Name: Lazik Ahmed

Student Id: 20213

Course: Macroeconomics

Macroeconomics
Assignment # 1

 Q 2: Choose any one CAUSE (Great Depression, First Oil Price Shock, Second Oil Price
Shock and 9/11/2001) and define how an economy is affected by these factors.

The Great Depression and its effects on an economy.

The Great Depression (1929–1939) was a global economic crisis that caused significant declines in
economic activity, widespread unemployment, and severe deflation.

Effects of the Great Depression on an Economy:

1. Mass Unemployment:
o Industries faced plummeting demand, leading to layoffs and unemployment. In
the U.S., unemployment rates peaked at around 25%.
2. Decline in Gross Domestic Product (GDP):
o The global economy shrank drastically. In the U.S., GDP fell by nearly 30% from
1929 to 1933.
3. Deflation:
o Prices of goods and services dropped sharply, reducing profits for businesses and
discouraging production.
4. Banking Failures:
o A wave of bank collapses wiped out personal savings, further reducing consumer
spending and economic activity.
5. Global Trade Contraction:

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 oProtectionist policies, like the U.S.'s Smoot-Hawley Tariff Act, caused global
trade to decline by nearly 66% from 1929 to 1934.
6. Widening Inequality:
o Wealth disparities exacerbated the crisis as lower-income households bore the
brunt of unemployment and poverty.

Graph Representation:

The graph will show the following:

 GDP Decline: A sharp downward trend in GDP during 1929–1933.

 Unemployment Rates: A spike in unemployment rates during the same period.
 Deflation: A line showing the significant drop in price levels.

 GDP Decline (Blue Line): GDP fell sharply between 1929 and 1933, reflecting a severe
contraction in economic activity.
 Unemployment Rate (Red Line): Unemployment surged, peaking around 25% by 1933,
demonstrating the human cost of the crisis.
 Price Level (Green Line): Deflation occurred as prices plummeted, reducing purchasing
power and discouraging investment.

Chapter 2
 Q1: Difference between GDP & GNP.

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 GDP (Gross Domestic Product) GDP (Gross Domestic Product)

Total market value of all goods and Total market value of all goods and services produced

services produced within a country’s within a country’s borders during a specific period.

borders during a specific period.

Only includes the value of goods and Only includes the value of goods and services produced
services produced within the country. within the country.

GDP = C + I + G + (X - M) (Consumption +
GDP = C + I + G + (X - M) (Consumption + Investment +
Investment + Government spending + Net
Government spending + Net exports)
exports)

 Q2: Differentiate Nominal GDP and real GDP. Explain with numerical examples.

Nominal GDP

Nominal GDP is the total value of all goods and services produced in a country within a
given time period, valued at current prices. It does not account for inflation or deflation,
meaning it can be affected by changes in the price level over time.

Formula:

Nominal GDP=∑ (Quantity of goods and services x Current prices)

Real GDP

Real GDP, on the other hand, adjusts for inflation by valuing goods and services at
constant prices from a base year. This provides a more accurate representation of an
economy’s true growth by isolating changes in output from changes in price levels.

Formula:

Real GDP=∑ (Quantity of goods and services x base year prices)

Example:

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Let’s consider an economy with only two goods: Apples.

Price per Book (P) Nominal GDP Price Index (Base

Year Quantity of Books (Q)
(P × Q) Year = 2022)
2022 100 apples $10 $1000 100
2023 120 apples $12 $1440 120

1. Nominal GDP:

Nominal GDP is calculated using current prices:

 2022: 100×10=1,000100 \times 10 = 1,000100×10=1,000

 2023: 120×12=1,440120 \times 12 = 1,440120×12=1,440

2. Real GDP:

Real GDP adjusts for price changes using a base year's prices (2022 prices in this example):

 2022: 100×10=1,000100 \times 10 = 1,000100×10=1,000

 2023: 120×10=1,200120 \times 10 = 1,200120×10=1,200

Differences:
 Nominal GDP (2023): $1,440 (reflects both quantity and price increases).

 Real GDP (2023): $1,200 (reflects only quantity increase, holding prices constant).

 Q3: What do you understand about the GDP Deflator? Do you think inflation rate
represents GDP Deflator?

The GDP deflator is an economic measure that helps to adjust Nominal GDP to Real GDP, effectively
removing the impact of price changes (inflation or deflation) from the GDP calculation. It reflects the
ratio of Nominal GDP to Real GDP and is used to measure the level of prices of all goods and services in
an economy. The formula for the GDP deflator is:

by comparing these two measures, the GDP deflator indicates how much of the change in GDP
is due to changes in the price level rather than changes in the quantity of goods and services

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produced. A GDP deflator greater than 100 suggests that prices have risen since the base year
(inflation), while a deflator less than 100 indicates deflation.

 Q4: Compute the CPI. What is the difference between CPI and GDP deflator?
Difference Between CPI and GDP Deflator
The Consumer Price Index (CPI) and GDP Deflator are both measures of price levels, but they differ in
the following ways:

 CPI: Measures the price level of a fixed basket of goods and services purchased by
consumers. It includes goods and services purchased by households, such as food,
clothing, and entertainment.
 GDP Deflator: Measures the price level of all final goods and services produced
within a country. It includes both consumption and investment goods, government
spending, and exports, but excludes imports.

1. Cost of the Basket for Each Year:

Since we're assuming 1 unit of each good:
2012: Cost of Basket (2012)=(100×1)+(200×1)=100+200=300
2013:Cost of Basket (2013)=(150×1)+(200×1)=150+200=350
2014:Cost of Basket (2014)=(180×1)+(250×1)=180+250=430
2015:Cost of Basket (2015)=(200×1)+(300×1)=200+300=500
2016 (Base Year): Cost of Basket (2016)=(200×1)+(400×1)=200+400=600

2. CPI for Each Year (using 2016 as the base year):

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 2012:

2013:

2014:

2015

2016

3. Inflation Rate (Year-to-Year):

The Inflation Rate is calculated as:

2013 (Inflation from 2012 to 2013):

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2014 (Inflation from 2013 to 2014):

2015 (Inflation from 2014 to 2015):

2016 (Inflation from 2015 to 2016):

Final Summary:

Year Cost of Basket ($) CPI Inflation Rate (%)

2012 300 50 -
2013 350 58.3 16.67
2014 430 71.7 23
2015 500 83.3 16.33
2016 600 100 20

This table shows the cost of the basket, CPI, and inflation rate for each year with 2016 as the base year.

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We choose 2018 as the base year, and the basket's quantities will be fixed as the base year's
quantities (100 units of Good X and 40 units of Good Y).

Base Year 2018:

Year 2018 = (100×10)+(40×5)=1,000+200 = 1,200

Year 2019 = (150 x 20) + (45 x 8) = 2,000 + 320 = 3360
Year 2020 = (200 x 30)+ (50 x 10) = 3000+400 = 6500

To calculate real GDP for each year using 2018 as the base year, we use the formula:

Real GDP=(Base Year Price of Good X×Quantity of Good X)+(Base Year Price of Good Y×Qua
ntity of Good Y)

In this case, 2018 prices are used for the calculation of real GDP in subsequent years (2019 and
2020). We will calculate real GDP for each year as follows:

Base Year Prices (2018):

 Price of Good X = 10
 Price of Good Y = 5

For 2018 (Real GDP using 2018 as the base year):

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Since it's the base year, real GDP equals nominal GDP:

Real GDP (2018)=(10×100)+(5×40)=1000+200=1200

For 2019 (using 2018 prices):

Real GDP (2019)=(10×150)+(5×45)=1500+225+=1725

For 2020 (using 2018 prices):

Real GDP (2020)=(10×200)+(5×50=2000+250=2250

Summary of Real GDP for each year:

 2018: 1200
 2019: 1725
 2020: 2250

These are the real GDP values for each year based on 2018 as the base year.

 Q5: Justify the reasons why CPI may overstate inflation.

The Consumer Price Index (CPI) may overstate inflation due to several factors. First, substitution bias
occurs because the CPI uses a fixed basket of goods, ignoring consumer shifts to cheaper alternatives
when prices rise. Second, the quality adjustment problem arises when price increases are not fully
adjusted for improvements in product quality. Third, the CPI may not capture the effects of new
products or innovations, which can lead to an overestimation of inflation. Lastly, geographic bias can
occur, as the CPI is based on urban prices and may not reflect regional differences. These factors can
cause the CPI to overstate the true cost of living.

 Q6:Define unemployment rate. How can we represent the unemployment rate in an

economy?

The unemployment rate is the percentage of the labor force that is actively seeking employment but is
unable to find work. It is a key indicator of labor market health and reflects the portion of the population
that is willing and able to work but is unable to secure a job.

Representation in an Economy:

The unemployment rate is typically represented as a percentage and is often reported monthly
or quarterly by government statistical agencies, like the Bureau of Labor Statistics (BLS) in the
United States. It provides insight into the economic health of a country or region. High
unemployment can indicate economic distress, while low unemployment suggests a healthy,
thriving economy.

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The unemployment rate is also commonly broken down into various types, including:

 Frictional Unemployment: Short-term unemployment as individuals move between jobs or

enter the labor market.
 Structural Unemployment: Unemployment due to shifts in the economy that create a mismatch
between workers' skills and job requirements.
 Cyclical Unemployment: Unemployment caused by economic downturns or recessions.

In economic models, the unemployment rate is a crucial variable used to assess economic
performance and labor market dynamics.

Chapter 3

 Q2: Define GDP. Also define the Components of GDP a) Consumption b) Investment c)
Government Spending

Gross Domestic Product (GDP)

GDP refers to the total monetary or market value of all final goods and services produced
within a country’s borders over a specific time period (usually a year or a quarter). It is used to
measure the size and health of an economy, indicating the total economic output of a nation.

Components of GDP:

Consumption (C):

Consumption refers to the total spending by households on goods and services. This
includes durable goods (e.g., cars, appliances), non-durable goods (e.g., food, clothing),
and services (e.g., healthcare, education, entertainment). Consumption is the largest
component of GDP in most economies and reflects consumer demand in the economy.

Investment (I):

Investment refers to spending on capital goods that will be used for future production.
It includes business investments in equipment, machinery, and infrastructure, as well as
residential construction and inventory changes. Investment is crucial because it
represents spending on productive capacity that can increase future output and
economic growth.

Government Spending (G):

Government Spending includes all government expenditures on goods and services that
are used to provide public goods and services, such as defense, education,

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 infrastructure, healthcare, and public employee wages. It does not include transfer
payments (e.g., social security, unemployment benefits), as they are not payments for
goods or services but rather a redistribution of income.

 Q4: What is Diminishing Marginal Return?

Diminishing Marginal Return refers to the economic principle that as more units of a variable input (like
labor) are added to a fixed amount of other inputs (like capital), the additional output (marginal return)
from each new unit of input will eventually decrease. Initially, adding more input can increase output,
but after a certain point, each additional unit contributes less to total production. Eventually, too many
inputs can lead to reduced efficiency or even negative returns. This concept highlights the limits to
productivity growth from increasing a single input while keeping others constant.

 Q5: Define the Following terms

 Budget Surplus
 Budget Deficit

Budget Surplus:

A budget surplus occurs when a government's revenues exceed its expenditures over a specific
period, typically a year. In other words, the government collects more money in taxes and other
revenues than it spends on public services, infrastructure, and other programs. A budget
surplus can be used to pay down debt, save for future spending, or fund other projects.

Budget Deficit:

A budget deficit happens when a government's expenditures exceed its revenues during a
given period. In this situation, the government spends more money than it earns through taxes
and other revenue sources. To cover the shortfall, the government may borrow money, often
by issuing bonds. A persistent budget deficit can lead to higher national debt.

Chapter 4
 Q1: Define Money. What are the functions of Money
Money: is any asset that is widely accepted as a medium of exchange for goods, services, or
settlement of debts within an economy. It serves as a standard of value, making transactions
easier compared to barter systems, where goods are directly exchanged for other goods.

Functions of Money:

Money serves several essential functions in an economy, which are:

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 1. Medium of Exchange: Money is used to facilitate transactions. Instead of exchanging
goods directly (barter), money allows people to buy and sell goods and services
efficiently.
2. Unit of Account: Money provides a standard measure of value, allowing goods and
services to be priced and compared. It helps in tracking the value of things in a
consistent way.
3. Store of Value: Money retains its value over time, allowing individuals to store wealth
and use it in the future. It doesn't lose value quickly, making it a reliable way to save.
4. Standard of Deferred Payment: Money is used to settle debts and obligations that are
due in the future. It allows agreements to be made where payment is promised at a
later date.

 Q16: How many kinds of Money are there?

 Define the following term

 OMO (Open Market Operation)

 Reserve Ratio
 Money Multiplier

Here are generally three main kinds of money in an economy, based on their form and how they are
used:

1. Commodity Money:
o This type of money has intrinsic value, meaning the material itself is valuable. It can be
used for trade or consumption, even if it were not used as money. Examples include
precious metals like gold or silver, or other items such as grain or cattle in ancient
economies.
2. Fiat Money:
o Fiat money is money that has no intrinsic value but is made legal tender by government
decree. Its value comes from the trust and confidence people have in the government
that issues it. Modern currencies like dollars, euros, and yen are examples of fiat
money. It is the most common form of money used today.
3. Representative Money:
o Representative money is a type of money that represents a claim on a commodity (such
as gold or silver) that can be redeemed upon demand. It has no intrinsic value on its
own but can be exchanged for a specific amount of a commodity. Examples include
paper notes that were once backed by a reserve of gold, like gold certificates.

Open Market Operations (OMO) refer to the buying and selling of government securities
(such as Treasury bonds or bills) by a country's central bank (e.g., the Federal Reserve in the
U.S.) in the open market. OMOs are a key tool used by central banks to regulate the money
supply and influence short-term interest rates.

Reserve Ratio:

The reserve ratio (also known as the reserve requirement) is the fraction of customer deposits
that commercial banks are required to hold in reserve and not lend out. This reserve can be held

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 as cash in the bank or as deposits with the central bank. The reserve ratio is set by the central
bank and is a tool used to control the amount of money circulating in the economy. A higher
reserve ratio means banks must keep more money in reserve, limiting the amount available for
loans, while a lower reserve ratio increases the capacity for banks to lend, thereby stimulating
economic activity.

Money Multiplier:

The money multiplier refers to the process by which the banking system can increase the total
money supply in an economy, based on the reserve ratio. It is the ratio of the amount of money the
banking system generates with each dollar of reserves.

 Q17: What are the three Primary functions of the Central Bank? What are the problems
faced by Central Bank to control the Money Supply

Three Primary Functions of the Central Bank:

1. Monetary Policy: The central bank controls the money supply and interest rates to stabilize the
economy.
2. Lender of Last Resort: It provides emergency funding to banks facing liquidity issues.
3. Banking Regulation: The central bank supervises and regulates the banking system to ensure
stability.

Problems Faced by the Central Bank in Controlling the Money Supply:

1. Liquidity Traps: When interest rates are low, monetary policy may become ineffective, as
people may hoard money.
2. Uncertainty: Expectations about inflation or deflation can disrupt the central bank’s policy
actions.
3. Time Lags: Monetary policies take time to affect the economy.
4. Global Influences: External factors like foreign investment and global trade can impact domestic
money supply.
5. Bank Behavior: Banks may be reluctant to lend, limiting the central bank’s influence on the
money supply.
6. Fiscal Policy Conflicts: Government spending and borrowing can complicate the central bank’s
efforts to control inflation and the money supply.

 Q18: What are the tools of Monetary Policy?

The main tools of monetary policy are:

1. Open Market Operations (OMO): Buying or selling government securities to increase or

decrease the money supply.
2. Discount Rate: The interest rate at which commercial banks borrow from the central bank,
influencing borrowing and lending.

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 3. Reserve Requirements: The percentage of deposits banks must hold in reserve, controlling how
much they can lend.
4. Interest on Reserves: The rate paid on reserves held by banks at the central bank, affecting their
lending behavior.

Chapter 5
 Q19: What are the connection between Money and Prices?

The connection between money and prices is fundamentally rooted in the quantity theory of money,
which suggests that the amount of money in circulation directly affects the price level in an economy.
This relationship can be summarized as follows:

1. Inflation: When the money supply increases faster than the economy's output of goods and
services, there are more dollars chasing the same amount of goods. This can lead to higher
prices (inflation). In other words, if there’s more money in the economy but no corresponding
increase in goods and services, the purchasing power of money decreases, causing prices to rise.
2. Price Level: The price level refers to the average prices of goods and services in the economy.
An increase in the money supply, if not matched by an increase in the supply of goods and
services, tends to push prices up. Conversely, a reduction in the money supply can lead to falling
prices (deflation).
3. Demand and Supply: The demand for goods and services in the economy is influenced by the
amount of money available. More money can lead to higher demand, which can push prices
higher. Conversely, less money can reduce demand and lead to lower prices.

 Q20: What is the Role of the Central Bank. What do you understand by Quantity Theory of
Money

Role of the Central Bank:

1. Monetary Policy: Controls money supply and interest rates to manage inflation, stabilize the
currency, and support economic growth using tools like open market operations and reserve
requirements.
2. Lender of Last Resort: Provides emergency loans to banks in crises to prevent financial
instability.
3. Banking Regulation: Oversees the banking sector to ensure stability and consumer protection.
4. Issuing Currency: Manages and issues the country's currency to meet economic demand.
5. Foreign Exchange Management: Manages foreign reserves and may intervene in currency
markets to stabilize the exchange rate.

Quantity Theory of Money:

The Quantity Theory of Money is an economic theory that asserts a direct relationship between the
money supply in an economy and the price level. It is often expressed by the equation:

M×V=P×T

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Where:

 M = Money supply
 V = Velocity of money (the number of times money circulates in the economy)
 P = Price level
 T = Total output (real GDP)

 Q21: Define Velocity. What do you understand by Money Demand and the Quantity
Equation

Velocity: Velocity, in physics, is the rate of change of an object's position with respect to time. It's a
vector quantity, measured in meters per second (m/s) or other units of distance per unit time. In
economics, velocity refers to:

Velocity of Circulation (or Money Velocity): The rate at which money changes hands within an
economy, measured by the number of times a unit of currency is spent within a given period.

Velocity of Money: The rate at which money circulates through the economy, influencing inflation
and economic activity.

Money Demand:

Money Demand refers to the desire of individuals, businesses, and governments to hold cash or
other liquid assets (e.g., checking accounts) for transactions, precautionary, and speculative
purposes. It represents the amount of money people want to keep available for spending.

Factors influencing Money Demand:

 Income
 Interest rates
 Inflation expectations
 Transaction costs
 Uncertainty

Quantity Equation (Money Supply and Money Demand):

The Quantity Equation, also known as the Fisher Equation, relates the money supply (M) to the
velocity of money (V), the price level (P), and the quantity of goods and services (Q):

MV = PQ

Where: M = Money Supply (stock of money) V = Velocity of Money (rate of circulation) P = Price
Level (average price of goods and services) Q = Quantity of Goods and Services (real GDP)

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This equation states that the money supply multiplied by its velocity equals the price level multiplied by
the quantity of goods and services.

 Q22: What are the Confronting, the Quantity Theory with Data Analysis

Confronting the Quantity Theory with data analysis involves testing its predictions against empirical
evidence. Here's a breakdown:

Quantity Theory Predictions:

 Money supply growth → Inflation (MV = PQ)

 Velocity (V) remains relatively constant
 Money demand is proportional to income (Transaction motive)

Data Analysis Challenges:

 Measuring Money Supply (M): Various definitions (M1, M2, M3) and difficulties in
tracking money creation.
 Estimating Velocity (V): Complexities in measuring money circulation.
 Identifying Price Level (P): Choosing appropriate price indices (CPI, GDP Deflator).
 Accounting for Quantity (Q): Measuring real GDP.

Empirical Findings:

 Velocity instability: V has varied significantly over time, contradicting the assumption of
constancy.
 Money demand instability: Income elasticity of money demand has changed, casting
doubt on the transaction motive.
 Inflation deviations: Money supply growth doesn't always lead to inflation (e.g., during
periods of low demand).
 Complex relationships: Multiple factors influence money supply, velocity, and prices,
making it challenging to isolate causal relationships.

Data Analysis Techniques:

 Time Series Analysis (TS)

 Regression Analysis
 Vector Auto regression (VAR)
 Cointegration Analysis
 Granger Causality Test

 Q23: What is the relationship between Inflation and Interest Rate (Fishers effect)

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The relationship between interest rates and inflation is complex and influenced by various economic
factors. Here's a breakdown:

Positive Relationship:

1. Inflation Expectations: Higher inflation expectations: lead to higher interest rates, as

lenders demand compensation for potential losses in purchasing power.
2. Monetary Policy: Central banks increase interest rates to combat inflation by reducing
borrowing, spending, and money supply.
3. Fisher Effect: Nominal interest rates rise with inflation, maintaining the real interest rate
(adjusted for inflation).

Negative Relationship:

1. Inflation Reduction: Lower interest rates can reduce inflation by stimulating economic
growth, increasing demand, and encouraging borrowing.
2. Deflationary Pressures: Low interest rates can combat deflation by encouraging
spending and investment.
3. Liquidity Trap: During economic downturns, low interest rates may not stimulate

 Q24: What is the relationship between Money Demand and the Nominal Interest Rate

Relationship between money demand and nominal interest

The relationship between money demand and nominal interest rate is inverse. As nominal interest rates
rise, the demand for money decreases, and vice versa. This is because higher interest rates make holding
money less attractive, as individuals and businesses can earn higher returns on investments. Conversely,
lower interest rates increase the demand for money, as borrowing becomes cheaper and saving less
lucrative. This phenomenon is known as the "opportunity cost" effect. According to the Liquidity
Preference Theory, people hold money for transactions, precautionary, and speculative motives. When
interest rates rise, the opportunity cost of holding money increases, reducing money demand.
Conversely, when interest rates fall, money demand increases as the opportunity cost decreases.

 Q25: Define the Money Demand Function / Equation. What is the Equilibrium Condition?

Money Demand Function:

The money demand function represents the relationship between the quantity of money demanded (M)
and its determining factors. It's typically expressed as: M = L(Y, r, π)

 Where:
 M = Quantity of money demanded
 L = Money demand function
 Y = Real income or GDP (transaction motive)
 i = Nominal interest rate (opportunity cost motive)

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  r = Real interest rate (opportunity cost motive)
 P = Price level (inflation expectations)
 π = Inflation rate (inflation expectations)

Determinants of Money Demand:

 Transaction motive (Y): Increased economic activity requires more money.

 Opportunity cost motive (i or r): Higher interest rates reduce money demand.
 Precautionary motive (P or π): Uncertainty and inflation expectations increase money
demand.
 Speculative motive (i or r): Expected changes in interest rates or asset prices influence
money demand.

Equilibrium Condition Characteristics:

 Quantity of money supplied equals quantity of money demanded.

 Interest rate adjusts to equilibrate the money market.
 Money market equilibrium influences overall economic equilibrium.

Types of Equilibrium:

Static Equilibrium: Short-run equilibrium, assuming fixed prices and income.

Dynamic Equilibrium: Long-run equilibrium, considering changes in prices, income, and expectations.

 Q26: If Money Supply Changes what will be the effect on prices in an Economy.

The effect of a change in money supply on prices in an economy depends on various factors, including
the state of the economy, monetary policy, and the elasticity of money demand. Here's a breakdown:

Increase in Money Supply:

 Short-term effects: - Increased borrowing and spending - Boost to economic activity -

Potential decrease in interest rates
 Long-term effects: - Inflation (higher prices) - Decreased purchasing power of money -
Potential currency devaluation

Decrease in Money Supply:

 Short-term effects: - Reduced borrowing and spending - Economic slowdown - Potential

increase in interest rates
 Long-term effects: - Deflation (lower prices) - Increased purchasing power of money -
Potential currency appreciation

Factors Influencing the Effect:

 Economic Growth: Strong growth can absorb increased money supply without inflation.

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  Unemployment: Low unemployment can lead to wage pressures and inflation.
 Inflation Expectations: Anchored expectations can mitigate inflationary effects.
 Monetary Policy Framework: Central bank's reaction function and policy goals.

 Q27: What do you understand by expected Inflation and why is Inflation bad in any
Economy

Expected inflation refers to the anticipated rate of inflation in the future, based on individuals',
businesses', and investors' expectations. These expectations influence economic decisions, such as wage
negotiations, pricing, investment choices, and monetary policy. Expected inflation can be shaped by past
inflation experiences, economic indicators, monetary policy actions, and global events.

Here are the reasons why inflation is considered harmful to the economy:

Negative Effects of Inflation:

 Erodes Purchasing Power: Inflation reduces the value of money, decreasing the
purchasing power of consumers.
 Uncertainty: Unpredictable price changes hinder long-term planning and investment.
 Inequality: Fixed-income earners, pensioners, and creditors lose purchasing power.
 Distorted Price Signals: Inflation obscures price information, leading to inefficient
resource allocation.
 Reduced Savings: High inflation discourages savings, as money loses value over time.

 Q28: Define the Term Hyperinflation. What are the causes of Hyperinflation? Why do
Government create Hyper Inflation?

Hyperinflation: Hyperinflation is an extremely high and accelerating rate of inflation, typically exceeding
50% per month or 100% per year. It renders the currency nearly worthless, causing widespread
economic disruption and social unrest.

Causes of Hyperinflation:

 Excessive Money Printing: Central banks print excessive amounts of money, flooding the
economy.
 Fiscal Irresponsibility: Governments incur massive debt, often due to war, corruption, or
poor economic management.
 Monetary Policy Mistakes: Central banks fail to adjust interest rates or maintain
adequate reserves.
 Supply Chain Disruptions: Wars, natural disasters, or global events disrupt production
and distribution.
 Loss of Confidence: Investors, consumers, and businesses lose faith in the currency and
economy.
 Political Instability: Weak or fragmented governments fail to implement effective
economic policies.

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Why Governments Create Hyperinflation:

 Revenue Generation: Governments may print money to finance spending and pay off
debts.
 War Efforts: Financing wars or military conflicts through money printing.
 Economic Stimulus: Attempting to boost economic growth through increased money
supply.
 Debt Monetization: Paying off debts by printing money.
 Political Expediency: Avoiding tough economic reforms or austerity measures.

Chapter # 06

 Q31: Differentiate between Nominal & Real Exchange Rate?

Nominal Exchange Rate (NER) and Real Exchange Rate (RER) are two distinct concepts in international
finance:

Nominal Exchange Rate (NER):

 The price of one country's currency in terms of another country's currency.

 Quoted exchange rate (e.g., USD/EUR, USD/JPY).
 Reflects current market conditions. Example: 1 USD = 0.88 EUR (nominal exchange rate)

Real Exchange Rate (RER):

 Adjusts NER for differences in countries' price levels (inflation).

 Measures purchasing power parity (PPP) between currencies.
 Reflects the relative value of goods and services.

RER = NER x (Foreign Country's Price Index / Domestic Country's Price Index)

Example: If US inflation is 2% and EU inflation is 1%, the RER would adjust the NER to reflect the
difference.

 Q32: What is the net export function and how NX (Net Export) depends on Exchange Rate.

Net Export Function:

NX = X - M Where: NX = Net Exports X = Exports M = Imports

Determinants of Net Exports:

 Exchange Rate (E)

 Foreign Income (Yf)

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  Domestic Income (Yd)
 Relative Prices (Domestic vs. Foreign)
 Trade Policies (Tariffs, Quotas)
 Exchange Rate and Net Exports:

Depreciation (Weakening) of Domestic Currency:

 Increases Export Competitiveness (Cheaper Exports)

 Reduces Import Demand (More Expensive Imports)
 Increases NX (Higher Exports, Lower Imports)
 Appreciation (Strengthening) of Domestic Currency:
 Reduces Export Competitiveness (More Expensive Exports)
 Increases Import Demand (Cheaper Imports)
 Decreases NX (Lower Exports, Higher Imports)

 Q34: Define PPP (Purchasing Power Parity) Does it hold in the real world?

Purchasing Power Parity (PPP):

Purchasing Power Parity is a theory that states that exchange rates should adjust to equalize the
purchasing power of different currencies. According to PPP, a unit of currency should be able to buy the
same amount of goods and services in different countries.

PPP Formula: PPP = Domestic Price / Foreign Price = Exchange Rate

Does PPP Hold in the Real World?

Empirical evidence suggests that PPP does not hold perfectly in the real world due to:

Violations of Assumptions:

 Trade barriers
 Transportation costs
 Non-homogeneous goods
 Different consumer preferences
 Exchange rate fluctuations

Empirical Findings:

 PPP deviations persist in the long run.

 Exchange rates can deviate from PPP by up to 50%.

 Q35: Which of these are Money

1. Currency

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 2. Demand
3. Debit Card
4. Demand Deposit
5. Time Deposit

Here's the classification:

Money:
 Currency (cash)
 Demand Deposit (checking account)
 Time Deposit (savings account, certificates of deposit)

Currency:
 Coins
 Banknotes

Demand Deposit:
 Checking accounts
 Current accounts
 Debit cards (linked to checking accounts)

Time Deposit:
 Savings accounts, Certificates of deposit (CDs),
 Fixed deposits
 Term deposits

Debit Card:
 A payment card linked to a demand deposit account (checking account)
 Not a type of money or deposit, but a means to access demand deposits

Not classified as Money:

 Credit cards (revolving credit)
 Loans
 Investments (stocks, bonds, etc.)
 Digital currencies (crypt currencies, not widely accepted as legal tender)

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