“drifting away” in this unfortunate manner? One possibility is to try to formulate the tasks of the central
bank and the financial supervisory authority so that they make a unanimous assessment of what needs
to be done. In the figure this would correspond to the green and red curves coinciding. If the curves lie
exactly on top of one another, there will not be any interaction that leads to the two means of control
being used too aggressively.

PART C
The Taylor rule (TR) has replaced the LM curve in modern business cycle models. The Taylor rule
describes how the central bank should set the interest rate, depending on the target interest rate,
inflation and output gap. The output gap is the deviation of output from its natural or potential level.
Inflation is assumed to match the inflation target of the ECB. Therefore, the Taylor rule can be written as

i = i + bY

where i is the target interest rate of the central bank, and b is a parameter governing the central bank’s
response to the output gap, denoted by Y . The Taylor rule represents the combinations of output and
interest rate that characterize the central bank’s monetary policy. The TR curve moves only if monetary
policy is changed.
IFM SCHEDULE:

Equilibrium on the international financial markets (IFM)

EXCHANGE RATE REGIME OF DENMARK:

(Fixed Exchange Rate):

Central Bank stands ready to buy and sell their currencies at a fixed price CB intervenes when there is an
excess supply or demand of the currency at the fixed exchange rate Ex: Denmark → Euro

EXCHANGE RATE REGIME OF NORWAY:

(Flexible Exchange Rate):

Central banks allow the exchange rate to adjust to equate the supply and demand for foreign currency.
The British pound floats freely against both the US dollar and the Euro. The fluctuations can be very
large.

PART D:

The primary cause of shifts in the economy is aggregate demand. Recall that aggregate demand can be
affected by consumers both domestic and foreign, the Fed, and the government. For a review of the
shifters of aggregate demand, see the SparkNotes on aggregate demand. In general, any expansionary
policy shifts the aggregate demand curve to the right while any contractionary policy shifts the
aggregate demand curve to the left. In the long run, though, since long-term aggregate supply is fixed by
the factors of production, short-term aggregate supply shifts to the left so that the only effect of a
change in aggregate demand is a change in the price level.

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