KATHMANDU UNIVERSITY

SCHOOL OF LAW (KUSL)

End Semester Examination 2020

Answer Book

Level: BBM.LLB

Roll No: 41

Registration No: 023555-18

Course Code: ECO 210

Course Title: MACRO ECONOMICS

Date: 23rd August - 24th August.

[Please read carefully and follow the Examination Guidelines provided ear-
lier to you for online (Open Book) Examination 2020]

Q.No. Marks Obtained Q.No. Marks Ob-

tained

1. 6.

2. 7.

3. 8.

4. 9.

5. 10.

Total of Subjective

Grand Total
In Words: .......................................................................................

....................................... ...........................................

Member of Scru3ny Board Examiner

Date: Date:

1. Gross domes3c product (GDP) does not measure the distribu3on of income. Explain.

ANS 1. Gross domes*c product (GDP) is the total monetary or market value of all the fin-
ished goods and services produced within a country's borders in a specific *me period.
As a broad measure of overall domes*c produc*on, it func*ons as a comprehensive
scorecard of a given country’s economic health. Gross Domes*c Product (GDP) is the
monetary value of all finished goods and services made within a country during a specif-
ic period. GDP provides an economic snapshot of a country, used to es*mate the size of
an economy and growth rate. GDP can be calculated in three ways, using expenditures,
produc*on, or incomes. It can be adjusted for infla*on and popula*on to provide deeper
insights. GDP = Consumer ( c ) + Investment ( I ) + Government expenditure ( G ) + Export
- Import ( N-X ). This formula measure the country GDP, GDP is rally taken out to see the
economic growth of the country but, it has its own limita*ons, Pros and cons. If the GDP
is in higher range doesn’t mean it can show that the living standard of the country is also
well and good because, countries popula*on might also differ by goods produced. Hypo-
the*cal example if India and Sri lankas GDP is same yet the popula*on is different India
has larger popula*on which means the good produced Sri lanka gets to keep more and
earn more income due to lesser popula*on than India. So, to find out which country has
what economic standard we should take out GDP per capita, GDP divided by total popu-
la*on. as a measure of economic welfare or standard of living in a na*on. Which shows
how much GDP does one person have. Even aUer taking out the GDP per capita in some
countries such as India and while we take out the GDP and it turns out to be high yet 30-
35% of the popula*on in below the poverty line then, people like Ambani etc have con-
tributed a lot towards the GDP growth and half of the popula*on is poor and below the
poverty line. When we take out the GDP it the rate shows high like the standard of living
shows in high so, the Gross domes*c product doesn’t show whose standard is high or
low individually, how the income in economy is being distributed, GDP has nothing much
to say about what technology and products are available, GDP has nothing to say about
the level of inequality in society, But what is shows is, How many good and services are
being produced, what all countries economy are being contributed.
2. Suppose you are the governor of the central bank of Nepal at a 3me when the
economy is experiencing a recession due to COVID 19 pandemic, and you are called to
tes3fy before a ministers’ cabinet mee3ng. Discuss your explana3on to the ministers
highligh3ng what monetary steps you would take to prevent the recession.

ANS 2. A recession is a period of declining economic performance across an en*re econ-

omy that lasts for several months. Monetary steps that can precent the recession are:
Money supply to increase in economy, make people spend more as in this pandemic sit-
ua*on government can distribute some amount of money by which people can use
them to buy goods or can fulfill their normal basic needs. If any person wants to take
loan from the bank then the interest rate of the bank loan system to be decreased at the
present situa*on so, that people get encouraged to take loan without of fear of heavy
interest rates. Reduce or decrease the reserve ra*o of the bank as such, banks keep cer-
tain amount of money in reserve and gives out certain money so, if bank is keeping 10%
of the money in reserve then now, decrease the amount with 5% with that if people
have had stored Rs. 10,000 in a bank and the bank had returned Rs. 9,000 then now,
Banks to return Rs. 9,500 by reducing the reserve ra*o. Who so ever lenders have taken
the money and loans from the bank and have to pay back the interest then for the cer-
tain *me being to freeze the *me like aUer the situa*on gets beaer then to pay back the
interest rate amount but, at this *me and at this period of pandemic not making the
lenders pay. Cubng interest rates should help to boost aggregate demand. Amongst
other things, lower interest rates reduce mortgage interest payments, giving consumers
more disposable income. Lower interest rates also encourage firms and consumers to
spend rather than save. (effect of lower interest rates). Government to bring up plans
and policies due to which small corporate houses and rural areas industry can borrow
the money due to the situa*on and provide them cash for help to run the area. Devalu-
ate countries exchange rate by decreasing other countries currency due to the reduc*on
in currency value the products gets cheaper and the foreigners get aaracted and the
product demand can also get increased in the market. A devalua*on in the exchange
rate can cause a boost in aggregate demand. A fall in the value of the dollar makes ex-
ports cheaper and imports more expensive increasing domes*c demand. So, the overall
and general steps would be, Money supply should increase, interest rate to be de-
creased and currency value should also be decreased so that the value of currency
would decrease and eventually the value gets higher. When our countries products de-
mand and supply gets increased due to which infla*on happens in the economy and due
to the infla*on apprecia*on Nepali currency gets depreciated.
3. Even if the government spends billions on non-produc3ve military pieces of equip-
ment, this ac3on of government can create many jobs in a recession. Discuss.

ANS 3. A recession is a period of declining economic performance across an en*re econ-

omy that lasts for several months. A recession will cause several economic problems, in-
cluding falling living standards, rising unemployment and price defla*on, and for this
reason macro-economic policy will target the avoidance of a recession as its main objec-
*ve.Even if the country spends billion on non-produc*ve military pieces of equipment,
this ac*on of government can create may jobs in a recession. As the equipment are de-
manded this would make the company to hire more workers and increase their produc-
*on as well if the people in military are not enough this may create more jobs for people
in military and may be trained to use and take care of such equipment. For the producer,
as there is increase in demand this means it would increase the total quan*ty of goods
and services demanded at each price level. This would increase the aggregate demand
which would shiU towards the right in the curve which is from AD1 to AD2 in the follow-
ing figure. As government spend this huge amount of money in the product which
means the producer would surely store the money in the bank and could get some in-
terest rate. This would lead to increase in money supply in the bank and with the help of
mul*plier effect the amount that gets created by the government money would be larg-
er in the economy. Likewise, we may even have the opposite effect. As the government
increases the purchases which would increase the aggregate demand for goods and ser-
vices, this would also cause the interest rate to rise. This would reduce investment
spending as people would borrow less money that would again put downward pressure
on aggregate demand. This reduc*on in aggregate demand which is due to fiscal expan-
sion is called crowding-out effect. From the below figure we can see that as the money
supply increases from A to B this would increase the interest rate from r1 to r2. As there
is increase in interest rate this would discourage investment and would lead to down-
ward pressure on aggregate demand. This is a kind of government spending which is a
form a injec*on into the economy. However, military spending creates opportunity costs
of spending on merit goods. And military equipment might not help long term growth of
economy because it is rather just a spending than a investment.
This above graph shows aUer the military demands for the equipment and spends bil-
lions of amount the aggregate demand increases.
4. Three major func3ons of money are affected by infla3on. Discuss with relevant ex-
amples:

ANS 4. Money is something that people use every day. We earn it and spend it but don't
oUen think much about it. Economists define money as any good that is widely accepted
as final payment for goods and services. They share the three func*ons of money:

A. Money is a store of value: We value goods and wealth through money. Money makes
it easy to compare goods. If I work today and earn 25 dollars, I can hold on to the money
before I spend it because it will hold its value un*l tomorrow, next week, or even next
year.Infla*on will have an effect. Infla*on reduces purchasing power to the extent that
prices adjust more quickly than wages which are “s*cky”. So, excessive and pervasive in-
fla*on reduces standards of living in an economy by reducing purchasing power. It re-
duces the future value of savings to the extent that prices move higher more quickly
than savings can generate return. This is why inves*ng and receiving an adequate rate of
return is so important. Your savings need to generate more over your life*me than the
rate of infla*on.
B. Money is a unit of account: Prices and accoun*ng records use money, If you are shop-
ping for a new computer, the price could be quoted in terms of t-shirts, bicycles, or corn.
So, for instance, your new computer might cost you 100 to 150 bushels of corn at today's
prices, but you would find it most helpful if the price were set in terms of money be-
cause it is a common measure of value across the economy.
C. Money is a medium of exchange: Used for buying and selling goods. Because before
the money the system was the barter. This func*on would be affected by the infla*on
through the loose of value of the money and in consequence it would be necessary
more money to do the same transac*ons, that could be posi*ve for the economy on the
way that the producer would receive more monetary benefits, the output could increase
and finally the workers would receive higher wages. But if the producer don’t translate
the growth of the prices in a growth of the salaries, a big share of the popula*on would
be worse than aUer the infla*on due to the decrease on their purchasing power.

Infla*on means an increase in the general price level. An infla*on rate of 10% means
that the average price level rises by 10%. Infla*on means that the value of money de-
creases. High infla*on means that it becomes difficult to place a value on goods because
the value of money is always falling. In extreme cases of hyper infla*on prices can rise so
much that money becomes worthless and people resort to a barter economy. As infla-
*on increases, the vola*lity of the infla*on rate tends to increase. This means that it is
harder to place a value on money, thus it becomes more difficult to use it as a store of
value. With a high rate of infla*on, the real value of debt erodes. This means that it is
effec*vely easier to pay back the debt. Therefore, in periods of high infla*on, banks will
be less willing to lend money because they will lose out if people pay back the debt in
the future when money is worth less. They will not lend money unless they can charge
an interest rate higher than the rate of infla*on. If the rate of infla*on is stable it is easi-
er to make these calcula*ons.With high infla*on there will be greater Menu costs. This is
the cost of changing price lists to reflect the changing value of money.

5. As the economy of Nepal is heading to the recession, the central bank increases the
money supply to increase Real GDP. Can anything offset the increase in the money
supply so that Real GDP does not rise? Explain your answer using the quan3ty theory
of money.

ANS 5. For now and looking at the state of this pandemic as people are not able to join
their work sta*ons government should bring up policies due to which the policy should
supply money by which people can use them so, government should supply more money
to it’s people. AUer supplying money what happens or how situa*ng changes can be
found out by looking at quan*ty theory equa*on which is states that, money supply and
price level in an economy are in direct propor*on to one another. When there is a
change in the supply of money, there is a propor*onal change in the price level and vice-
versa.

Formula for quan*ty theory of money is; M*V= P*T

where,

M = Money supply, V = Velocity of money, The velocity of money is a measurement of

the rate at which money is exchanged in an economy. Simply put, it's the rate at which
consumers and businesses in an economy collec*vely spend money, P = Price level, T =
Output of economy.

By all this, Economist look at Velocity of money and Output of economy as a constant,
and by seeing them as constant then where ever the money supply increases then the
price level also rapidly increases price level increase which means infla*on also increases
and the expense increases in the market product price increases as the people have
more money, government is supplying more money to people so the expense also in-
creases as people can invest accordingly as capacity and demand also increases due to
which price level increases and infla*on increases. If we take real GDP in considera*on
we measure it using the constant prices in real GDP so, the real GDP will not increase in
any ways real GDP only increases when the produc*on increases because in real GDP we
take base year prices so the real GDP will not increase even if we increase the money
supply and it will rather increase the infla*on rate in the economy.

6. A growing economy is a changing economy, and some unemployment is a necessary

consequence of economic growth, discuss:
ANS 6. To understand the answer beaer first lets look at the three types of unemploy-
ment: Cyclical unemployment Over *me, the economy experiences many ups and
downs. That's what we call cyclical unemployment because it goes in cycles. Cyclical un-
employment occurs because of these cycles. When the economy enters a recession,
many of the jobs lost are considered cyclical unemployment. Fric*onal
unemployment occurs because of the normal turnover in the labor market and the *me
it takes for workers to find new jobs. Throughout the course of the year in the labor
market, some workers change jobs. When they do, it takes *me to match up poten*al
employees with new employers. Even if there are enough workers to sa*sfy every job
opening, it takes *me for workers to learn about these new job opportuni*es, and for
them to be considered, interviewed and hired. Structural unemployment happens when
the skills set of a worker does not match the skills demands of the jobs available or if the
worker cannot reach the geographical loca*on of a job. An example is a teaching job
that requires reloca*on to China, but the worker cannot secure a work visa due to cer-
tain visa restric*ons. It can also happen when there is a technological change in the or-
ganiza*on, such as workflow automa*on. Natural unemployment is the minimum un-
employment rate resul*ng from real or voluntary economic forces. It represents the
number of people unemployed due to the structure of the labor force, including those
replaced by technology or those who lack the skills necessary to get hired. To meet ag-
gregate demand the aggregate supply is equal at that *me there is slight bit of unem-
ployment exists. Which means, in your economy there is no 100% of employment there
is always a certain no. of unemployment, but in countries it differs in 3-5% if the em-
ployment rate meets then they take it as full employment, Full employment is when all
available labor resources are being used in the most efficient way possible.Full employ-
ment embodies the highest amount of skilled and unskilled labor that can be employed
within an economy at any given *me.In any kind of economy there is never 100% econ-
omy that is why whenever full economic growth happens then fic*onal and structural
unemployment keep occurring. Due to which natural rate of unemployment happens
and even aUer mee*ng the aggregate demand with the aggregate supply s*ll certain
amount of people are leU unemployed so, even if there is economic growth s*ll some
level of unemployment does take place but, cyclical unemployment to come over in the
economy is not good because, whenever recession happens then unemployment in-
creases and by that economic growth does not take place at the same *me Fric*onal
and structural are different and are not as problema*c.
LONG ANSWER 1. Suppose your maternal aunt saves Rs 1000 on her piggy bank
at home, she gi]s this money to you on your birthday. Show the maximum change
in the money supply, if you happily deposit this money in a checking account.
Would the maximum change in the money supply s3ll be the same if central bank
prints and gi]s this money to you? Explain.

ANS 1. If my maternal aunt saves Rs 1000 on her piggy bank at home, she giUs this
money to me on my birthday. To Show the maximum change in the money supply, if I
happily deposit this money in a checking account. To understand the answer beaer in
numerical form; If I deposit Rs. 1000 in the bank and if they have policy to reserve 4%
then the bank would loan out Rs. 960 to another bank and reserve Rs. 40 so again,
the loaned amount reaches to another bank and they would reserve Rs. 38.4 and
would loan out Rs. 921.6 in this way, money is mul*plied and the crea*on of money
by bank is done.

(i.e. money mul*plier = 1 reserve ra*o )

The money mul*plier is the amount of money that banks generate with each dollar of
reserves. Reserves is the amount of deposits that the Federal Reserve requires banks to
hold and not lend. Banking reserves is the ra*o of reserves to the total amount of de-
posits.The amount of money mul*plied depends upon the reserve ra*on of the bank

Then, money mul*plier is = 1/( reserve ra*o ) = 1/ (0.04 ) = 25

Now to see the money crea*on in the bank we must mul*ply the money mul*plier
with the loaned amount that is, 25 X 960 = 24000.

Therefore, the money created by the bank was Rs.24000 and total money supply is
25000.

Now looking towards in the 2nd half of the ques*on if I get a giU from the central bank
of Rs.1000 than there are two op*ons that I could apply. If I keep that Rs.1000 to myself
than there will be no change in money supply. I would save that money with myself and
it would be Rs.1000 at the end or I could spend that money. Whereas if I deposit that
money in the bank then there to calculate the maximum change in money supply we
must MS = 1/ R x1000 = 1/ 0.04 x 1000 = 25000.

Therefore, there would be increase in the maximum change in money supply as the
1000 has been created by central bank we must add all Rs.1000

The maximum change in the money supply s*ll be the same if central bank prints and
giUs this money to you there are two understandings or scenario. The first one is to keep
the money by myself, or what happens if i keep the money to myself. If the central bank
gives me the amount/ money and if i keep it to myself then it is not maximum change as
the money is with me, i have not invested it anywhere rather, i would spent it off so, it
does not get mul*plied but, When we look at the second scenario that is if i give the
money to the bank what happens to it, if the given amount / money like material aunt i
deposit it in the bank the like shown in above i can do money crea*on of Rs. 24,000.
LONG ANSWER 2. Suppose that our economy grows and that the United States’ econ-
omy does not. This will affect the exchange rate between the Nepalese rupees and US
dollars. Do you agree? Explain with an example and figures showing the market for
Nepalese rupees and the market for US dollars.

ANS 2. An exchange rate is the price of one currency expressed in terms of another cur-
rency, or against a basket of other currencies. In a floa*ng exchange rate regime rates
are determined by the forces of demand and supply in the foreign exchange market.
Whenever Nepals economic growth rate increases it means Nepal increasing its produc-
*on rate, when the produc*on rate increases like that economic growth rate increase
means demand is also increasing or might increase to buy the products in Nepal. If these
two happen then economic growth rate happens when these products to go in-
terna*onal market the the price lowers that means the foreigners are also lead to buy
our Nepali products in the interna*onal market and Nepali product are quite compe*-
*ve in the interna*onal market as usually the price are quite inexpensive and affordable.
Now what happens is US economy is as same as usual and due to the higher demand
rates of the Nepali products the Nepali economy has increased that leads to the follow-
ing NEPALI MARKET graph which explains, at the star*ng the demand is at DO and sup-
ply at S and at the middle the equilibrium eventually, when people start buying and de-
manding the products more then they cannot buy through the US dollar they need to
buy the Nepali product through Nepali currency so even before buying the product they
need to buy the Nepali currency which means, the demand of Nepali currency increases
as DO in the following graph.
Now looking towards the second graph there is demand, which shows the UD dollars
demand and US dollar supply. To buy Nepali currency foreigners have to buy it trough
the US dollars so the US dollar supply has gone from S0 to S1 ( Increase ) AUer the in-
crement of US dollar supply they buy the Nepali current which eventually means Nepal
gebng the US dollars. Whenever such thing happens looking at the first NEPALI MAR-
KET graph E0 to E1 travels and Q0 to Q1 because, Nepali currency demands has in-
creased so the quan*ty demand has also increased by this E0 goes to E1 and Nepali cur-
rency value gets apprecia*on. Similarly, At the US MARKET GARPH down below, Quan*-
ty supply Q1 to Q0 which means supply is increasing quan*ty of dollar ( As stated
below ) whenever the supply of dollar increases from E0 to E1 means, US money value is
reducing ( Devalua*on ). In simple terms, In US if a Nepali had to buy 1 dollar and had to
pay RS. 120 for it then now that same Rs. 120 can buy 2 dollar by increase of economic
growth.