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Question#1:- Why does the LM curve slope upwards?

Answer#1:-The IS curve in the IS-LM aggregate demand model is downward sloping because as the
interest rate falls, investment increases, thus increasing output. The LM curve describes equilibrium
in the market for money. The LM curve is upward sloping because higher income results in higher
demand for money, thus resulting in higher interest rates. The intersection of the IS curve with the
LM curve shows the equilibrium interest rate and price level.

The IS curve and the LM curve shift in response to economic activities. The IS curve shifts outward
as a result of increased government purchases, exogenous increases in investment, decreases in taxes,
and exogenous increases in consumption. The IS curve shifts inward as a result of decreases in
government purchases, exogenous decreases in investment, increases in taxes, and exogenous
decreases in consumption. The LM curve shifts outward as a result of increases in the money supply
and decreases in the price level. The LM curve shifts inward as a result of decreases in the money
supply and increases in the price level.

When the price level increases, the LM curve shifts inward. An inward shift in the LM curve results
in an intersection of the IS-LM model at a lower level of output and income and a higher interest rate.
When a line connecting the old price level and the old output and income to the new price level and
the new output and income in the price level and output and income space, the downward sloping
aggregate demand curve appears. In general, from the IS-LM model, it is clear that aggregate demand
slopes downward because as the price level increases, output and income decrease.

Question#2:- Use the Keynesian cross to predict the impact of:

a) An increase in government purchases.

b) An increase in taxes.
c) An equal increase in both government purchases and taxes

Answer#2:-The Keynesian Cross looks like this:

Aggregate Demand is on the vertical axis, and income on the

horizontal. The upward sloping line indicates that aggregate demand
rises with income for both households and business firms.

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a) An increase in government purchases. The increase adds to income, therefore equilibrium

GDP will rise.

b) An increase in taxes. An increase in taxes reduces income, therefore

equilibrium GDP will fall.

c) An equal increase in both government These two actions will cancel each other, therefore
purchases and taxes. GDP is likely to stay about the same.

Question#3:- The Keynesian cross, assume that the consumption function is given by
C=200+0.75(Y-T) Planned investment is 100; government purchases and taxes are both 100.
a) Graph planned expenditure as a function of income.
b) What is the equilibrium level of income?
c) If government purchases increase to 125, what is the new equilibrium income?
d) What level of government purchases is needed to achieve an income of 1,600?
Answer#3:-
a) PE=C+I+G=200+0.75(Y-100) +100+100=325+0.75Y

b) The equilibrium level of income obtained by equating actual expenditure with panned
expenditure:
PE=AE
Y=325+0.75Y
Y=1300
c) Since this is a stylized Keynesian cross model, we can use the government purchase multiplier
directly.

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1
∆𝑌 = ∆𝐺
1 − 𝑀𝑃𝐶
1
= ∗ 25 = 100
1 − 0.75
As a result, the new equilibrium income is 1300+100=1400

Question#4:- Differentiate the concepts of microeconomics and macroeconomics.

Answer#4:-

Microeconomics is the study of particular markets, and segments of the economy. It looks at issues
such as consumer behaviour, individual labour markets, and the theory of firms. It is concerned with:

 Supply and demand in individual markets

 Individual consumer behaviour. e.g. Consumer choice theory
 Individual labour markets – e.g. demand for labour, wage determination
 Externalities arising from production and consumption. e.g. Externalities

Macroeconomics is the study of the whole economy. It looks at ‘aggregate’ variables, such as
aggregate demand, national output and inflation. It is concerned with

 Monetary / fiscal policy. e.g. what effect does interest rates have on the whole economy?
 Reasons for inflation and unemployment.
 Economic growth
 International trade and globalization
 Reasons for differences in living standards and economic growth between countries.
 Government borrowing

The main differences between micro and macro economics

1) Small segment of economy vs whole aggregate economy.

2) Microeconomics works on the principle that markets soon create equilibrium. In macroeconomics,
the economy may be in a state of disequilibrium (boom or recession) for a longer period.
3) There is little debate about the basic principles of micro-economics. Macroeconomics is more
contentious. There are different schools of macroeconomics offering different explanations (e.g.
Keynesian, Monetarist, Austrian, Real Business cycle e.t.c).

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4) Macroeconomics places greater emphasis on empirical data and trying to explain it. Micro economics
tends to work from theory first.

Similarities between microeconomics and macroeconomics

Although it is convenient to split up economics into two branches – microeconomics and

macroeconomics, it is to some extent an artificial divide.

1) Micro principles are used in macroeconomics. If you study the impact of devaluation, you are likely
to use same economic principles, such as the elasticity of demand to changes in price.
2) Micro effects macroeconomics and vice versa. If we see a rise in oil prices, this will have a significant
impact on cost-push inflation. If technology reduces costs, this enables faster economic growth.
3) Blurring of distinction. If house prices rise, this is a micro economic effect for the housing market.
But, the housing market is so influential that it could also be considered a macro-economic variable,
and will influence monetary policy.
4) There have been efforts to use computer models of household behavior to predict the impact on the
macro economy.
Question#5:-Discuss the concepts of aggregate demand and aggregate supply taking an Ethiopian
case as expel for your justifications.

Answer#5:-

Aggregate Demand?

Aggregate demand (AD) is the total demand for final goods and services in a given economy at a
given time and price level. Aggregate Demand is the total of Consumption, Investment, Government
Spending and Net Exports (Exports-Imports). Aggregate Demand = C + I + G + (X – M). It shows
the relationship between Real GNP and the Price Level.

Factors that Affect Aggregate Demand

i. Net Export Effect: When domestic prices increase, then demand for imports increases (since
domestic goods become relatively expensive) and demand for export decreases.
ii. Real Balances: When inflation increases, real spending decreases as the value of money
decreases. This change in inflation shifts Aggregate Demand to the left/decreases.

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iii. Interest Rate Effect: Real Interest is the nominal interest rate adjusted to the inflation rate.
When inflation increases, nominal interest rates increase to maintain real interest rates. Lower
real interest rates will lower the costs of major products such as cars, large appliances, and
houses; they will increase business capital project spending because long-term costs of
investment projects are reduced.
iv. Inflation Expectations: If consumers expect inflation to go up in the future, they will tend to
buy now causing aggregate demand to increase or shift to the right.

Aggregate Supply?

While, the Aggregate Supply is the total of all final goods and services which firms plan to produce.
During a specific time period. It is the total amount of goods and services that firms are willing to
sell at a given price level in an economy. There are two views on Long Run Aggregate Supply, the
Monetarist view and the Keynesian view. The curve is upward sloping in the short run and vertical,
or close to vertical, in the long run.

Investment, technology changes that result in productivity improvements and positive institutional
changes can increase short-run and long-run aggregate supply. Some factors can only affect
Aggregate Supply in the short run.

Factors that Affect Aggregate Supply

i. Supply Shocks: Adverse supply shocks shift AS to the left, i.e., a decrease in the AS curve.
Usually, a huge rise in oil prices can cause a supply shock. Natural catastrophes or hikes in
taxes can also shift AS to the left. It is either a leftward shift in the short run AS curve (the
one on the left) or by the leftward shift in the vertical long-run AS curve. However, the long
run AS curve is best suited for natural disasters or setbacks in the economy, such as corrupt
governments.
ii. Resource Price Changes: Changes in the short run resource prices can alter the Short Run
Aggregate Supply curve. Unless the price changes reflect differences in long-term supply, the
Long Run Aggregate Supply is not affected.
iii. Changes in Expectations for Inflation: If suppliers expect goods to sell at much higher prices
in the future, they will be less willing to sell in the current period. As a result, the Short Run
Aggregate Supply will shift to the left.

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iv. Capacity Increase: A rightward or an increase in AS implies an increase in the productive

capacity of the economy. You can think of this as an outward shift in the production possibility
curve. An increase in the quality and quantity of the factors of production or technological
advancements or any increase in productivity can cause an outward shift.

Question#6:- Differentiate the concepts GDP and GNP by giving some actual justification in a real
world of work.

Answer#6:-

Definition of GDP?

Gross Domestic Product or GDP, is the value of everything that is produced within the country’s
domestic territory in a particular financial year. During the calculation of GDP, the primary focus is
to capture the goods produced or services rendered within the nation’s border, whether the output is
produced by the residents or non-residents of the country. The output produced outside the
geographical boundaries of the country are not included in GDP.GDP is an indicator of the size of
the economy. It reflects the aggregate of consumption, investments, spending by the government and
net export (export – import). In general, the GDP is calculated for one year. However, it can also be
calculated for any term to forecast economic trends.

Definition of GNP?

Gross National Product or GNP is the total market value of everything (i.e. goods and services)
produced by the residents of the country during a particular accounting year. GNP includes the
income earned by the country’s nationals within and outside the country, but it excludes the income
earned by the foreign citizens and companies within the country. You can understand the statement,
through an example: There are many enterprises which are operating outside the country. Many
citizens of a country work in another country. The income earned by all these persons is known as
factor income earned from abroad. Likewise, non-residents render factor services within the domestic
territory of the country for which they earn income. When you deduct the factor income paid to non-
residents for rendering services from factor income received from abroad, the result will be the Net
Factor Income received from Abroad (NFIA).

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BASIS FOR GDP GNP

COMPARISON

Meaning The worth of goods and services The worth of goods and services
produced within the geographical produced by the country's citizens
limits of the country is known as irrespective of the geographical
Gross Domestic Product (GDP). location is known as Gross National
Product (GNP).

What is it? Production of products within the Production of products by the

country's boundary. enterprises owned by the residents of
the country.

Basis Location Citizenship

Calculation GDP = Consumption + Investment GNP = GDP - NFIA

+ Government Spending + Net
Export

On which scale On a local scale On international scale

productivity is
measured?

Focus on Domestic production Production by nationals

Outlines The strength of the country's How the residents are contributing
domestic economy. towards the country's economy.

Key Differences between GDP and GNP

The major differences between GDP and GNP are explained in the given below points:

1) The monetary value of all the goods and services produced within the geographical limits of the
country is known as GDP. GNP is the money value of all the goods and services made by the citizens
of the country, no matter where they dwell.
2) GDP gauges production of products within the country’s boundary. Conversely, GNP measures the
production of products by the companies and industries owned by the residents of the country.

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3) The basis for calculating the GDP is the location, whereas GNP is based on citizenship.
4) In the case of GDP, the measurement of productivity is done on a local scale while if we talk about
GNP, it measures the productivity on an international level.
5) GDP focuses on measuring domestic production, but GNP focuses on production by the nationals,
i.e., individuals or corporations, of the country.
6) GDP outlines the strength of the domestic economy of a country. On the other hand, GNP outlines
how the residents are contributing towards the economy of the country.

Example of GNP

If a Japanese multinational produces cars in the UK, this production will be counted towards UK
GDP. However, if the Japanese firm sends £50m in profits back to shareholders in Japan, then this
outflow of profit is subtracted from GNP. UK nationals don’t benefit from this profit which is sent
back to Japan.
If a UK firm makes a profit from insurance companies located abroad, then if this profit is returned
to UK nationals, then this net income from overseas assets will be added to UK GNP.
Note, if a Japanese firm invests in the UK, it will still lead to higher GNP, as some national workers
will see higher wages. However, the increase in GNP will not be as high as GDP.
 If a county has similar inflows and outflows of income from assets, then GNP and GDP will
be very similar.
 However, if a country has many multinationals who repatriate income from local production,
then GNP will be lower than GDP.
For example, Luxembourg has a GDP of $87,400 but a GNP of only $45,360.