Assignment No: 02 Subject: 9302 Macroeconomics

ALLAMA IQBAL OPEN UNIVERSITY, ISLAMABAD

Assignment No: 02

Student Name: Saiqa Yaseen

Student ID: 19pnl03038

Level: B.S: Accounting and Finance

Course Code: 9302

Subject: Macroeconomics

Semester: Spring 2023

Assignment No: 02 Subject: 9302 Macroeconomics

Assignment No. 02

Q.1 Describe the economic logic behind the theory of

purchasing-power parity.

Q.2 Discuss the components of the aggregate demand curve.

Q.3 Describe the short-run aggregate supply curve and long-run

aggregate supply curve. Why is one of these curves
horizontal and the other vertical?

Q.4 Draw the long-run trade-off between inflation and

unemployment. Explain how the short-run and long-run
trade-offs are related?

Q.5 Describe the role of supply shocks to shifts in Philips curve.

Assignment No: 02 Subject: 9302 Macroeconomics

Q.1
Describe the economic logic behind the theory of purchasing-power
parity.
Answer:
Understanding the Purchasing Power Parity (PPP) Theory in Global Economics:

The Purchasing Power Parity (PPP) theory is a fundamental concept in international

economics, offering a framework for comparing the economic productivity and standard
of living across countries.

Core Principle of PPP: At its heart, PPP posits that, when stripped of transportation
costs and trade barriers, the same product or service should cost similarly when priced in
a consistent currency.

Law of One Price: Serving as the cornerstone of PPP, the Law of One Price articulates
that when converted into a universal currency, identical goods or services should
maintain uniform pricing across nations. If discrepancies were to arise – say, a car being
more affordable in country A compared to country B – this would pave the way for
arbitrage. Traders could capitalize by purchasing the car in the cheaper country and
selling it at a profit in the pricier one. Over time, such arbitrage activities would
invariably push prices to align across both nations.

Relative Version of PPP: While the concept of absolute PPP is seldom seen in practice
due to factors such as transportation costs, taxation, differences in product standards, and
varying consumer preferences, its relative counterpart is more prevalent. The relative PPP
theory contends that disparities in national inflation rates will, in the long term, be
counterbalanced by proportional shifts in exchange rates.

Implications for Exchange Rates: For instance, consider a scenario where the US
witnesses an inflation rate of 4%, while the European Union experiences a 2% rate. If the
Assignment No: 02 Subject: 9302 Macroeconomics

initial exchange rate between the euro and the dollar stood at parity (1:1), the PPP theory
would forecast that, in the long run, the dollar would weaken against the euro by
approximately the difference in their inflation rates, which in this case is 2%. The
rationale being that as US goods and services become relatively pricier, the value of the
dollar would need to adjust to maintain purchasing power equivalency with the euro.

Further Relevance of PPP: Beyond academic discussions, PPP is crucial in real-world

applications like adjusting GDP for international comparisons. By accounting for price
level differences across countries, PPP-adjusted GDP metrics provide a clearer picture of
relative economic sizes and standards of living. This ensures more accurate and equitable
assessments in a globally interconnected economy.

Factors Influencing Deviations from Purchasing Power Parity (PPP):

There are multiple reasons why real-world exchange rates might not align with those
predicted by Purchasing Power Parity (PPP), especially in the short term:

Transportation Costs: The expenses associated with moving goods between countries
can often make arbitrage unfeasible, even when price differences exist.

Trade Barriers: Governments may implement tariffs or non-tariff barriers, which can
have a direct impact on the domestic prices of imported and exported goods.

Quality and Brand Perception: The perceived value of goods can differ based on their
origin or brand reputation. For instance, a car manufactured in Germany might be
considered superior in quality to a similar model produced in another country, leading to
variations in pricing.

Non-traded Goods: There are certain goods, like real estate or personal services (e.g.,
haircuts), that cannot be traded across borders. As a result, their prices might diverge
significantly between countries, without any scope for arbitrage.
Assignment No: 02 Subject: 9302 Macroeconomics

Financial and Investment Dynamics: Factors beyond the price of goods, such as
speculative movements, variations in interest rates, and international capital flows, can
also sway exchange rates.

Utility in Comparative Analysis: One of the primary applications of PPP is to enable a

more accurate comparison of economic outputs across countries than mere nominal
values would allow. Organizations like the World Bank's International Comparison
Program utilize PPP to equate the GDPs of diverse nations. This adjusted comparison
offers a clearer picture of the actual buying power of a currency in its native country, as
opposed to just its nominal value.

Conclusion: At its core, the principle of PPP posits that a currency should possess
equivalent purchasing power across different countries. Even though various factors can
result in short-term deviations from PPP, in the long run, it serves as a valuable tool not
just for anticipating shifts in exchange rates but also for equitably contrasting the
economic prosperity of nations.

Q.2
Discuss the components of the aggregate demand curve.
Answer:
The Aggregate Demand (AD) curve visually captures the total demand for goods and
services in an economy across varying overall price levels. This curve illustrates how the
aggregate quantity of goods and services demanded interacts with the overall price level,
assuming all other influencing factors are stable. This AD curve is pivotal in the study of
macroeconomics. There are four primary components within the AD curve:

Consumption (C): This pertains to the cumulative expenditure by households on both

goods and services. Several elements influence consumption, including disposable
income, the level of consumer confidence, and prevailing interest rates. When prices
surge (a situation often termed as inflation), the value of money in real terms diminishes,
Assignment No: 02 Subject: 9302 Macroeconomics

leading to reduced consumption levels. Hence, there exists a reverse correlation between
consumption and the price level, manifesting as a downward slope on the AD curve.

Investment (I): Investment refers to business expenses on capital items such as

machines, tools, and infrastructural facilities. This also encompasses spending on
innovation and research. Elements like interest rates, anticipations of businesses, and
specific government policies impact investment. In scenarios where interest rates are
diminished, businesses tend to invest more, leading to a rise in aggregate demand.
Consequently, a direct correlation exists between investment and the price level,
translating to an upward trajectory on the AD curve.

Government Spending (G): This involves the outlays by the government on public
goods and services like health, defense, and education. Typically, government spending
isn't directly linked to the overall price level. It's predominantly dictated by governmental
budgetary decisions and overarching policies instead of purely market dynamics. Hence,
on the AD curve, government spending is often portrayed as a constant or horizontal line.

Net Exports (NX): This is an additional component not mentioned in the original text.
Net exports refer to the difference between what a country sells to foreign countries
(exports) and what it buys (imports). When a country exports more than it imports, it can
increase aggregate demand. Fluctuations in exchange rates, global economic conditions,
and trade policies can influence net exports.
In a broader context, understanding the intricacies of the AD curve is crucial for
policymakers and economists, as it provides a holistic view of the factors driving demand
within an economy.
Net Exports (X - M): Net exports represent the difference between a country's exports
(X) and imports (M). Exports add to aggregate demand, while imports subtract from it.
The level of net exports is influenced by factors like exchange rates, foreign income
levels, and trade policies. When a country's currency depreciates, its exports become
Assignment No: 02 Subject: 9302 Macroeconomics

cheaper for foreign buyers, which can increase net exports and boost aggregate demand.
Conversely, a stronger domestic currency can reduce net exports.

The aggregate demand curve is typically represented as AD = C + I + G + (X - M),

where:
AD represents aggregate demand.
C represents consumption.
I represents investment.
G represents government spending.
X represents exports.
M represents imports.

The AD curve typically slopes downward to the right, indicating the inverse relationship
between the overall price level and aggregate demand.Changes in any of the components
mentioned above can shift the AD curve either to the right (increasing aggregate demand)
or to the left (decreasing aggregate demand), leading to changes in the level of real GDP
and the overall price level in the economy.

Q.3
Describe the short-run aggregate supply curve and long-run aggregate supply
curve. Why is one of these curves horizontal and the other vertical?
Answer:
The Aggregate Supply (AS) delineates the entirety of goods and services manufactured
within an economy at varying price levels. The short-run aggregate supply (SRAS) curve
and the long-run aggregate supply (LRAS) curve visually represent this. However, the
two differ in shape and underlying justifications.

Short-run Aggregate Supply (SRAS) Curve:

Assignment No: 02 Subject: 9302 Macroeconomics

Overview: The SRAS curve visualizes the total production of goods and services that
businesses in an economy are ready and can supply at various price levels within a
shorter timeframe.

Form: Typically, it slopes upwards, suggesting that when there's a rise in the general
price level in an economy, the supplied quantity of goods and services goes up and vice
versa. Still, during times of significant economic underutilization (idle resources), it
might appear almost flat.

Rationale: In the interim, some production factors remain unchanged, such as capital or
current technological advancements. A surge in the price level can make firms more
eager to increase production since the relative price of their products escalates, ushering
in enhanced profit margins. Due to delays in adjustment, costs, especially wages, might
not immediately reflect the alterations in price levels, which provides a temporary
advantage to businesses.

Long-run Aggregate Supply (LRAS) Curve:

Overview: The LRAS curve illustrates the correlation between the price level and the
output volume once all assets (like manpower and capital) have been completely
optimized and harnessed efficiently. Essentially, it echoes the economy's potential or
maximum output capacity.

Form: It stands vertical, indicating that the long-term potential output remains constant,
irrespective of the fluctuating price level.

Rationale: Over an extended period, all assets can be optimized and utilized at peak
efficiency. An economy's maximum potential output is influenced by elements like
resource availability, technological advancements, and governing structures, all of which
remain impervious to price level variations.
Assignment No: 02 Subject: 9302 Macroeconomics

Additional Information: The distinction between SRAS and LRAS is vital for
policymakers. Adjustments in monetary and fiscal policies can shift the SRAS in the
short term but might have limited effects on the LRAS. Understanding this helps in
making informed decisions during economic downturns or inflationary periods.

The following diagram shows the short-run aggregate supply curve (SRAS) and the long-
run aggregate supply curve (LRAS):

The SRAS curve is upward sloping, while the LRAS curve is vertical. The intersection of
the SRAS curve and the LRAS curve is the economy's equilibrium.

The SRAS curve can shift due to changes in factors that affect production costs, such as
changes in wages, productivity, or taxes. The LRAS curve can shift due to changes in the
economy's potential output, such as changes in the size of the labor force or the amount
of capital stock.

Q.4
Draw the long-run trade-off between inflation and unemployment. Explain how the
short-run and long-run trade-offs are related?
Answer:
The relationship between inflation and unemployment over time can be understood
through the concepts of short-run and long-run trade-offs. In the long run, the correlation
Assignment No: 02 Subject: 9302 Macroeconomics

between inflation and unemployment aligns with the natural rate of unemployment,
indicating that there's no enduring connection between the two. Essentially, regardless of
the inflation rate, unemployment will gravitate back to its inherent rate.

Conversely, the short-term reveals a different dynamic. Here, a descending curve portrays
the trade-off, signifying that an uptick in inflation leads to a decrease in unemployment
temporarily. Yet, this inverse relationship doesn't last forever. Given time, as the
economy reacts and adapts to any inflation variations, unemployment will resettle to its
intrinsic or natural rate.

Connecting these short-term and long-term perspectives:

when a government intervenes by expanding the money supply via monetary policy, it
can momentarily reduce unemployment, albeit at the expense of higher inflation. But
such effects are transitory. As the economy adjusts to this new volume of money, costs
and wages surge, resetting the unemployment back to its foundational level.
Consequently, a perpetual reduction in unemployment can't be achieved merely by
pumping more money into the system.

Moreover, it's vital to understand that these economic phenomena do not operate in
isolation. Factors like expectations of future inflation, technological advancements, and
global economic trends can also influence these relationships. Therefore, while monetary
policy can be a tool, it is not a panacea and must be used judiciously.

The following diagram shows the long-run trade-off between inflation and
unemployment:

graph with inflation on the vertical axis and unemployment on the horizontal axis. The
line is vertical at the natural rate of unemployment.
Assignment No: 02 Subject: 9302 Macroeconomics

The natural rate of unemployment is the rate of unemployment that exists when the
economy is at full employment. It is the rate of unemployment that is consistent with
stable prices.

The short-run trade-off between inflation and unemployment is shown by the curve that
slopes downward. This curve is called the Phillips curve. The Phillips curve is not a
stable relationship. It can shift due to changes in expectations, productivity, supply
shocks, and policy interventions.

The government can use monetary policy to try to lower the unemployment rate in the
short run. However, this will only lead to higher inflation in the long run. Therefore, the
government should focus on policies that will promote economic growth and productivity
in the long run. This will help to lower the natural rate of unemployment and reduce the
trade-off between inflation and unemployment.

Q.5 Describe the role of supply shocks to shifts in Philips curve.

Answer:
The Phillips Curve postulates a negative correlation between inflation and unemployment
rates. This means that, in many situations, an increase in inflation might correspond to a
Assignment No: 02 Subject: 9302 Macroeconomics

decrease in unemployment, and conversely, a dip in inflation can be associated with a rise
in unemployment. Yet, this dynamic is not set in stone and can be nuanced based on
different circumstances.

Notably, external factors play a pivotal role in affecting this relationship. One prominent
factor that can disrupt the conventional understanding of the Phillips Curve is supply
shocks. Supply shocks, whether positive or negative, can lead to unforeseen changes in
the cost of production. This could either be due to sudden increases in raw material prices
or unforeseen events, such as natural disasters, that disrupt the supply chain.

A supply shock is an unexpected event that changes the supply of a product or

commodity, resulting in a sudden change in its price. Such shocks can be positive
(increasing supply) or negative (decreasing supply). These shocks can stem from various
sources such as natural disasters, technological changes, or geopolitical events.

The role of supply shocks in shifting the Phillips Curve can be explained as follows:
Assignment No: 02 Subject: 9302 Macroeconomics

Stagflation and the 1970s Oil Crisis: The oil crises of the 1970s serve as a prime
illustration of how supply shocks can impact the Phillips Curve. Due to geopolitical
upheavals, there was a sharp increase in oil prices, which subsequently drove up
production costs across numerous sectors. This led to a dual challenge of soaring inflation
(as the costlier production translated to higher consumer prices) and rising unemployment
(since businesses struggled to sustain or grow their employee base). This simultaneous
occurrence of escalating inflation and unemployment is known as "stagflation." It
questioned the conventional perspective on the Phillips Curve.

Shift vs. Movement Along the Curve: A demand-side change in the economy, like a
change in aggregate demand, will typically result in a movement along the Phillips
Curve. On the other hand, a supply shock can cause the entire Phillips Curve to shift. For
instance, a negative supply shock that raises production costs might shift the curve
upwards, indicating higher inflation for any given level of unemployment.

Short-term vs. Long-term Effects: The short-term effects of supply shocks might be
different from their long-term effects. Initially, a negative supply shock can lead to higher
inflation and unemployment (an upward shift in the Phillips Curve). But in the long run,
as firms and workers adjust their expectations and other market adjustments take place,
the Phillips Curve might return to its original position or take a new shape altogether.

Role of Expectations: Contemporary interpretations of the Phillips Curve take into

account the expectations regarding inflation. When individuals anticipate a rise in
inflation following a supply shock, they may seek increased wages, inadvertently
exacerbating the inflationary trend. This intricate dance of expectations can further
muddle the connection between inflation and unemployment in the aftermath of a supply
shock.
Assignment No: 02 Subject: 9302 Macroeconomics

In conclusion, while the Phillips Curve offers a simplified view of the trade-off between
inflation and unemployment, real-world events like supply shocks can greatly influence
and complicate this relationship.

THE END THANK YOU!