micro economics

1. LOVELY PROFESSIONAL UNIVERSITY
HOME WORK NO. 1
School of Commerce and Economics
Domain: D 11
Name of the faculty member: Chander Shekhar Dogra
Course Code: ECO 161
Course Title: Macroeconomic Theory
Class: BBA Hons.
Term:
Section: Q1117
Batch: 2011
Max. Marks: 20 marks
Date of Allotment: 20/2/12
Date of Submission: 29/2/12
S.
No
Roll No
Objectives of
Academic
Activity
1
To impart a
conceptual
understanding
of
various
topics
in
macroeconomi
cs
with
practical
implications
Topic
1) Relative Income Hypothesis
2) Life Cycle Hypothesis
3) Keynesian Theory of Income,
Output and Employment
4) National Income
Date:
Organization
Evaluation
Details
4 questions of 5
marks each.
Sig. of Faculty member
Remarks by COS-F (Mandatory)
Sig. of COS-F with date
Remarks by COD-F (Mandatory)
Sig. of COD-F with date
HW 2 ECO 161

2. Q1
“The consumption of a household depends not only upon its own income but on his income relative to other
households in the neighbourhood. Thus a poor individual living among rich people is likely to consume a greater
proportion of his income as compared to other individuals in his income class.” Do you agree with this statement?
Support your answer with two examples that you see in the real world.
Q2
“An individual tries to balance his lifetime consumption and lifetime income. Thus he works and saves during his
working life, and spends that saved income after retirement.” How is this principle given by Franco Modigliani used to
devise pension reform plans and welfare systems in developed countries? Give an example in one country where the
retired population is growing faster than the working population creating problems in pension reform programs.
Q3
Marginal Efficiency of Capital is a theoretical and abstract concept while Marginal Efficiency of Investment depends
upon the excess capacity or “ability to increase production” in response to demand. Illustrate this point giving a
numerical example.
Questions 4 and 5 are based on the following case:
Article on RBI Policy
The last year was bad for Indian industry. It was made to be so. I have been predicting for a long time that India was
doomed if the RBI persisted with the kind of monetary policy it did: 13 hikes since March 2010. Finally, the government
confirmed the doomsday prophecy: industrial production had shrunk 5.1 per cent in October. But there was a much
bigger shock: capital goods had shrunk 25.5 per cent. Every sector is shrinking, except power, which too will due to
the constraints on coal supply and delay in environmental clearances. In the long run, there is a huge funds crunch as
well. All five manufacturing sectors turned negative. Basic goods: 0.1 per cent, intermediate goods: 4.73 per cent,
consumer durables: 0.3 per cent, consumer non-durables: 1.3 per cent, and the biggest slaughter, capital goods: 25.5
per cent. It sent shock waves. Even the finance minister said he would try to persuade the RBI to do something about
it.
But there was no reason for the shock waves if somebody, with a little common sense, had seen the storm coming.
There was a continued deceleration in output growth since the beginning of the year. Industrial production grew at the
dismal rate of 3.8 per cent in July, the lowest in 21 months. Manufacturing, which constitutes 75 per cent in the Index
of Industrial production (IIP), grew by just 2.3 per cent on a yearly basis, compared to 8.7 per cent last year. Mining
output declined by 3.4 per cent, compared to the same month last year. Indicators for September were worse,
especially industrial growth which slumped to 1.9 per cent, compared to 3.6 per cent in August. This was the lowest
growth rate in two years. The RBI squeezed the Indian industry.
A 25.5 per cent fall in capital goods is a nightmare. Production of capital goods is the best indicator of economic
direction. Capital goods are used in the production of other goods. So, a shrinkage of capital goods production has a
multiplier effect. This may not be visible soon, but it is going to show itself in 2012 and in the coming years. No
investment is taking place in the most crucial sector. On the investment front as a whole, the figures are disappointing.
The 2011 September quarter saw new investment worth only Rs 2.6 lakh crore, compared to Rs 7.2 lakh crore in the
2010 June quarter. 2011 was one of the worst years for the stock market, losing a quarter of its value (down from
20,500 to 15,455 on the BSE index). Investors lost Rs 20 lakh crore.
Who is to blame for this mess? The RBI believes the only way to combat inflation is through rate hikes. Milton
Friedman must be happy with the conservative monetarists who follow textbook undergraduate macroeconomic
theory. The simple Friedman logic is: the only reason for inflation is over-supply of money. According to Friedman’s kper cent rule, if the money supply is squeezed, prices will come down. It is fallacious on many counts, just two of
which are: nobody has succeeded in fighting food inflation or fuel inflation through monetary policy. Demand-side
controls will not succeed in a country like India. It has to be dealt with on the supply side, which means good
governance. Inflation, driven by cost-push factors and supply-side constraints, cannot be fought through rate hikes.
When global interest rates are close to zero, how can Indian industry compete when they have to borrow at 15 per
cent? That’s a 15 per cent competitive disadvantage. Add another 10 per cent minimum overheads, and Indian
industry starts with a 25 per cent disadvantage in the global market. How are they expected to export with such huge
competitive disadvantages? The RBI wrecked Indian industry at a time when India should have been trying to capture
the world market during the global turmoil. We are going to see one of the biggest trade deficits this year. I guess it will
be close to $200 billion. Given the state of capital goods production, what are we going to produce that’s exportable?
With such a huge trade deficit, the demand for dollars is going to be insatiable. We have not seen the bottom yet. The
rupee fell 19 per cent to the dollar in 2011. I predict it will go down close to 60 to a dollar in 2012. That is importing
inflation in a big way.
The RBI has not only wrecked Indian industry, but it has also wrecked the future of India. Who can afford a student
loan at 15 per cent?

3. The RBI’s meeting on December 16 was unusual: they didn’t hike rates. They patted each other on the back because
food inflation was down. Perhaps they were sure they got Friedman’s k-per cent rule perfectly right for vegetables!
Indian cricketers are getting thrashed Down Under by Pattinson & Co. The RBI is doing a fine Pattinson to Indian
industry. I am told that even Kaushik Basu, chief economic advisor to the government, is very unhappy about the
RBI’s hit-wicket policy.
Here’s a message for the RBI: Get real and bring down the rates. Give India a chance in 2012.
Q4
Write a note on the trends in industrial production witnessed due to rise in interest rates? You should support your
answer not only by taking data from the above case but from other sources available in the library.
Q5
In the above case, which components of GDP have been affected by rise in interest rates and what remedy is
suggested for overcoming this issue?