Assignment 1: Introduction to Macroeconomics & Pakistani Economy

1. Questions Macroeconomics Seeks to Answer

Macroeconomics generally tries to answer big-picture questions about the entire economy. Here are three
common ones:

 Why do economies grow over time? This involves looking at factors like technology, human capital,
and investment that lead to higher living standards.

 What causes unemployment and how can it be reduced? Macroeconomics examines why people
are out of work and policies to create jobs.

 What causes prices to rise (inflation) and how can it be controlled? This field studies the money
supply, demand, and other factors that influence the overall price level.

2. Pakistan's Long-Run Economic Growth

Pakistan's economic growth has been mixed since independence. There have been periods of good growth,
but also times of slow or even negative growth. Factors like political instability, insufficient investment in
education and infrastructure, and recurring balance of payments issues have often held it back.

Regarding optimism or pessimism:

 Optimistic perspective: Pakistan has a large, young population, abundant natural resources, and a
growing middle class, which are strong foundations for future growth. Increased focus on CPEC
(China-Pakistan Economic Corridor) and reforms in various sectors could unlock significant potential.

 Pessimistic perspective: Persistent political instability, high external debt, energy crises, and a
relatively low tax base continue to be significant challenges that could hinder sustained growth.

3. Business Cycles

Business cycles are the natural ups and downs of economic activity over time. Think of it like a roller
coaster for the economy:

 Boom (Expansion): A period of rapid economic growth, low unemployment, and rising prices.

 Bust (Recession/Contraction): A period of economic slowdown, rising unemployment, and

sometimes falling prices.

Factors leading to frequent boom and bust cycles in Pakistan can include:

 Political Instability: Frequent changes in government and policy uncertainty deter long-term
investment.

 External Shocks: Reliance on a few major exports and imports makes the economy vulnerable to
global price changes (e.g., oil prices) or international demand fluctuations.

 Fiscal Imbalances: Large government deficits and borrowing can lead to economic instability.

 Monetary Policy Issues: Inconsistent or poorly timed monetary policies can either overheat the
economy or stifle growth.

4. Unemployment Trends in Pakistan and Solutions

Pakistan faces high unemployment, especially among the youth and educated. This is often due to a
mismatch between skills demanded by the market and skills provided by the education system, as well as
insufficient job creation in the formal sector.

Three practical solutions:

 Vocational Training Programs: Invest in skills training that aligns with industry needs, making
graduates more employable.

 Support for Small and Medium Enterprises (SMEs): Provide access to finance and simplify
regulations for SMEs, as they are major job creators.

 Infrastructure Development: Large-scale infrastructure projects (roads, energy) create jobs directly
and indirectly by improving the business environment.

5. Effective Policies for Inflation Control in Pakistan

Inflation has been a recurring problem in Pakistan. There isn't one "best" decade, as different policies had
varying degrees of success. However, periods of tighter monetary policy (e.g., higher interest rates) by the
State Bank of Pakistan, coupled with responsible fiscal policy (managing government spending and
deficits), have generally been more effective in controlling inflation. For example, some would argue that
periods where the State Bank was more independent and focused on price stability saw better inflation
control.

6. Open vs. Closed Economy & Welfare Economy

 Open Economy: An economy that trades goods, services, and financial assets with other countries.
Pakistan is an open economy because it engages in significant international trade and receives
foreign investment.

 Closed Economy: An economy that does not trade or interact financially with other countries. This
is purely theoretical in the modern world.

Can Pakistan become a welfare economy? A welfare economy is one where the government plays a
significant role in providing social safety nets, healthcare, education, and other services to its citizens.
Pakistan can aspire to become more of a welfare economy, but it faces challenges like limited tax revenue,
large population, and competing demands on resources. Achieving this would require substantial reforms
in taxation, governance, and public service delivery.

7. Fiscal vs. Monetary Policies

 Fiscal Policy: This refers to the government's use of spending and taxation to influence the
economy.

o Example in Pakistan: If the government wants to boost economic activity, it might increase
its spending on public projects (like building roads) or cut taxes to leave more money in
people's hands. If inflation is high, it might reduce spending or increase taxes.

 Monetary Policy: This refers to the central bank's (State Bank of Pakistan - SBP) management of
the money supply and interest rates to influence the economy.
 o Example in Pakistan: If the SBP wants to slow down inflation, it might raise interest rates,
making it more expensive for people and businesses to borrow money, which reduces
spending. If it wants to stimulate growth, it might lower interest rates.

8. Positive vs. Normative Analysis

 Positive Analysis: Deals with factual statements and objective analysis that can be tested or
proven. It describes "what is."

o Example: "If the State Bank of Pakistan increases interest rates, inflation will likely decrease."
This is a testable hypothesis.

 Normative Analysis: Deals with value judgments, opinions, and what "should be." It involves
subjective statements that cannot be proven or disproven empirically.

o Example: "The government should increase spending on education." This is a

recommendation based on a value judgment.

9. Classical-Keynesian Debate

This is a fundamental debate in macroeconomics about how economies work and the role of government.

 Classical Economics: Believes that markets naturally tend towards equilibrium and full employment.
They advocate for minimal government intervention, arguing that prices and wages are flexible
enough to adjust and correct imbalances. They focus on the long run.

 Keynesian Economics: Argues that economies can get stuck in recessions with high unemployment
due to insufficient demand. They advocate for active government intervention (through fiscal and
monetary policies) to stimulate demand and stabilize the economy, especially in the short run.

Assignment 2: National Income & Economic Indicators

1. Circular Flow of National Income Model

The Circular Flow of National Income model shows how money, goods, and services move between
different parts of the economy, mainly households and firms. It explains why an economy's income must
equal its expenditure because every transaction involves both a buyer and a seller.

 When a household buys goods from a firm, it's an expenditure for the household and income for
the firm.

 When a firm pays wages to a household, it's an expenditure for the firm and income for the
household. This continuous flow means that the total value of all goods and services produced
(output) equals the total income earned from producing them, which in turn equals the total
spending on them.

2. Contribution to GDP: Small Economy Car vs. Luxury Sports Car

The production of a luxury sports car contributes more to GDP. Why? GDP (Gross Domestic
Product) measures the total market value of all final goods and services produced within a country's
borders in a specific time period. A luxury sports car has a much higher market value (price) than a small
economy car. Therefore, its production adds significantly more to the total value of goods produced in the
economy.

3. Wheat to Bread Transactions and GDP Contribution

 Farmer sells wheat to bakery for Rs. 20,000.

 Bakery uses wheat to make bread, sold for Rs. 30,000.

The total contribution of these transactions to GDP is Rs. 30,000. Why? GDP only counts the value of final
goods and services to avoid double-counting. Wheat is an intermediate good in this case because it's used
to produce the final good (bread). If we counted both the wheat and the bread, we'd be counting the value
of the wheat twice. The Rs. 30,000 value of the bread already includes the value of the wheat and the value
added by the bakery.

4. GNI vs. GDP in Pakistan

 GDP (Gross Domestic Product): Measures the value of all final goods and
services produced within a country's borders, regardless of who owns the production factors.

 GNI (Gross National Income): Measures the value of all final goods and services produced by a
country's residents, regardless of where they are located. It includes income earned by Pakistani
citizens and companies abroad, and excludes income earned by foreigners and foreign companies in
Pakistan.

GNI is generally higher than GDP in Pakistan. Why? A significant reason is the large amount
of remittances sent by overseas Pakistanis. These remittances are income earned by Pakistani residents
(abroad) and sent back home, contributing to Pakistan's GNI but not its GDP. Also, income from Pakistani
investments abroad contributes to GNI.

5. Desirability of Large GDP and GNI

It is generally desirable for Pakistan to have a large GDP and GNI because:

 Higher living standards: A larger economy means more goods and services are available, potentially
leading to higher incomes and better quality of life for citizens.

 More resources for development: A larger economic pie provides more tax revenue for the
government to invest in education, healthcare, infrastructure, and poverty reduction.

 Improved international standing: A strong economy can lead to greater influence on the global
stage.

Example of a policy that raises GDP but has undesirable long-run consequences: Imagine a policy that
allows widespread, unregulated deforestation to boost timber production and short-term agricultural land
availability.

 Raises GDP: In the short run, the increased logging and agricultural output would boost GDP.

 Undesirable long-run consequences:

o Environmental Degradation: Leads to soil erosion, loss of biodiversity, and climate change
impacts, harming future agricultural productivity and overall environmental health.
 o Resource Depletion: Depletes natural resources that are essential for long-term sustainable
growth.

o Health Issues: Increased pollution from unregulated industries can lead to higher healthcare
costs and reduced quality of life. Such a policy prioritizes short-term economic gains over
long-term sustainability and well-being.

6. Consumer Price Index (CPI)

The Consumer Price Index (CPI) measures the average change over time in the prices paid by urban
consumers for a market basket of consumer goods and services. It is constructed by:

1. Selecting a "basket" of goods and services: This basket represents what a typical household
consumes (food, housing, transportation, healthcare, etc.).

2. Conducting a price survey: Prices of these goods and services are collected regularly.

3. Calculating the index: The cost of the basket in the current period is compared to the cost of the
same basket in a base period.

Why CPI is an imperfect measure of the cost of living (three reasons):

 Substitution Bias: The CPI basket is fixed for a period. When prices of some goods rise, consumers
often substitute them with cheaper alternatives. The CPI doesn't immediately account for this
substitution, so it might overestimate the true cost of living increase.

 Introduction of New Goods: The CPI struggles to incorporate new goods and services quickly. When
new, often cheaper, goods enter the market, the CPI might not fully capture the improved
purchasing power of consumers.

 Quality Change Bias: Over time, goods and services improve in quality (e.g., a smartphone today is
much more powerful than one a few years ago for a similar price). The CPI has difficulty
distinguishing between a pure price increase and an increase in price due to improved quality,
potentially overstating inflation.

Divergence between Price Level/Inflation calculated using CPI and GDP Deflator:

 CPI measures the price of goods and services bought by consumers. It includes imports.

 GDP Deflator measures the price of all goods and services produced domestically. It excludes
imports.

They can diverge because:

 Different Baskets: The CPI basket is consumer-focused, while the GDP deflator includes all goods
and services produced in the economy (like investment goods, government purchases, and exports).

 Imports: A rise in the price of imported goods (e.g., oil) would affect the CPI more significantly than
the GDP deflator, as CPI includes imported consumer goods, while the GDP deflator does not.

 Weighting: The weights given to different goods and services can vary between the two measures.

7. Pakistan Bureau of Statistics (PBS) Data (Not executable, but explanation provided)
To answer this, you would need to visit the Pakistan Bureau of Statistics (PBS) website
(www.pbs.gov.pk) and look for data on National Accounts, specifically GDP.

You would typically look for tables containing:

 Nominal GDP (current prices): This is GDP measured at the prices prevailing in that year.

 Real GDP (constant prices): This is GDP adjusted for inflation, measured at the prices of a specific
base year (in this case, 2015-16).

Steps for Calculation:

1. Collect Data: Find Nominal GDP and Real GDP for the last 5 years (using 2015-16 as the base year).

2. Calculate Real GDP Growth for each year:

o Real GDP Growth Rate = $[(Real GDP{current year} - Real GDP{previous year}) / Real
GDP_{previous year}] \times 100$

3. Calculate the GDP Deflator for each year:

o GDP Deflator = $(Nominal GDP / Real GDP) \times 100$

4. Calculate Inflation Rates (using GDP Deflator values):

o Inflation Rate = $[(GDP Deflator{current year} - GDP Deflator{previous year}) / GDP

Deflator_{previous year}] \times 100$

Assignment 3: Money and Monetary Policy

1. "Money is what money does"

This statement means that the definition of money comes from its functions. Money isn't just a piece of
paper or metal; it's anything that performs certain roles in an economy.

These functions include:

 Medium of Exchange: It's widely accepted for buying and selling goods and services. Without it,
we'd rely on barter, which is inefficient.

 Store of Value: It can be saved and retrieved later to purchase goods and services. Its value should
not significantly depreciate over time.

 Unit of Account: It provides a common measure of value for goods and services. We can easily
compare prices using money.

Relation to Fiat and Crypto Currencies:

 Fiat Currency: (e.g., Pakistani Rupee, US Dollar) These are government-issued currencies that
are not backed by a physical commodity (like gold). Their value comes from government decree
and the trust people have in the issuing authority. "Money is what money does" applies perfectly
here; fiat money is money because people accept it as a medium of exchange, store of value, and
unit of account, not because it has intrinsic value.
  Cryptocurrencies: (e.g., Bitcoin, Ethereum) These are digital currencies secured by cryptography.
While they aim to fulfill the functions of money, their acceptance as a medium of exchange is still
limited compared to fiat currencies. Their store of value function is often highly volatile. The
statement "money is what money does" applies, but their ability to consistently perform these
functions is still evolving and debated.

2. State Bank of Pakistan (SBP) Responsibilities and Money Supply Increase

The State Bank of Pakistan (SBP) is Pakistan's central bank. Its primary responsibilities include:

 Monetary Policy: Controlling the money supply and interest rates to achieve price stability and
economic growth.

 Financial Stability: Regulating and supervising commercial banks to ensure the stability of the
financial system.

 Issuing Currency: Printing and managing the circulation of the Pakistani Rupee.

 Government's Bank: Managing the government's accounts and public debt.

If the SBP wants to increase the supply of money, it typically uses these tools:

 Open Market Operations (OMOs): SBP buys government bonds from commercial banks. This
injects money into the banking system, increasing bank reserves and allowing them to lend more.

 Lowering the Discount Rate (or Policy Rate): This is the interest rate at which commercial banks can
borrow directly from the SBP. A lower rate makes borrowing cheaper for banks, encouraging them
to borrow more and lend more to the public.

 Reducing Reserve Requirements: The SBP can lower the percentage of deposits that banks must
hold in reserve. This frees up more money for banks to lend out.

Impact on Economic Growth and Inflation in Pakistan:

 Economic Growth (Positive Impact): An increased money supply generally leads to lower interest
rates, making it cheaper for businesses to borrow and invest, and for consumers to borrow and
spend. This stimulates aggregate demand, leading to higher production and employment, thus
fostering economic growth.

 Inflation (Potential Negative Impact): If the money supply grows too quickly relative to the supply
of goods and services, it can lead to "too much money chasing too few goods," resulting in higher
prices, i.e., inflation. The SBP constantly balances stimulating growth with controlling inflation.

3. Money Creation: SBP vs. Commercial Banks

 State Bank of Pakistan (SBP): The SBP creates "base money" or "high-powered money." This
includes physical currency (notes and coins) and commercial banks' reserves held at the SBP. The
SBP does this through actions like open market operations (buying bonds) or lending to banks.

 Commercial Banks: Commercial banks create "deposit money" through lending. This is known as
the money multiplier effect. When a commercial bank receives a deposit, it's only required to keep
a fraction as reserves. The rest can be lent out. When that loan is deposited in another bank, that
bank can again lend out a portion, and so on. This process expands the overall money supply in the
economy, even though the SBP only created the initial base money.
4. "Inflation is always and everywhere a monetary phenomenon" - Milton Friedman

This famous quote by Nobel laureate Milton Friedman, a prominent monetarist economist, means
that inflation (a sustained increase in the general price level) is primarily caused by an excessive increase
in the money supply relative to the growth of goods and services in an economy.

Based on the Quantity Theory of Money: The Quantity Theory of Money is often expressed by the
equation: $M \times V = P \times Y$ Where:

 $M$ = Money Supply

 $V$ = Velocity of Money (the average number of times a unit of money is spent in a given period)

 $P$ = Price Level

 $Y$ = Real Output (GDP)

Friedman argued that in the long run, the velocity of money ($V$) and real output ($Y$) are relatively
stable or grow at a predictable rate. Therefore, if the money supply ($M$) increases significantly faster than
real output ($Y$), the only way for the equation to hold is for the price level ($P$) to increase, leading to
inflation.

In simpler terms, if there's much more money circulating in the economy but roughly the same amount of
goods and services, people will bid up prices because there's more money available to buy the same
quantity of things.

5. Challenges for SBP in Monetary Policy Implementation

The State Bank of Pakistan faces several challenges:

 Political Interference: Governments might pressure the SBP to keep interest rates low to stimulate
short-term growth, even if it risks inflation, undermining the SBP's independence and its ability to
maintain price stability.

 Exchange Rate Volatility: Pakistan's economy is highly susceptible to exchange rate fluctuations.
Managing the exchange rate can sometimes conflict with inflation control or economic growth
objectives.

 Fiscal Imbalances: Large and persistent government budget deficits can lead to the government
borrowing heavily, sometimes from the SBP, which can increase the money supply and fuel inflation,
making the SBP's job harder.

 Supply Shocks: External factors like global oil price increases or domestic issues like natural
disasters can cause supply shortages, leading to "cost-push" inflation that monetary policy alone
cannot fully control.

 Informal Economy: A significant portion of Pakistan's economy is informal, making it harder for the
SBP's policies to have their full intended effect, as many transactions occur outside the formal
banking system.

Assignment 4: National Saving, Investment, and Loanable Funds

1. National, Private, and Public Saving
  National Saving (S): The total income in an economy that remains after paying for consumption and
government purchases. It's the sum of private and public saving. In a closed economy, National
Saving equals Investment ($S = I$).

o Formula: $S = Y - C - G$ (where Y = GDP, C = Consumption, G = Government Purchases)

 Private Saving (Sp): The income that households have left after paying for taxes and consumption.

o Formula: $Sp = Y - T - C$ (where T = Taxes)

 Public Saving (Sg): The tax revenue that the government has left after paying for its spending. It's
also known as the government budget balance.

o Formula: $Sg = T - G$

How these three variables are related: National Saving is the sum of private saving and public saving. $S =
Sp + Sg$ Substitute the formulas: $S = (Y - T - C) + (T - G)$ $S = Y - C - G$ This shows that national saving is
indeed the sum of private and public saving, and represents the total resources available for investment in
an economy.

2. Investment and National Saving

 Investment (I): In macroeconomics, investment refers to the creation of new capital goods, such as
factories, machinery, equipment, and new housing. It's spending on goods that will be used in the
future to produce more goods and services.

 How it's related to National Saving: In a closed economy, Investment (I) must equal National
Saving (S). This is a fundamental macroeconomic identity. The funds that are saved by households
and the government (national saving) are precisely the funds available to finance investment in new
capital. Savers supply the funds, and investors demand the funds.

3. Incentive for Increasing Private Saving in Pakistan (Closed Economy)

An incentive for increasing private saving could be to introduce higher, tax-free interest rates on savings
accounts or specific savings schemes offered by banks.

How this policy would affect the market for loanable funds:

 Loanable Funds Market: This is a conceptual market where the supply of funds comes from savers
(private and public saving), and the demand for funds comes from investors. The price in this
market is the real interest rate.

 Impact of Policy: If the government offers tax-free interest on savings, it makes saving more
attractive for households. This would increase the supply of private saving at every given interest
rate.

 Graph: On a graph with the real interest rate on the vertical axis and the quantity of loanable funds
on the horizontal axis:

o The Supply of Loanable Funds curve would shift to the right.

o This rightward shift would lead to a lower equilibrium real interest rate and a higher
equilibrium quantity of loanable funds (which also means higher investment, as $I=S$).

4. Incentive for Increasing Investment in Pakistan (Closed Economy)

An incentive for increasing investment could be to offer tax credits or subsidies to businesses that invest in
new capital (e.g., new machinery, technology upgrades).

How this policy would affect the market for loanable funds:

 Impact of Policy: Tax credits or subsidies effectively reduce the cost of borrowing for firms that want
to invest. This would increase the demand for loanable funds at every given interest rate.

 Graph: On a graph with the real interest rate on the vertical axis and the quantity of loanable funds
on the horizontal axis:

o The Demand for Loanable Funds curve would shift to the right.

o This rightward shift would lead to a higher equilibrium real interest rate and a higher
equilibrium quantity of loanable funds (which again means higher investment).

5. Government Budget Deficit

A government budget deficit occurs when the government spends more money than it collects in tax
revenue in a given period.

 Formula: $Deficit = G - T$ (where G = Government Purchases, T = Taxes). It's the opposite of public
saving ($Sg = T - G$).

How it affects interest rates, investment, and economic growth:

 Interest Rates: When the government runs a deficit, it needs to borrow money to cover the
shortfall. It does this by issuing government bonds. This increased borrowing by the
government increases the demand for loanable funds. In the loanable funds market, an increased
demand for funds, with an unchanged supply, leads to a higher equilibrium real interest rate. This
phenomenon is often called "crowding out."

 Investment: A higher real interest rate makes it more expensive for private businesses to borrow
money for investment projects. As a result, private investment tends to decrease because it
becomes less profitable.

 Economic Growth: Reduced private investment means less capital accumulation (fewer new
factories, machines, etc.). Less capital accumulation in the long run generally leads to slower
economic growth and potentially lower living standards because the economy's productive capacity
is not expanding as rapidly.

6. Calculation of Consumption, Government Purchases, National Saving, and Investment

Given:

 GDP ($Y$) = $8 trillion

 Taxes ($T$) = $1.5 trillion

 Private Saving ($Sp$) = $0.5 trillion

 Public Saving ($Sg$) = $0.2 trillion

 Economy is closed.

Let's calculate the unknowns:

 1. Calculate Government Purchases (G): We know Public Saving ($Sg$) = $T - G$. $0.2 trillion = 1.5
trillion - G$ $G = 1.5 trillion - 0.2 trillion$ G = $1.3 trillion

2. Calculate National Saving (S): We know National Saving ($S$) = Private Saving ($Sp$) + Public Saving
($Sg$). $S = 0.5 trillion + 0.2 trillion$ S = $0.7 trillion

3. Calculate Investment (I): In a closed economy, National Saving ($S$) = Investment ($I$). I = $0.7
trillion

4. Calculate Consumption (C): We know GDP ($Y$) = Consumption ($C$) + Investment ($I$) +
Government Purchases ($G$) in a closed economy. $Y = C + I + G$ $8 trillion = C + 0.7 trillion + 1.3
trillion$ $8 trillion = C + 2.0 trillion$ $C = 8 trillion - 2.0 trillion$ C = $6.0 trillion

Summary of Calculations:

 Consumption (C): $6.0 trillion

 Government Purchases (G): $1.3 trillion

 National Saving (S): $0.7 trillion

 Investment (I): $0.7 trillion