Question

1. Critically examine the phases of Business cycle. Explain the short-run Philips curve for inflation and Unemployment? Also explain its application in the ongoing scenario of Covid-19 outbreak                                                                                                                          
2. What makes the CPI an imperfect measure to compute the inflation rate? The new measure SPI has become the new normal for computing Inflation, please discuss its advantages and disadvantages over the CPI.

1. Why is it important for people who owns stocks and bonds to diversify their holdings?
2. Explain the Consumption function (including Autonomous and Induced consumption) and Marginal propensity to consume (MPC)? Graphical representation is must.

1. What is a Kuznets curve and why is it significant?
2. Keeping the definition and application of the curve in mind, draw two Kuznet curves: one for Pakistan, a developing country and one for Sweden a developed country.
3. Also explain why you think the curves look like they do for both the countries?
4. How are the two curves different from each other?

Answer 1

a.1) A business cycle has four peaks namely expansion, peak, contraction and trough. An expansionary phase represents such a phase with upward pressure on the prices and hence includes characteristics like high employment and economic growth. It would reach the highest value during the peak stage wherein the employment levels and the output levels are at the peak. In this phase, the inflationary situations are more evident in an economy. After a peak, the economy would then move on to a contractionary phase wherein the growth is expected to slow down and the pricing levels are expected to fall with an effect of increasing unemployment levels in the economy. It would reach the minimum point or the trough where the levels are at the lowest and then again would move on to the expansionary phase in the next cycle

Phillips curve represents a graphical relationship between inflation and unemployment and the short run Phillips curve represents that there is always a trade off between inflation and unemployment in the short run. In the long-run, the unemployment rate is expected to be steady regardless of the inflation levels of the economy. Thus, a clear inverse relationship can be seen between inflation and unemployment from the short-run Phillips curve.

In the ongoing Covid-19 crisis scenario, we can see that with increased lockdown measures across the globe, the output has been stalled all over the globe and the investment patterns have declined. All these factors have resulted in lowering the employment levels of the economy by a huge margin in the short-run. Thus, in this scenario, it is clearly evident that the short-run Phillips curve holds.

b) The following are the reasons why the Consumer Price Index [CPI] is a bad measure of the inflation rate of an economy

· It does not measure the change in the inflation rather measures the cost of living

· In case where the consumer is ready to substitute for lower price products, the CPI would become a bad indicator of the inflationary changes in an economy.

· The spending behaviours of the consumers are given importance and the inflationary effects are thus given lesser importance

· The assumption that the consumer behavioural patterns changes with changes in the prices of an economy is itself a clear indicator of the lower importance given to the inflation effects caused in the economy

· All samples of production and consumption are not covered under CPI

The following are the advantages of Sensitive Price Index [SPI] over CPI in measuring the inflationary effects in an economy

· Price sensitivity takes in to account the changes in the consumption behaviours with variations in the pricing mechanism of an economy and hence the inflation levels are taken in to consideration

· The elasticity of the demand and the changes in the prices are also considered in this method of calculation

· The changes in the cost of a fixed basket of goods and services are analysed and hence the variations can be evident

Although the above are the advantages of the SPI over CPI, there is a disadvantage that since the sensitivity is taken in to consideration, even a smaller change in the prices may bring about larger changes in the calculations and hence may prove difficult in the analysis.

c) a.2) The following are the reasons why the people who owns the stocks and bonds should diversify their holdings

· Due to diversification, they would have only smaller stakes in each asset which would help in reducing the risk of investment patterns.

· It would allow the investor to cancel any investment as per the requirements and still hold some assets at the same time

· It brings in flexibility in the investment patterns and thus would help in bringing more profits

d) b.2) A consumption function describes the relationship between the consumption and the disposable income. It is given by

                                             C = a+(b*Yd)

Where, C -> Consumption function, a -> Autonomous consumption, b*Yd -> Induced consumption, b -> Marginal Propensity to consume

Autonomous consumption is defined as the expenditure made by the consumers even at times of not having a disposable income. This indicates that there are certain products that have to be consumed at all times and even at times of not having a disposable income, the consumer tends to borrow them somehow

Induced consumption indicates that portion of the consumption that changes with changes in the disposable income levels. Here, the changes in the disposable income induces a change in the consumption patterns

Marginal Propensity to Consume indicated that rise in the pay the consumer has to incur in order to increase the consumption patterns. Thus, the proportion of the disposable income that a consumer spend on consumption indicates the propensity to consume