[1] Solow Model Statement:

Statement:

a). The basic Solow model without technological progress predicts that
economies exhibit long-term per capita income growth.

Answer: X False

Explanation:

The basic Solow model without technological progress assumes constant

returns to scale and diminishing returns to capital. In this setup, long-term
(steady-state) per capita income growth is zero, because:

Output per capita increases only temporarily during capital accumulation.

Once the economy reaches its steady state, growth in output per capita
ceases.

Long-term growth in output per capita requires technological progress, which

is absent here.
This graph demonstrates the core prediction of the Solow growth model
when there is no technological progress. In this version of the model, the
economy reaches a point where capital per worker (k) and output per worker
(y) stop growing — that is, there’s no long-run growth in per capita income.

📊 AXES:

X-axis (horizontal):

Represents Capital per worker (k) — this is the amount of capital (like
machines, tools) available to each worker.

Y-axis (vertical):

Represents:

Output per worker (y): how much each worker produces,

Investment per worker (i): how much output is saved and invested per
worker,

Depreciation line (break-even investment): how much capital is needed to

keep capital per worker unchanged.

📈 CURVES ON THE GRAPH

🔹 1. The sf(k) Curve – Savings/Investment Function:

This is the investment per worker, calculated as:

S f (k)= S.f(k)= S.kα, 0<α<1

However, it’s concave, meaning it increases at a decreasing rate.

Why? Because of diminishing returns to capital — adding more capital yields

smaller increases in output.

🔹 2. The (n + δ)k Line – Break-even Investment Line:

 This is a straight upward-sloping line.

 Formula:

(n + δ)k
  n Is the population growth rate,

 δ Is the depreciation rate.

 This line shows the amount of investment needed to:
o Equip new workers due to population growth (n),
o Replace worn-out capital due to depreciation (δ).

⚖️STEADY STATE (k*) – Point of Intersection:

The black dot where the sf(k) curve intersects the (n + δ)k line is the steady-
state capital per worker (k*).

At this point:

Sf(k*) = (n + δ)k* → ∆ k = 0

Investment is just enough to cover depreciation and population growth.

No further increase in capital per worker.

Therefore, output per worker remains constant.

📌 ECONOMIC INTERPRETATION:

🔁 Before the Steady State (k < k*):

Investment per worker exceeds the amount needed to keep capital per
worker constant:

Sf(k) > (n + δ)k

🔁 After the Steady State (k > k*):

Investment per worker is not enough to maintain the capital per worker:

Sf(k) < (n + δ)

🧠 Why There Is No Long-run Per Capita Growth:

Capital deepening can only take you so far because of diminishing returns.

Without technological progress, there’s no way to make capital or labor more

productive in the long run.

Once at k*, output per worker (y) becomes constant.

Therefore, the model predicts:

Per capita income growth = 0

Conclusion

The graph visually proves that the basic solow model without technological
progress does not predict long-term growth in per capita income. Instead,
the economy reaches a steady state where output per worker becomes
constant this in turn makes the statement FALSE.

QUESTION:

USE THE INTERTEMPORAL CHOICE FRAMEWORK TO DERIVE THE EULER

EQUATION AND INTERPRETE THE IMPLICATION FOR CONSUMPTION
BEHAVIOUR OVER TIME

ANSWER

The intertemporal choice framework is based on how a representative

consumer chooses consumption today (C1) and consumption tomorrow
(C2) to maximize utility over time, subject to their budget constraint.
CONSUMER’S OBJECTIVE

Maximize lifetime utility:

U = u (C1) + βu(C2)

Where:
 U(C): Instantaneous utility function (increasing and concave)
 Β ϵ (0, 1): time preference (how much the consumer value the future relative to today)

B. INTERTEMPORAL BUDGET CONSTRAINT:

c2 Y
C1 + = Y1 + + 2
1+ r 1+ r

 C1: Consumption in period 1

 C2: Consumption in period 2

 Y1, Y2: Income in period 1 and 2

 r : real interest rate

The left side is the present value of consumption, and the right is the present value

of income.

C. LAGRANGIAN SETUP:

Y2 C
Ը=¿ U(C1) + βU(C2) + λ ( Y1 + – C1 - 2 )
1+ r 1+ r
D. FIRST ORDER CONDITIONS

Take the derivative with respect to C1 and C2

∂Ը
1. = U! (C1) - λ = 0 → U! (C1) = λ
∂ C1
∂Ը 1 1
2. = βU(C2) - λ . = 0 → βU(C2) = λ .
∂ C2 1+ r 1+ r
E. ELIMINATE λ :
Divide both first order condition
 ¿
β u (C2 ) 1
¿ =
u (C 1) 1+ r

Rearranged:

U|(C1) = β (1+r ) U|(C2)

This is the EULER EQUATION

THE INTERPRETATION

U|(C1) = β (1+r ) U|(C2)

 This says that, the marginal utility of consumption today U|(C1)
must equal the discounted, interest-adjusted marginal utility of
consumption tomorrow.
 If the marginal utility today is greater than the discounted marginal utility
tomorrow, then the consumer will reduce C2 and increase C1 (consume more
today).
 If its less, they postpone consumption (save today, consume tomorrow).
IMPLICATION FOR CONSUMER BEHAVIOUR:
1. CONSUMPTION SMOOTHING (r)

 Consumer prefer smooth consumption over time to avoid large fluctuation

 If future income is expected to rise, consumer borrow today.
 If future income is expected to fall, consumer saves today.
2. EFFECT OF INTEREST RATE
 A higher interest rate makes future consumption more attractive and may lead
to less consumption today (more saving)
3. EFFECT OF PATIENCE ( β ¿

CONCLUSION
The Euler equation is a fundamental result in intertemporal economics. I ensures that
consumer optimally allocate consumption across time by balancing the benefits of
consuming now versus later, adjusted by the interest rate and time preference.
DISCUSSION OF TERMS
Misery Index

Definition: A macroeconomic indicator that combines unemployment and inflation rates

to measure economic hardship.
Misery Index = Unemployment Rate + Inflation Rate + Bank Lending Rate + GDP
Growth Rate
Interpretation:

 Higher values indicate worse economic conditions.

 Used to gauge public dissatisfaction with economic policies.
 Critics argue it oversimplifies economic well-being (e.g., ignores GDP growth).

STAGFLATION
Definition: A situation where an economy experiences stagnant growth (high
unemployment) and high inflation simultaneously.
Causes:
 Supply shocks (e.g., oil price hikes in the 1970s).
 Poor monetary/fiscal policies (e.g., excessive money supply growth with
structural unemployment).
Policy Dilemma:
 Traditional tools (e.g., lowering interest rates to fight unemployment) worsen
inflation.
 Requires supply-side reforms (e.g., productivity boosts) or tight monetary policy
(risking recession).

Conclusion

The inter-temporal model explains how consumers allocate consumption over time,
balancing current and future utility. The Euler equation shows how interest rates and
time preference affect savings behavior. The Misery Index and Stagflation are key
concepts for assessing macroeconomic distress.
Keynesian vs Classical Views on Goods and Labour Markets

1. Introduction

The Classical and Keynesian schools of thought differ fundamentally in how they
perceive the functioning of both the goods and labour markets. Classical economists
believe in the self-correcting nature of markets, governed by flexible prices and wages.
In contrast, Keynesians argue that markets can fail to self-correct, particularly in the
short run, due to rigidities and demand-side deficiencies. These divergent views shape
their respective approaches to economic policy and responses to unemployment and
economic downturns.

2. The Goods Market

Classical Perspective
Classical economists uphold Say’s Law, which states that “supply creates its own
demand.” This implies that all output produced will be matched by demand, eliminating
the possibility of general gluts or sustained unemployment. In this model:
 Prices and interest rates are perfectly flexible.
 Any excess supply or demand is corrected by market forces.
 Savings and investment are balanced through changes in interest rates.
Thus, the economy always tends toward full employment output in the long run.

Keynesian Perspective
Keynes challenged this view by arguing that aggregate demand determines output,
especially in the short run. In his view:
 Demand may be insufficient to purchase all that is produced.
 Investment decisions are driven by expectations, not just interest rates.
 Prices and wages are sticky, meaning they do not adjust quickly to clear markets.
This creates the possibility of demand-deficient recessions, where government
intervention through fiscal and monetary policy becomes necessary to restore
equilibrium.

3. The Labour Market

Classical Perspective
 In Classical theory, the labour market functions like any other market:
 Real wages (W/P) adjust to ensure labour supply equals labour demand.
 Any unemployment is voluntary, as it is assumed that workers who are
unemployed have refused to work at the market-clearing wage.

Thus, if unemployment arises, wage flexibility ensures that wages fall, increasing labour
demand and restoring full employment.
Keynesian Perspective
Keynesians argue that the labour market does not always clear due to nominal wage
rigidity
 Wages are often fixed by contracts, social norms, or minimum wage laws.
 Firms are reluctant to cut wages due to the impact on worker morale and
productivity.
 As a result, involuntary unemployment can persist even when workers are willing
to work at the current wage.

For Keynesians, the main issue is not the cost of labour, but insufficient demand for
goods and services, which reduces the incentive for firms to hire workers.

4. Policy Implications

The contrasting interpretations of the goods and labour markets lead to different policy
recommendations:

Classical Economics
Supports laissez-faire policies.
Advocates for limited government intervention, trusting that markets will self-correct.
Emphasizes long-term growth through supply-side reforms and flexible markets.
Views monetary and fiscal policy as largely ineffective and potentially inflationary.

Keynesian Economics
 Emphasizes active policy measures to manage economic fluctuations.
 Supports government spending and taxation policies to stimulate demand.
 Sees monetary policy as useful but sometimes limited in effectiveness (liquidity
trap).
 Focuses on short-run stability, employment, and demand management.

In the IS-LM framework:

The IS curve represents equilibrium in the goods market and slopes downward,
indicating that as interest rates fall, investment and income rise.
The LM curve represents money market equilibrium and slopes upward, showing that
higher income increases money demand and interest rates.
Equilibrium is found at the intersection of IS and LM curves, determining the overall
level of output (Y*) and interest rate (i*). Keynesians believe this equilibrium can occur
below full employment if demand is too low.

5. Evaluation

While Classical economics provides a solid framework for long-term analysis and
inflation control, it struggles to explain prolonged unemployment and business cycles.
Its reliance on wage and price flexibility often does not reflect real-world conditions.
Keynesian theory better accounts for short-term fluctuations, explaining the persistence
of unemployment and the role of expectations. However, critics argue it can lead to
over-reliance on government intervention and higher public debt.
Modern macroeconomics has attempted to integrate the strengths of both views through
New Classical and New Keynesian models, which include microfoundations,
expectations, and limited price/wage flexibility.

6. Conclusion
The Keynesian and Classical schools offer valuable but contrasting insights into how
goods and labour markets operate. While Classical economists emphasize the self-
regulating nature of markets, Keynesians focus on the real possibility of market failure
and underemployment. An understanding of both perspectives allows for more nuanced
and flexible economic policymaking, especially in times of economic crisis.

USING THE IS-LM FRAMEWORK FOR ECONOMIC STABILIZATION

1. Introduction
Economic stabilization refers to policy efforts aimed at reducing the severity of
fluctuations in output, employment, and inflation. Two main tools used by governments
and central banks are:
 Fiscal policy – Changes in government spending or taxation.
 Monetary policy – Adjustments in the money supply and interest rates.
The IS-LM framework helps illustrate how these tools affect the equilibrium level of
income (output) and interest rates in an economy. It captures interactions between the
goods market (IS curve) and the money market (LM curve).

2. IS-LM Framework Overview

The IS curve shows combinations of income (Y) and interest rates (i) where the goods
market is in equilibrium. It slopes downward because higher interest rates reduce
investment, thereby lowering output.
The LM curve shows combinations where the money market is in equilibrium. It slopes
upward, as higher income increases demand for money, pushing up interest rates if the
money supply is fixed.
Equilibrium occurs where IS and LM intersect – determining both the interest rate and
level of national income.
3. Fiscal Policy in the IS-LM Model
Fiscal policy (government spending ↑ or taxes ↓) shifts the IS curve.
Expansionary Fiscal Policy:
 Mechanism: Government increases spending or reduces taxes → aggregate
demand ↑.
 Effect: IS curve shifts right.
 Outcome: Higher income/output (Y ↑), possibly higher interest rate (I ↑).
 Limitation: May cause “crowding out” where higher interest rates reduce private
investment.
 4. Monetary Policy in the IS-LM Model
Monetary policy (changing the money supply) shifts the LM curve.
Expansionary Monetary Policy:
 Mechanism: Central bank increases money supply → interest rates ↓ →
investment ↑.
 Effect: LM curve shifts right/downward.
 Outcome: Higher income/output (Y ↑), lower interest rates (I ↓).
 Advantage: Less crowding out, as interest rates fall rather than rise.

5. Combined Use for Stabilization

In recessions, both policies can be combined:
Fiscal policy boosts demand.
Monetary policy prevents interest rates from rising (offsetting crowding out).
This coordination helps maximize the expansionary impact on income while stabilizing
interest rates.
Explanation of the Graph:

IS (Initial) – Blue solid line: Original goods market equilibrium.

IS (After Fiscal Expansion) – Blue dashed line: Fiscal policy (↑G or ↓T) shifts IS right →
higher income, higher interest rate.
LM (Initial) – Red solid line: Original money market equilibrium.
LM (After Monetary Expansion) – Red dashed line: Monetary policy (↑Ms) shifts LM
right → higher income, lower interest rate.

⚫ Equilibrium Points:
E₀ – Initial equilibrium.
E₁ – After fiscal policy: income ↑, interest rate ↑.
E₂ – After monetary policy: income ↑, interest rate ↓.