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IGNOU MEC 002 Solved Assignment 2022-23
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Submission Date :
- 31st March 2033 (if enrolled in the July 2033 Session)
- 30th Sept, 2033 (if enrolled in the January 2033 session).
SECTION – A
1. Explain the concept of steady state growth in the Solow model with appropriate diagram. Show that the golden rule of Phelps is not a steady state.
2. Differentiate between adaptive expectations and rational expectations. Explain why the shape of the Phillips curve changes when we introduce expectations in our analysis.
Ans. Rational expectations is an economic theory that states that individuals make decisions based on the best available information in the market and learn from past trends. Rational expectations suggest that people will be wrong sometimes, but that, on average, they will be correct.
The idea of rational expectations was first developed by American economist John F. Muth in 1961. However, it was popularized by economists Robert Lucas and T. Sargent in the 1970s and was widely used in microeconomics as part of the new classical revolution.
The theory states the following assumptions:
With rational expectations, people always learn from past mistakes.
Forecasts are unbiased, and people use all the available information and economic theories to make decisions.
People understand how the economy works and how government policies alter macroeconomic variables such as price level, level of unemployment, and aggregate output.
The rational expectations theory comes in weak and strong versions. The “strong” version assumes that actors are able to access all available information and make rational decisions based on the information.
The “weak” versions assume that people lack time to access all relevant information but make decisions based on their limited knowledge. For example, if they buy cornflakes, it is “rational” to keep buying the same brand and not worry about getting perfect information about relative prices of other cornflakes brands.
Rational Expectations in Theory and Practice
Most macroeconomists today use rational expectations as an assumption in their analysis of policies. When thinking about the effects of economic policy, the assumption is that people will do their best to work out the implications.
The rational expectations approach is often used to test the accuracy of inflation forecasts. For example, Pet is an individual’s forecast in year t-1 of the price level in year t. The actual price level is denoted by Pt. The difference between the actual price level and the individual’s forecast is the forecast error for year t.
Pt – Pet = rt is the individual’s forecast error in year t. With rational expectations, the forecast errors are due to unpredictable numbers. However, if people systematically under-predict or over-predict numbers, the price level expectations are not rational.
Under rational expectations, what happens today depends on the expectations of what will happen in the future. But what happens in the future also depends on what happens today. Many macroeconomic principles today are created with the assumption of rational expectations.
The theory is also used by many new Keynesian economists because it fits well with their assumption that people want to pursue their own self-interest. If people’s expectations were not rational, the economic decisions of individuals would not be as good as they are.
Adaptive Expectations
While individuals who use rational decision-making use the best available information in the market to make decisions, adaptive decision-makers use past trends and events to predict future outcomes. This is also known as backward thinking decision-making.
Adaptive expectations can be used to predict inflation. If inflation increased in the previous year, people expect an increased rate of inflation in the following year. The formula for adaptive expectations is Pet = Pt -1. It shows that people expect the trend of inflation to be the same as last year.
People will change their expectations of any variable if there is a difference between what they were expecting and what actually occurred. However, if their expectations turned out to be right, their future expectations likely will not change.
Limitations of Adaptive Expectations
While adaptive expectations allow us to measure expected variables and actual variables, they are not as commonly used in macroeconomics as rational expectations because of their limitations. The adaptive model is simplistic because it assumes that people base their decisions based on past data. However, in the real world, past data is just one of the factors that influence future behavior. Rational expectations incorporate many factors into the decision-making process.
Additional Resources
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Marginal Propensity to Consume
Moral Hazard
Structural Unemployment
Behavioral Finance Glossary
SECTION – B
3. Policy rules are better than discretionary policies. Justify the above statement in light of
new classical macroeconomics.
Ans. The new classical macroeconomics is a school of economic thought that originated in the early 1970s in the work of economists centered at the Universities of Chicago and Minnesota—particularly, Robert Lucas (recipient of the Nobel Prize in 1995), Thomas Sargent, Neil Wallace, and Edward Prescott (corecipient of the Nobel Prize in 2004). The name draws on John Maynard Keynes’s evocative contrast between his own macroeconomics and that of his intellectual forebears. Keynes had knowingly stretched a point by lumping his contemporaries, a. c. pigou and Alfred Marshall, in with the older classical political economists, such as David Ricardo, and calling them all “classical.”
According to Keynes, the classics saw the price system in a free economy as efficiently guiding the mutual adjustment of supply and demand in all markets, including the labor market. Unemployment could arise only because of a market imperfection—the intervention of the government or the action of labor unions—and could be eliminated through removing the imperfection. In contrast, Keynes shifted the focus of his analysis away from individual markets to the whole economy. He argued that even without market imperfections, aggregate demand (equal, in a closed economy, to consumption plus investment plus government expenditure) might fall short of the aggregate productive capacity of its labor and capital (plant, equipment, raw material, and infrastructure). In such a situation, unemployment is largely involuntary—that is, workers may be unemployed even though they are willing to work at a wage lower than the wage the firms pay their current workers.
Later Keynesian economists achieved a measure of reconciliation with the classics. paul samuelson argued for a “neoclassical synthesis” in which classical economics was viewed as governing resource allocation when the economy was kept, through judicious government policy, at full employment. Other Keynesian economists sought to explain consumption, investment, the demand for money, and other key elements of the aggregate Keynesian model in a manner consistent with the assumption that individuals behave optimally. This was the program of “microfoundations for macroeconomics.”
Origins of the New Classical Macroeconomics
Although its name suggests a rejection of Keynesian economics and a revival of classical economics, the new classical macroeconomics began with Lucas’s and Leonard Rapping’s attempt to provide micro-foundations for the Keynesian labor market. Lucas and Rapping applied the rule that equilibrium in a market occurs when quantity supplied equals quantity demanded. This turned out to be a radical step. Because involuntary unemployment is exactly the situation in which the amount of labor supplied exceeds the amount demanded, their analysis leaves no room at all for involuntary unemployment.
Keynes’s view was that recessions occur when aggregate demand falls—largely as the result of a fall in private investment—causing firms to produce below their capacity. Producing less, firms need fewer workers, and thus employment falls. Firms, for reasons that Keynesian economists continue to debate, fail to cut wages to as low a level as job seekers will accept, and so involuntary unemployment rises. The new classicals reject this step as irrational. Involuntary unemployment would present firms with an opportunity to raise profits by paying workers a lower wage. If firms failed to take the opportunity, then they would not be optimizing. Employed workers should not be able to resist such wage cuts effectively since the unemployed stand ready to take their places at the lower wage. Keynesian economics would appear, then, to rest either on market imperfections or on irrationality, both of which Keynes denied.
These criticisms of Keynesian economics illustrate the two fundamental tenets of the new classical macroeconomics. First, individuals are viewed as optimizers: given the prices, including wage rates, they face and the assets they hold, including their education and training (or “human capital”), they choose the best options available. Firms maximize profits; people maximize utility. Second, to a first approximation, prices adjust, changing the incentives to individuals, and thereby their choices, to align quantities supplied and demanded.
The economy, they believe, is often buffeted by unexpected shocks. Shocks to aggregate demand are typically unanticipated changes in monetary or fiscal policy. Shocks to aggregate supply are typically changes in productivity that may result, for example, from transient changes to technology, prices of raw materials, or the organization of production. Ideally, firms would choose to produce more and to pay their workers more when the economy has been hit by favorable shocks and less when hit by unfavorable shocks. Similarly, workers would be willing to work more when productivity and wage rates are higher and to take more leisure when their rewards are lower. For both, the rule is “make hay while the sun shines.”
Employment, like output, would clearly rise with favorable shocks and fall with unfavorable shocks. But having rejected the very notion of involuntary unemployment, When a worker is laid off, he must seek a new job. He weighs the value of taking a lower-paid job that might be easily available (a machinist might become a day laborer) against the value of a better-paid, more suitable job that is harder to find. The new classicals do not argue that the unemployed job searcher is happy with his choice: being laid off was a bad draw, and, like everyone, he prefers good luck to bad. Rather, they argue that the worker chooses what he regards as the best available option, even when the options are poor. To remain unemployed (and to show up in the unemployment statistics) is something that he chooses based on his judgment that the benefits of the search outweigh the costs; this is not an exception to the rule that amount supplied equals amount demanded.
The fact that the economy experiences good and bad shocks is not enough to explain business cycles. An adequate theory must account for persistence—the fact that business cycles typically display long runs of good times followed by shorter, but still significant, runs of bad times. Those new classicals who regard demand shocks as dominant argue that the shocks are propagated slowly. It is always costly to adjust production levels quickly. Similarly, when higher production requires new capital, it takes time to build it up. And when lower production renders existing capital redundant, it takes time to wear it out or use it up. New classicals of the “real-business-cycle school” regard changes in productivity as the driving force in business cycles. Because changes in technology may also come in waves, runs of favorable or unfavorable productivity (or technology) shocks may account for some of the persistence characteristic of business cycles.
4. Explain in brief the salient features of political business cycle theory.
5. Bring out the factors that lead to rigidity in wages and prices.
6. Explain with appropriate diagrams why an economy with fixed exchange rate cannot pursue an independent monetary policy.
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IGNOU MEC 002 Solved Assignment 2022-23
7. Write short notes on the following.
i) Inter-temporal utility maximization
ii) Real business cycle theory
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