MEC-002: MACROECONOMIC ANALYSIS

Assignment

Course Code: MEC-002

Assignment Code: MEC-002/AST/2017-18
Maximum Marks: 100

Note: Answer all the questions. While questions in Section A carry 20 marks each, those in
Section B carry 12 marks each.

Section A

1. Bring out the salient features of Ramsey model for decentralized households (your
answer should include the assumptions, important equations, phase diagram and its
interpretation). In what respect is it different from the Solow model?

2. In an open economy with fixed exchange rate, the government does not have autonomy
in monetary policy. Do you agree with this statement? Justify your answer.

Section B

3. Explain how inflation unemployment trade off is not possible in the long run.

4. Critically evaluate the endogenous growth theory.

5. Specify, in detail, the various components that put together, generate business cycle
according to Michal Kalecki.

6. Explain why prices and wages may not be flexible in an economy.

7. Write short notes on the following.

a) Lucas Critique

b) Absolute and Conditional Convergence

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 ASSIGNMENT SOLUTION GUIDE
SESSION: (2017-2018)

MEC-02
MACRO ECONOMIC ANALYSYS
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ANSWERS
Section - A
Q1. Bring out the salient features of Ramsey model for decentralized households (your
answer should include the assumptions, important equations, phase diagram and its
interpretation). In what respect is it different from the Solow model?
ANS.
The Ramsey–Cass–Koopmans model, or Ramsey growth model, is a neo-classical model of economic growth based
primarily on the work of Frank P. Ramsey, with significant extensions by David Cass and Tjalling Koopmans. The
Ramsey–Cass–Koopmans model differs from the Solow–Swan model in that the choice of consumption is explicitly
micro founded at a point in time and so endogenizes the savings rate. As a result, unlike in the Solow–Swan model,
the saving rate may not be constant along the transition to the long run steady state. Another implication of the
model is that the outcome is Pareto optimal or Pareto efficient.

Originally Ramsey set out the model as a central planner's problem of maximizing levels of consumption over
successive generations. Only later was a model adopted by Cass and Koopmans as a description of a decentralized
dynamic economy. The Ramsey–Cass–Koopmans model aims only at explaining long-run economic growth rather
than business cycle fluctuations, and does not include any sources of disturbances like market imperfections,
heterogeneity among households, or exogenous shocks. Subsequent researchers therefore extended the model,
allowing for government-purchases shocks, variations in employment, and other sources of disturbances, which is
known as real business cycle theory.

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Phase space graph (or phase diagram) of the Ramsey model. The blue line represents the dynamic adjustment (or
saddle) path of the economy in which all the constraints present in the model are satisfied. It is a stable path of the
dynamic system. The red lines represent dynamic paths which are ruled out by the transversality condition.

Like the Solow–Swan model, the Ramsey–Cass–Koopmans model starts with an aggregate production function that
satisfies the Inada conditions, of Cobb–Douglas type, with factors capital K and labour L

where k is capital intensity (capital per worker), k is change in capital per

worker over time

c is consumption per worker, f(k) is output per worker, and is the depreciation rate of capital. Under the
simplifying assumption that there neither population growth nor an increase in technology level, this equation
states that investment, or increase in capital per worker is that part of output which is not consumed, minus the
rate of depreciation of capital. Investment is, therefore, the same as savings.

It also yields a potentially optimal steady-state of the growth model, in which k=0 i.e. no (further) change in capital
intensity. Now, an has to determine the steady-state which maximizes consumption c , and yields an optimal savings
rate

This is the “golden rule” optimality condition proposed by Edmund Phelps in 1961.

where I is the level of investment, Y is level of income and s is the savings rate, or the proportion of income that is
saved.

The second equation concerns the saving behavior of households and is less intuitive. If households are maximizing
their consumption intertemporally, at each point in time they equate the marginal benefit of consumption today

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with that of consumption in the future, or equivalently, the marginal benefit of consumption in the future with its
marginal cost. Because this is an intertemporal problem this means an equalization of rates rather than levels. There
are two reasons why households prefer to consume now rather than in the future. First, they discount future
consumption. Second, because the utility function is concave, households prefer a smooth consumption path. An
increasing or a decreasing consumption path lowers the utility of consumption in the future. Hence the following
relationship characterizes the optimal relationship between the various rates:

rate of return on savings = rate at which consumption is discounted − percent change in marginal utility times the
growth of consumption.

Mathematically:

A class of utility functions which are consistent with a steady state of this model are the isoelastic or constant
relative risk aversion (CRRA) utility functions, given by:

In this case we have:

Then solving the above dynamic equation for consumption growth we get:

which is the second key dynamic equation of the model and is usually called the "Euler equation".

With a neoclassical production function with constant returns to scale, the interest rate, r, will equal the marginal
product of capital per worker. One particular case is given by the Cobb–Douglas production function.

which implies that the gross interest rate is

hence the net interest rate r

Setting k and c equal to zero we can find the steady state of this model.

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Q2. In an open economy with fixed exchange rate, the government does not have
autonomy in monetary policy. Do you agree with this statement? Justify your answer.
ANS.
A fixed exchange rate, monetary autonomy and the free flow of capital are incompatible, according to the last in
our series of big economic ideas. The policy trilemma, also known as the impossible or inconsistent trinity, says a
country must choose between free capital mobility, exchange-rate management and monetary autonomy (the
three corners of the triangle in the diagram). Only two of the three are possible. A country that wants to fix the
value of its currency and have an interest-rate policy that is free from outside influence (side C of the triangle)
cannot allow capital to flow freely across its borders. If the exchange rate is fixed but the country is open to cross-
border capital flows, it cannot have an independent monetary policy (side A). And if a country chooses free capital
mobility and wants monetary autonomy, it has to allow its currency to float (side B).

To understand the trilemma, imagine a country that fixes its exchange rate against the US dollar and is also open
to foreign capital. If its central bank sets interest rates above those set by the Federal Reserve, foreign capital in
search of higher returns would flood in. These inflows would raise demand for the local currency; eventually the
peg with the dollar would break. If interest rates are kept below those in America, capital would leave the country
and the currency would fall.

Where barriers to capital flow are undesirable or futile, the trilemma boils down to a choice: between a floating
exchange rate and control of monetary policy; or a fixed exchange rate and monetary bondage. Rich countries have
typically chosen the former, but the countries that have adopted the euro have embraced the latter. The sacrifice
of monetary-policy autonomy that the single currency entailed was plain even before its launch in 1999.

In the run up, aspiring members pegged their currencies to the Deutschmark. Since capital moves freely within
Europe, the trilemma obliged would-be members to follow the monetary policy of Germany, the regional power.
The head of the Dutch central bank, Wim Duisenberg (who subsequently became the first president of the European
Central Bank), earned the nickname “Mr Fifteen Minutes” because of how quickly he copied the interest-rate
changes made by the Bundesbank.

This monetary serfdom is tolerable for the Netherlands because its commerce is closely tied to Germany and
business conditions rise and fall in tandem in both countries. For economies less closely aligned to Germany’s

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business cycle, such as Spain and Greece, the cost of losing monetary independence has been much higher: interest
rates that were too low during the boom, and no option to devalue their way out of trouble once crisis hit.

As with many big economic ideas, the trilemma has a complicated heritage. For a generation of economics students,
it was an important outgrowth of the so-called Mundell-Fleming model, which incorporated the impact of capital
flows into a more general treatment of interest rates, exchange-rate policy, trade and stability.

The model was named in recognition of research papers published in the early 1960s by Robert Mundell, a brilliant
young Canadian trade theorist, and Marcus Fleming, a British economist at the IMF. Building on his earlier research,
Mr Mundell showed in a paper in 1963 that monetary policy becomes ineffective where there is full capital mobility
and a fixed exchange rate. Fleming’s paper had a similar result.

If the world of economics remained unshaken, it was because capital flows were small at the time. Rich-world
currencies were pegged to the dollar under a system of fixed exchange rates agreed at Bretton Woods, New
Hampshire, in 1944. It was only after this arrangement broke down in the 1970s that the trilemma gained great
policy relevance.

Perhaps the first mention of the Mundell-Fleming model was in 1976 by Rudiger Dornbusch of the Massachusetts
Institute of Technology. Dornbusch’s “overshooting” model sought to explain why the newish regime of floating
exchange rates had proved so volatile. It was Dornbusch who helped popularise the Mundell-Fleming model
through his bestselling textbooks (written with Stanley Fischer, now vice-chairman of the Federal Reserve) and his
influence on doctoral students, such as Paul Krugman and Maurice Obstfeld. The use of the term “policy trilemma”,
as applied to international macroeconomics, was coined in a paper published in 1997 by Mr Obstfeld, who is now
chief economist of the IMF, and Alan Taylor, now of the University of California, Davis.

But to fully understand the providence—and the significance—of the trilemma, you need to go back further. In “A
Treatise on Money”, published in 1930, John Maynard Keynes pointed to an inevitable tension in a monetary order
in which capital can move in search of the highest return:

This then is the dilemma of an international monetary system—to preserve the advantages of the stability of
local currencies of the various members of the system in terms of the international standard, and to preserve at
the same time an adequate local autonomy for each member over its domestic rate of interest and its volume of
foreign lending.

This is the first distillation of the policy trilemma, even if the fact of capital mobility is taken as a given. Keynes was
acutely aware of it when, in the early 1940s, he set down his thoughts on how global trade might be rebuilt after
the war. Keynes believed a system of fixed exchange rates was beneficial for trade. The problem with the interwar
gold standard, he argued, was that it was not self-regulating. If large trade imbalances built up, as they did in the
late 1920s, deficit countries were forced to respond to the resulting outflow of gold. They did so by raising interest
rates, to curb demand for imports, and by cutting wages to restore export competitiveness. This led only to
unemployment, as wages did not fall obligingly when gold (and thus money) was in scarce supply. The system might
adjust more readily if surplus countries stepped up their spending on imports. But they were not required to do so.

Instead he proposed an alternative scheme, which became the basis of Britain’s negotiating position at Bretton
Woods. An international clearing bank (ICB) would settle the balance of transactions that gave rise to trade
surpluses or deficits. Each country in the scheme would have an overdraft facility at the ICB, proportionate to its
trade. This would afford deficit countries a buffer against the painful adjustments required under the gold standard.
There would be penalties for overly lax countries: overdrafts would incur interest on a rising scale, for instance.
Keynes’s scheme would also penalise countries for hoarding by taxing big surpluses. Keynes could not secure

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support for such “creditor adjustment”. America opposed the idea for the same reason Germany resists it today: it
was a country with a big surplus on its balance of trade. But his proposal for an international clearing bank with
overdraft facilities did lay the ground for the IMF.

Fleming and Mundell wrote their papers while working at the IMF in the context of the post-war monetary order
that Keynes had helped shape. Fleming had been in contact with Keynes in the 1940s while he worked in the British
civil service. For his part, Mr Mundell drew his inspiration from home.

In the decades after the second world war, an environment of rapid capital mobility was hard for economists to
imagine. Cross-border capital flows were limited in part by regulation but also by the caution of investors. Canada
was an exception. Capital moved freely across its border with America in part because damming such flows was
impractical but also because US investors saw little danger in parking money next door. A consequence was that
Canada could not peg its currency to the dollar without losing control of its monetary policy. So the Canadian dollar
was allowed to float from 1950 until 1962.

A Canadian, such as Mr Mundell, was better placed to imagine the trade-offs other countries would face once
capital began to move freely across borders and currencies were unfixed. When Mr Mundell won the Nobel prize
in economics in 1999, Mr Krugman hailed it as a “Canadian Nobel”. There was more to this observation than mere
drollery. It is striking how many academics working in this area have been Canadian. Apart from Mr Mundell, Ronald
McKinnon, Harry Gordon Johnson and Jacob Viner have made big contributions.

But some of the most influential recent work on the trilemma has been done by a Frenchwoman. In a series of
papers, Hélène Rey, of the London Business School, has argued that a country that is open to capital flows and that
allows its currency to float does not necessarily enjoy full monetary autonomy.

Ms Rey’s analysis starts with the observation that the prices of risky assets, such as shares or high-yield bonds, tend
to move in lockstep with the availability of bank credit and the weight of global capital flows. These co-movements,
for Ms Rey, are a reflection of a “global financial cycle” driven by shifts in investors’ appetite for risk. That in turn is
heavily influenced by changes in the monetary policy of the Federal Reserve, which owes its power to the scale of
borrowing in dollars by businesses and householders worldwide. When the Fed lowers its interest rate, it makes it
cheap to borrow in dollars. That drives up global asset prices and thus boosts the value of collateral against which
loans can be secured. Global credit conditions are relaxed.

Conversely, in a recent study Ms Rey finds that an unexpected decision by the Fed to raise its main interest rate
soon leads to a rise in mortgage spreads not only in America, but also in Canada, Britain and New Zealand. In other
words, the Fed’s monetary policy shapes credit conditions in rich countries that have both flexible exchange rates
and central banks that set their own monetary policy.

Rey of sunshine

A crude reading of this result is that the policy trilemma is really a dilemma: a choice between staying open to cross-
border capital or having control of local financial conditions. In fact, Ms Rey’s conclusion is more subtle: floating
currencies do not adjust to capital flows in a way that leaves domestic monetary conditions unsullied, as the
trilemma implies. So if a country is to retain its monetary-policy autonomy, it must employ additional
“macroprudential” tools, such as selective capital controls or additional bank-capital requirements to curb excessive
credit growth.

What is clear from Ms Rey’s work is that the power of global capital flows means the autonomy of a country with a
floating currency is far more limited than the trilemma implies. That said, a flexible exchange rate is not anything

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like as limiting as a fixed exchange rate. In a crisis, everything is suborned to maintaining a peg—until it breaks. A
domestic interest-rate policy may be less powerful in the face of a global financial cycle that takes its cue from the
Fed. But it is better than not having it at all, even if it is the economic-policy equivalent of standing on one leg.

Section - B
Q3.Explain how inflation unemployment trade off is not possible in the long run.
ANS.
A look at the extent to which policy makers face a trade off between unemployment and inflation. The Phillips
curve suggests there is a trade off between inflation and unemployment, at least in the short term. Other
economists argue the trade off between inflation and unemployment is weak.

Theory behind the Unemployment – Inflation trade off

• If the economy experiences a rise in AD, it will cause increased output.

• As the economy comes closer to full employment, we also experience a rise in inflation.
• However, with the increase in real GDP, firms take on more workers leading to a decline in unemployment
( a fall in demand deficient unemployment)
• Thus with faster economic growth in the short-term, we experience higher inflation and lower
unemployment.

Increase in AD causing inflation

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This Keynesian view of the AS curve suggests there can be a tradeoff between inflation and demand
deficient unemployment.

Phillips Curve Showing Tradeoff between unemployment and inflation

In this Phillips curve, the increase in AD has caused the economy to shift from point A to point B.
Unemployment has fallen, but at a trade off of higher inflation.

If an economy experienced inflation, then the Central Bank could raise interest rates. Higher interest rates
will reduce consumer spending and investment leading to lower aggregate demand. This fall in aggregate
demand will lead to lower inflation. However, if there is a decline in Real GDP, firms will employ fewer
workers leading to a rise in unemployment.

Empirical evidence behind trade off

This graph shows unemployment and inflation rate for the US economy.

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There are occasions when you can see a trade off. For example, between 1979 and 1983, we see inflation
(CPI) fall from 15% to 2.5%. During this period, we see a rise in unemployment from 5% to 11%.

In 2008, we saw inflation fall from 5% to 2%. During this time, we see a sharp rise in unemployment from
5% to over 10%.

This suggests there can be a trade off between unemployment and inflation.

UK Evidence – Unemployment v Inflation

% annual change in inflation and unemployment.

Monetarist View

The Phillips curve is criticized by the Monetarist view. Monetarists argue that increasing aggregate
demand will only cause a temporary fall in unemployment. In the long run, higher AD only causes inflation
and no increase in real GDP in the long term.

Monetarists argue LRAS is inelastic and therefore Phillips Curve looks like this:

Monetarist Phillips Curve Diagram

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Rational expectation monetarists believe there is no trade-off even in the short-term. They believe if the
government or Central Bank increased the money supply, people would automatically expect inflation, so
there would be no improvement in real GDP.

Falling Inflation and Falling Unemployment

In some periods, we have seen both falling unemployment and falling inflation. For example, in the 1990s,
unemployment fell, but inflation stayed low. This suggests that it is possible to reduce unemployment
without causing inflation.

However, you could argue there is still a potential trade off except the Phillips curve has shifted to the
left, because there is now a better trade off.
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It also depends on the role of Monetary policy. If monetary policy is done well, you can avoid some of the
boom and bust economic cycles we experienced before, and enable sustainable low inflationary growth
which helps reduce unemployment.

Rising Inflation and Rising Unemployment

It is also possible to have a rise in both inflation and unemployment. If there was a rise in cost-push
inflation, the aggregate supply curve would shift to the left; there would be a fall in economic activity and
higher prices. For example, during an oil price shock, it is possible to have a rise in inflation (cost-push)
and rise in unemployment due to lower growth. However, there is still a trade off. If the Central Bank
sought to reduce the cost-push inflation through higher interest rates, they could. However, it would lead
to an even bigger rise in unemployment.

4.Critically evaluate the endogenous growth theory.

Endogenous growth theory holds that economic growth is primarily the result of endogenous and not external
forces. Endogenous growth theory holds that investment in human capital, innovation, and knowledge are
significant contributors to economic growth. The theory also focuses on positive externalities and spillover effects
of a knowledge-based economy which will lead to economic development. The endogenous growth theory
primarily holds that the long run growth rate of an economy depends on policy measures. For example, subsidies
for research and development or education increase the growth rate in some endogenous growth models by
increasing the incentive for innovation.

The endogenous growth theory was developed as a reaction to omissions and deficiencies in the Solow- Swan
neoclassical growth model. It is a new theory which explains the long-run growth rate of an economy on the basis
of endogenous factors as against exogenous factors of the neoclassical growth theory.

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The Solow- Swan neoclassical growth model explains the long-run growth rate of output based on two exogenous
variables: the rate of population growth and the rate of technological progress and that is independent of the saving
rate.

As the long-run growth rate depended on exogenous factors, the neoclassical theory had few policy implications.
As pointed out by Romer, “In models with exogenous technical change and exogenous population growth, it never
really mattered what the government did.”

The new growth theory does not simply criticise the neoclassical growth theory. Rather, it extends the latter by
introducing endogenous technical progress in growth models. The endogenous growth models have been
developed by Arrow, Romer and Lucas, among other economists. We briefly study their main features, criticisms
and policy implications.

The Endogenous Growth Models:

The endogenous growth models emphasise technical progress resulting from the rate of investment, the size of the
capital stock, and the stock of human capital.

1. Arrow’s Learning by Doing and Other Models:

The Arrow Model:

Arrow was the first economist to introduce the concept of learning by doing in 1962 by regarding it as
endogenous in the growth process. His hypothesis was that at any moment of time new capital goods
incorporate all the knowledge then available based on accumulated experience, but once built, their
productive deficiencies cannot be changed by subsequent learning. Arrow’s model in a simplified form
can be written as

Yi= A (K) F (Ki,Li)

Where Yi denotes output of firm i, Ki donates its stock of capital, Li, denotes its stock of labour, K without
a subscript denotes the aggregated stock of capital and A is the technology factor. He showed that if the
stock of labour is held constant, growth ultimately comes to a halt because socially very little is invested
and produced. Therefore, Arrow did not explain that his model could lead to sustained endogenous
growth.

The Levhari-Sheshinski Model:

Arrow’s model has been generalised and extended by Levhari and Sheshinski. They emphasise the
spillover effects of increased knowledge as the source of knowledge. They assume that the source of
knowledge or learning by doing is each firm’s investment.

An increase in a firm’s investment leads to a parallel increase in its level of knowledge. Another
assumption is that the knowledge of a firm is a public good which other firms can have at zero cost. Thus
knowledge has a non-rival character which spills-over across all the firms in the economy. This stems from

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the fact that each firm operates under constant returns to scale and the economy as a whole is operating
under increasing returns to scale.

In the Levhari-Sheshinski Model, endogenous technical progress in terms of knowledge or learning by

doing is reflected in an upward raising of the production function and economic growth is explained “in
the context of aggregate increasing returns being consistent with competitive equilibrium.”

The King-Robson Model:

King and Robson emphasise learning by watching in their technical progress function. Investment by a
firm represents innovation to solve the problems it faces. If it is successful, the other firms will adapt the
innovation to their own needs. Thus externalities resulting from learning by watching are a key to
economic growth.

The King and Robson study shows that innovation in one sector of the economy has the contagion or
demonstration effect on the productivity of other sectors, thereby leading to economic growth. They
conclude that multiple steady state growth paths exist, even for economies having similar initial
endowments, and policies that increase investment should be pursued.

The Romer Model:

Romer in his first paper on endogenous growth in 1986 presented a variant on Arrow’s model which is
known as learning by investment. He assumes creation of knowledge as a side product of investment. He
takes knowledge as an input in the production function of the following form

Y = A(R) F (Ri,Ki,Li)

Where Y is aggregate output; A is the public stock of knowledge from research and development R; R i is
the stock of results from expenditure on research and development by firm i; and K i and Li are capital
stock and labour stock of firm i respectively. He assumes the function F homogeneous of degree one in all
its inputs Ri, Ki, and Li, and treats Ri as a rival good.

Romer took three key elements in his model, namely externalities, increasing returns in the production of
output and diminishing returns in the production of new knowledge. According to Romer, it is spillovers
from research efforts by a firm that leads to the creation of new knowledge by other firms. In other words,
new research technology by a firm spills-over instantly across the entire economy.

In his model, new knowledge is the ultimate determinant of long-run growth which is determined by
investment in research technology. Research technology exhibits diminishing returns which means that
investments in research technology will not double knowledge.

Moreover, the firm investing in research technology will not be the exclusive beneficiary of the increase
in knowledge. The other firms also make use of the new knowledge due to the inadequacy of patent
protection and increase their production.

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Thus the production of goods from increased knowledge displays increasing returns and competitive
equilibrium is consistent with increasing aggregate returns owing to externalities. Thus Romer takes
investment in research technology as endogenous factor in terms of the acquisition of new knowledge by
rational profit maximisation firms.

2. The Lucas Model:

Uzawa developed an endogenous growth model based on investment in human capital which was used
by Lucas. Lucas assumes that investment on education leads to the production of human capital which is
the crucial determinant in the growth process.

He makes a distinction between the internal effects of human capital where the individual worker
undergoing training becomes more productive, and external effects which spillover and increase the
productivity of capital and of other workers in the economy. It is investment in human capital rather than
physical capital that have spillover effects that increase the level of technology. Thus the output for firm
i take the form

Yi = A(Ki).(Hi).He

Where A is the technical coefficient, Ki and Hi are the inputs of physical and human capital used by firms
to produce goods Yi. The variable H is the economy’s average level of human capital. The parameter e
represents the strength of the external effects from human capital to each firm’s productivity.

In the Lucas model, each firm faces constant returns to scale, while there are increasing returns for the
whole economy. Further, learning by doing or on-the-job training and spillover effects involve human
capital.

Each firm benefits from the average level of human capital in the economy, rather than from the
aggregate of human capital. Thus it is not the accumulated knowledge or experience of other firms but
the average level of skills and knowledge in the economy that are crucial for economic growth.

In the model, technology is endogenously provided as a side effect of investment decisions by firms.
Technology is treated as a public good from the point of view of its users. As a result, firms can be treated
as price takers and there can be equilibrium with many firms as under perfect competition.

Q5.Specify, in detail, the various components that put together, generate business cycle
according to Michal Kalecki.
Michał Kalecki was a Polish economist. Over the course of his life, Kalecki worked at the London School of
Economics, University of Cambridge, University of Oxford and Warsaw School of Economics and was an economic
advisor to the governments of Poland, Cuba, Israel, Mexico and India. He also served as the deputy director of the
United Nations Economic Department in New York City.

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Kalecki has been called "one of the most distinguished economists of the 20th century." It is often claimed that he
developed many of the same ideas as John Maynard Keynes before Keynes, but he remains much less known to the
English-speaking world. He offered a synthesis that integrated Marxist class analysis and the new literature on
oligopoly theory, and his work had a significant influence on both the Neo-Marxian (Monopoly Capital)and Post-
Keynesian schools of economic thought. He was one of the first macroeconomists to apply mathematical models
and statistical data to economic questions. Being also a political economist and a person of leftist convictions,
Kalecki emphasized the social aspects and consequences of economic policies.

Kalecki made major theoretical and practical contributions in the areas of the business cycle, growth, full
employment, income distribution, the political boom cycle, the oligopolistic economy, and risk. Among his other
significant interests were monetary issues, economic development, finance, interest, and inflation. In 1970, Michał
Kalecki was nominated for the Nobel Memorial Prize in Economics, but he died the same year.

If Kalecki had written nothing besides his theory of profits, he would still have deserved a relevant place amongst
twentieth-century economists. But he gave us much more than that, developing his economic theory of the
capitalist economy in many directions.

In the first place, he demonstrated that profits will also be affected by other components of effective demand. In
particular, he showed that an export surplus, which absorbs from abroad a greater purchasing power than it cedes
to foreign economies, raises sales and thus total profits over and above the level they would have reached in the
closed economy. Likewise, the budget deficit, whereby the demand of the government is not offset by a reduction
in the purchasing power of the private sector, and which entails a debt of the state vis-à-vis domestic capitalists,
enlarges sales and profits. The similarity between these two extra sources of profits led him to label the latter
“domestic exports”. His finding that both the export surplus and the budget deficit expand profits probably explains
his admiration for his compatriot Rosa Luxembourg, the Marxian revolutionary, who had to a certain extent, though
imperfectly, anticipated this idea some years before.

In the second place, Kalecki widened his inquiry to consider not only how profits, but also how the whole national
production is realized. National production cannot exceed the level set by the existing productive capacity; but its
real size is determined by effective demand. In developed capitalism demand is usually lower than the potential
output, and idle productive capacity allows supply to have some elasticity, even in the short-run. When supply is
lower than demand, production tends to increase and the opposite happens when demand is lower than supply;
without such changes in demand and output necessarily entailing changes in prices. From the above follows a
seemingly paradoxical consequence: in developed capitalism, demand creates its own supply.

Kalecki then went on to distinguish the autonomous from the induced components of effective demand. He singled
out investment as the central autonomous component of the latter, with the remaining elements of demand being
functions of investment. The crucial role of investment in the operation and the dynamics of capitalism, its position
as the primun movens of capitalism, and the conceptual difference between investment decisions and investment
spending, were two points that Kalecki raised raised the early stage of the construction of his overall vision.
Comprehending what determines investment decisions and investment spending thus became the task he set to
himself to further develop his macroeconomic system.

In the first steps of the formulation of his theory of investment decisions Kalecki gave prominence to the profit rate
and to the interest rate as the fundamental determinants of investment; and in a certain sense the real and
monetary factors were put on an equal footing. In this context, he assumed endogenous money, whereby banks
could, and during the upswing would, accommodate the forthcoming demand for credit ensuing from the needs of

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investment spending; such that a higher interest rate would not normally be an obstacle to a higher desired level
of investment.

However, in the course of the development of his ideas, Kalecki refined his view giving a greater weight to profits
than to purely monetary factors, because he realized that investment entails a risk for the entrepreneur, a risk that
increases with the size of investment (the “principle of increasing risk”). Therefore he concluded that profits play a
dual role in the determination of investment; namely, they (and more particularly the profit rate) provide, on the
one hand, an indicator of how lucrative investment has been in the past. But on the other hand higher profits, by
providing the internal funds with which to finance investment, reduce the risk associated with any given volume of
investment; and higher savings out of profits open up additional sources of finance external to the firm that can be
tapped . In this perspective, we can understand why Kalecki accorded a central place in his theory of investment
decisions to profits, and to the change in profits and the change in the amount of capital (the latter two together
establishing the profit rate). To this he added innovations, which provide an additional stimulus to investment.

6.Explain why prices and wages may not be flexible in an economy.

Keynesian macroeconomics argues that low spending causes unemployment. This problem is reflected in the labor
market; the number of people who want jobs at prevailing wages (labor supply) exceeds the number of people
firms are willing to hire (labor demand). The simplest of economic models suggests that when supply exceeds
demand the price in that market will fall; in the labor market this means that wages fall. If one looks at the labor
market in isolation, it seems intuitive that falling wages should encourage employers to hire more workers. In
addition, if wages fall, firms’ production costs will decline. This could induce competitive firms to reduce their prices
and possibly encouraging their customers to buy more goods and services. The implication seems to be that lower
wages and prices could solve the problem of unemployment and insufficient demand.

This perspective is widely shared among macroeconomists. Indeed the most widespread interpretation of
Keynesian macroeconomics is that the theory only applies when wages or prices are somehow “sticky.” That is,
they do not decline fast enough when demand declines.

This interpretation has an important implication: Keynesian unemployment due to low demand could be just
temporary. Once wages and prices fully adjust, the economy returns to full employment. This perspective is widely
known as the "neoclassical synthesis.” According to this school of thought, insufficient demand problems are
confined to the “short run.” In the “long run,” involuntary unemployment disappears and the economy approaches
full employment and potential output. In this sense, the neoclassical synthesis bridges the gap between Keynesian
and classical macroeconomics.

Unemployment, Wages, and Prices: How the Neoclassical Synthesis Works

It may be intuitive to assume that lower wages by themselves should raise employment. But if the initial problem
is low demand, this outcome is highly unlikely. The reason for unemployment is not that wages are too high.
Rather, the problem is insufficient sales. Clearly wages that are lower throughout the entire economy will not
encourage workers to buy more. They may imply higher profits for the firm, but because profits tend to flow to
higher income people, it seems very unlikely that new spending out of higher profits would offset spending
reductions due to lower wages. Therefore, if there is any direct effect of lower wages on demand, it is most likely
to be negative, magnifying the unemployment problem.

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Unemployment pushes wages down and lower wages lead to lower prices. Lower prices could induce demand to
rise through two channels. First, when prices fall, individuals can buy more with the money in their pockets. Even
though wage incomes are lower, some people might buy more because the purchasing power of money they
accumulated goes up. Economists call this channel a “wealth effect” because it represents additional spending
induced by the higher purchasing power of one part of household wealth, the stock of money. Second, when the
purchasing power of the economy’s money stock rises, people need less money to finance their day-to-day
transactions. The demand for holding money goes down, which lowers the “price” of money, that is, the interest
rate falls. A lower interest rate reduces the reward for saving, encouraging households to spend more. It also
makes loans cheaper which can encourage more borrowing by households and firms that leads to spending.

When prices drop across the economy, the purchasing power of each dollar increases. Any savings a person is
holding at the time thus increase in value: individuals experience a “wealth effect.” On the other hand, their flow
of income falls due to falling prices, so they do not experience an “income effect.” Importantly, while an income
effect would continue to work over time, a wealth effect occurs one time, immediately (and as such is likely rather
small).

These wealth effect and interest rate channels are stabilizing, because they tend to restore aggregate demand after
some downward movement of demand-caused unemployment—a stabilizing result for the economy. In the
absence of any other disturbance, this adjustment process continues as long as unemployment continues to put
downward pressure on wages; that is, until aggregate demand is restored to a level that supports full employment
and any unused resources are put to work again.

The answer depends on how quickly wages respond to unemployment and how fast prices respond to changes in
wages. Therefore the degree of wage and price “stickiness” determines the time frame over which demand
constraints cause unemployment.

This theory leads to results accepted by most mainstream macroeconomists: demand shortages can cause
Keynesian unemployment over some horizon until wages and prices fully adjust, but in the long run economic
growth is driven by the “supply side,” the evolution of technology and resources. Recessions should therefore be
temporary interruptions of the long-run, supply-driven growth trend. The theory is enshrined in generations of
macro textbooks. But according to our MWM perspective, this neoclassical synthesis perspective does not account
for important aspects of reality, as we now discuss.

Destabilizing Effects of Deflation

While the wage-price adjustment theory may at first appear convincing, the typical analysis ignores other channels
through which falling wages and prices affect demand. A more realistic and complete account shows that wage
and price adjustment is unlikely to solve the problem of insufficient demand. Indeed, widespread deflation may
well make Keynesian demand problems worse.

The key problem is that some effects of declining wages and prices depress demand, that is, there are destabilizing
channels that mitigate or even completely reverse the effect of the stabilizing channels discussed in the previous
section.

Q7. Write short notes on the following.

a) Lucas Critique
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The Lucas critique, named for Robert Lucas's work on macroeconomic policymaking, argues that it is naive 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.More formally, it states that the decision rules of Keynesian models—
such as the consumption function—cannot be considered as structural in the sense of being invariant with respect
to changes in government policy variables.The Lucas critique is significant in the history of economic thought as a
representative of the paradigm shift that occurred in macroeconomic theory in the 1970s towards attempts at
establishing micro-foundations.

The basic idea pre-dates Lucas's contribution—related ideas are expressed as Campbell's law and Goodhart's law—
but in a 1976 paper, Lucas drove to the point that this simple notion invalidated policy advice based on conclusions
drawn from large-scale macroeconometric models. Because the parameters of those models were not structural,
i.e. not policy-invariant, they would necessarily change whenever policy (the rules of the game) was changed. Policy
conclusions based on those models would therefore potentially be misleading. This argument called into question
the prevailing large-scale econometric models that lacked foundations in dynamic economic theory. Lucas
summarized his critique:

"Given that the structure of an econometric model consists of optimal decision rules of economic agents, and that
optimal decision rules vary systematically with changes in the structure of series relevant to the decision maker, it
follows that any change in policy will systematically alter the structure of econometric models."

The Lucas critique is, in essence, a negative result. It tells economists, primarily, how not to do economic analysis.
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 are assumed to govern individual
behavior: so-called "microfoundations." If these models can account for observed empirical regularities, 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.

Shortly after the publication of Lucas's article, Kydland and Prescott published the article "Rules rather than
Discretion: The Inconsistency of Optimal Plans", where they not only described general structures where short-
term benefits are negated in the future through changes in expectations, but also how time consistency might
overcome such instances.

Examples

One important application of the critique (independent of proposed microfoundations) 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. In other words, just because high inflation was associated with low unemployment under
early 20th century monetary policy does not mean that high inflation should be expected to lead to low
unemployment under every alternative monetary policy regime.

For a simple example, consider the question of how much Fort Knox should spend on protection.Fort Knox has
never been robbed. Statistical analysis using high-level, aggregated data would therefore indicate that the
probability of a robbery is independent of the resources spent on guards. The policy implication from such analysis
would be to eliminate the guards and save those resources. This analysis would, however, be subject to the Lucas
Critique, and the conclusion would be misleading. In order to properly analyze the trade-off between the probability
of a robbery and resources spent on guards, the "deep parameters" (preferences, technology and resource

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constraints) that govern individual behaviour must be taken explicitly into account. In particular, criminals'
incentives to attempt to rob Fort Knox depends on the presence of the guards. In other words, with the heavy
security that exists at the fort today, criminals are unlikely to attempt a robbery because they know they are unlikely
to succeed. However, a change in security policy, such as eliminating the guards, would lead criminals to reappraise
the costs and benefits of robbing the fort. So just because there are no robberies under the current policy does not
mean this should be expected to continue under all possible policies. In order to answer the question of how much
resources Fort Knox should spend on protection, the analyst must model the "deep parameters" and strive to
predict what individuals will do conditional on the change in policy.

Q7.B) Absolute and Conditional Convergence

Sometimes we want to decide whether a series is convergent or divergent, but the sequence isn't
necessarily positive. We will learn a technique to evaluate series of this nature but we must first look at a
very important definition regarding convergence first.

Definition: Let ∑∞n=1an is a convergent series. We say that this series is Absolutely Convergent if
∑∞n=1∣an∣ is also convergent. We say the original series is Conditionally Convergent if ∑∞n=1∣an∣ is not
convergent.

We will now look directly into an important theorem that may seem obvious.

Theorem 1: If the series ∑∞n=1∣an∣ converges then the series ∑∞n=1an also converges.

• Proof of Theorem: Suppose that ∑∞n=1∣an∣ is converges. Let the sequence {bn} be defined such
that for all n∈N, bn=an+∣an∣. Now we note that −∣an∣≤an≤∣an∣ and so 0≤an+∣an∣≤2∣an∣ so
then 0≤bn≤2∣an∣. Therefore ∑∞n=1bn converges by the comparison test, and so it follows that
∑∞n=1an=∑∞n=1bn−∑∞n=1∣an∣ must also converge.

From theorem 1, we see that if a series is absolutely convergent then it is convergent, which gives us a
test for convergence that does NOT require the series to be positive. Of course, if a series is already
positive, then testing for absolute convergence is the same thing as testing for regular convergence.

In the previous set of notes, we investigated the alternating series. We

learned a test that we could use to determine if this type of series converges
or diverges. Now the question is how can we determine if both the positive
term series and the related alternating series converge or diverge or if only
one of them converges. To talk about this we must define two terms.
FACT: ABSOLUTE CONVERGENCE

A series a n converges absolutely if the series of the absolute

values, |a n | converges.

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 This means that if the positive term series converges, then both the positive
term series and the alternating series will converge.

FACT: A series that converges, but does not converge absolutely,

converges conditionally.
This means that the positive term series diverges, but the alternating series converges.

EXAMPLE 1: Does the following series converge absolutely,

converge conditionally, or diverge?

SOLUTION: Let us look at the positive term series for this given series.

This is a geometric series with ratio, r = 4/5, which is less

than 1. Therefore, this series converges, and the given
series converges absolutely.

FACT:

This fact is also called the absolute convergence test.

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