1

a) An aggregate production function gives the level of output that will be produced for given levels
of the factor inputs, capital and labour. In the short run, the stock of capital (K) is fixed. Output (y)
varies as we change the labour input. An increase in the average and marginal productivity of labour
would shift the production function, f(K, N) schedule, upward. Because the slope of this curve is the
marginal productivity of labour (MPN) and higher MPN means higher the slop of the production
function and that means much output can be produced from a small number of inputs. As per unit of
inputs can produce more outputs, the aggregate output must be higher.

b)
The classical theory of labour supply and demand explains the behaviour of workers and firms in the
labour market. In the classical system labour supply and demand is determined by the real-wage.
Labour supply have positive relationship with real wage but there is a negative relationship belongs
between labour demand and real wage.
In the classical system labour supply is determined by two effects, substitution effect and income
effect.
Substitution Effect: When real-wage increase then households wish to supply more labours. Because,
higher real wage means higher price for leisure in terms of forgone income. Then households
substitute their leisure in order to supply more labour to earn more income.
Income Effect: When the real-wage is much high, labours can earn a greater amount on income and
satisfy their needs from working fewer hours. Then they prefer leisure than working more. That
means, at the higher wage rate labour supply is less.
In the demand side, labour demand is determined by real-wage and the marginal productivity of
labour. Firms will hire labours up to the points when MPN = Real Wage(W/P) to maximize their profit.

The labour demand schedule is downward sloping when plotted against the real-wage. Because, higher
real wage means higher cost of production and less profit. As firms want to maximize profit they will
hire up to the points where MPN = Real wage. When real wage is greater than the MPN, then their
profit is decreased. So, they will reduce employment and when MPN is greater than real wage, they
will assign more labours to increase profit. That is why the labour demand schedule is downward
sloping.
The labour supply schedule is upward sloping when plotted against the real-wage. Because, higher real
wage means higher price for leisure in terms of forgone income. So, households wish to supply more
labours as the real wage increases so that they can increase their income as well as purchasing power.

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a) The velocity of money refers to the rate at which money circulates or changes hands within an
economy in a specific period of time. It is a measure of how quickly money is used for transactions.
Mathematically, it can be expressed as:

𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐼𝑛𝑐𝑜𝑚𝑒 (𝑃 × 𝑌)
𝑉𝑒𝑙𝑜𝑐𝑖𝑡𝑦 𝑜𝑓 𝑀𝑜𝑛𝑒𝑦 (𝑉) =
𝑀𝑜𝑛𝑒𝑦 𝑆𝑢𝑝𝑝𝑙𝑦 (𝑀)

Factors Determining Velocity of Money in the Classical System:

In the classical economic model, several factors influence the velocity of money:
1. Frequency of Transactions: The more frequently money is exchanged, the higher the velocity
of money.
2. Payment Methods: The ease and speed of electronic transactions compared to physical cash
transactions can affect the velocity of money.
3. Economic Confidence: In stable economic conditions, people are more likely to spend money
quickly, increasing the velocity of money.
4. Interest Rates: When interest rates are low, borrowing is cheaper, and people are more likely
to spend, increasing the velocity of money.
5. Inflation Expectations: If people expect prices to rise (inflation), they are more likely to
spend money sooner, increasing velocity.
To determine velocity of money we have to know the value of price level, volume of transaction or
output and quantity of money supplied.

b) In the fisherian quantity theory of money the quantity equation is

MV = PT or MV = PY

In this equation, the velocity of money is assumed to be fixed and so the number of transaction or
output. M represents the money supply and price level depends on the money supply. If the money
supply change, the price level also changes. The Fisherian version of the quantity theory of money
emphasizes the long-term relationship between money supply, transactions, and price levels.

In contrast, Cambridge version focuses on the short-term demand for money, considering various
motives for holding money and incorporating real income into the analysis. The Cambridge equation is
Md = kPY

In this equation money demand is used instead of money supply and a constant ‘k’ is used that
represents the portion of nominal income people want to hold. In this equation the value of k can vary
and price level and output are balanced with money demand when the value of k change. The velocity
in the Fisharian equation can be considered as (1/k) in Cambridge equation which is variable depending
different situation.

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a) IS curve shows the relationship between interest rate and income in goods market. It represents
the good market equilibrium points.

There are two factors that shift the IS curve.

 Change in government spending:
At a given level of interest there remains a certain level of investment. So, if the government
expenditure increase, the value of I+G increase for a certain level of interest. In equilibrium S+T
have to be balanced with I+G. As Tax is exogenously fixed, the saving has to be increased to balance.
For a higher saving, higher income is required. So, the income shifts to the rightward at a certain
level of interest as the government expenditure increases. Thus, the IS schedule also shift to the
right.

 Change in Tax:
Investment remains same at certain a level of interest and government expenditure is fined
exogenously. So, if the tax is increased at a certain level of interest, the savings have to be
decreased to balance (I + G) and (S + T) in equilibrium condition. And for less savings less income is
required. Thus, if the tax increase, the income in decreased.
b) The LM curve shows the relationship between income and interest rate in money market. It
represents the money market equilibrium points.

There are two factors that shifts the LM curve.

 Change in Money Supply:
𝑀 =𝑐 +𝑐 𝑌−𝑐 𝑟
𝑐 1 𝑐
𝑟= − 𝑀 + 𝑌
𝑐 𝑐 𝑐
When LM schedule is plotted, intercept contains the money supply. Any time the money supply
change, the intercept will change and the LM schedule will shift. If money supply increases the LM
schedule will shift down. If the money supply decreases, the LM schedule will shift up.

 Shift in the Money Demand Function:

A shift in money demand function means a change in the amount of money demanded for a given level
of interest rate and income. Assume that there is an increase in money demand for a given level of
income and the interest rate. A possible reason for such a shift, as suggested previously, is a loss of
confidence in bonds.
A shift in the money demand function that increase the demand for money at a given level of both
the interest rate and income shifts the LM schedule upward and to the left. A reverse case in money
demand shifts the LM schedule downward to the right.

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a)
Expansionary Fiscal Policy:
An expansionary fiscal policy is characterized by increased government spending or reduced taxes to
stimulate economic growth.
Effect on Aggregate Output: When the government increases spending or reduces taxes,
households and businesses have more money to spend. Increased spending by both consumers and the
government stimulates aggregate demand, leading to higher production and GDP. Firms might hire
more workers and produce more goods and services to meet the rising demand.
Effect on Interest Rates: Initially, increased government spending can put upward pressure on
interest rates due to higher demand for borrowing. As a result, the tax can be increased.

Contractionary Fiscal Policy:

A contractionary fiscal policy involves reduced government spending or increased taxes to curb
inflation and prevent the economy from overheating.
Effect on Aggregate Output: When the government cuts spending or raises taxes, households and
businesses have less money to spend. Reduced spending by consumers and the government decreases
aggregate demand, leading to lower production and GDP. Firms might reduce production and lay off
workers due to lower demand.
Effect on Interest Rates: As the government spending decreases, there is less demand for
borrowing. Then, there remains excess supply of loanable funds and the interest rate decreases.

Expansionary Monetary Policy:

An expansionary monetary policy aims to lower interest rates and increase money supply to boost
economic activity.
Effect on Aggregate Output: Lower interest rates encourage borrowing and investment by
businesses and consumers. Cheaper credit leads to increased spending by consumers. This higher
spending boosts aggregate demand, leading to increased production and GDP.
Effect on Interest Rates: Increasing money supply leads to excess money supply than demand that
cause decreasing in interest rate.

Contractionary Monetary Policy:

A contractionary monetary policy aims to raise interest rates and reduce the money supply to control
inflation and prevent the economy from overheating.
Effect on Aggregate Output: Higher interest rates increase the cost of borrowing, leading to
reduced spending and investment by businesses and consumers. Decreased spending and investment
lower aggregate demand, leading to decreased production and GDP.
Effect on Interest Rates: Decreasing money supply leads to less money supply than demand that
cause increasing in interest rate.

b)
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5th question of 9th batch is out of syllabus.

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a) Consumption Function: The consumption function (C = a + bY) represents the relationship between
disposable income and consumer spending. It suggests that as income increases, individuals tend to
spend more, but not all of the additional income is spent. The consumption function helps understand
how changes in income impact overall consumer spending in an economy.

b) Autonomous Expenditure: Autonomous expenditure refers to the level of spending in an economy

that is not influenced by changes in income. It includes government spending, investment by
businesses, and exports. Autonomous expenditure is considered to be independent of the level of
income and is a crucial component in calculating the equilibrium level of output in an economy.

c) Balanced Budget Multiplier: Balanced budget multiplier is the combination of both government
expenditure multiplier and tax multiplier. Balanced-budget multiplier gives the change in equilibrium
output that results from a 1-unit increase or decrease in both taxes and government spending.
Balanced budget multiplier is always 1 that means 1 unit increase in government expenditure financed
by 1 unit increase in tax will cause the equilibrium income increased by 1 unit.

d) Quantity theory of money: The quantity theory of money is a monetary theory that suggests a
direct relationship between the money supply and the price level in an economy. It is represented by
the equation 𝑀𝑉 = 𝑃𝑇, where M is the money supply, V is the velocity of money, P is the price level,
and T is the transaction total output of goods and services. The theory states that changes in the
money supply leads to a proportional change in the price level, assuming velocity and output remain
constant. If the money supply increases, the price level also increases.

e) Liquidity Trap: Liquidity trap is the situation when speculative demand for money won't increase
though the interest rate is decreased. In this situation speculative demand curve is horizontal. We
know that when interest rate decrease, the speculative demand for money increases. But after a
certain level the speculative demand cannot be increased though the interest rate decreased. This
situation is called liquidity trap.