Name: Fahad Syedi Anzar Reg No: 1511-208-007 Assignment No: 01 Program: BBA (Marketing &Finance) Subject: Macro

Economics Submitted to: Dr. Hajjan Jamali Submission Date: 05-01-2011

Question No: 01 Examine the role of commercial banks in economic development of a country.
Banks play an important role in economic development of developing country. Economic development involves investment in various sectors of economy. The banks collect savings from the people and mobilize saving for investment in industrial project. The investors borrow from banks to finance the projects. Promote the growth rate through the reorientation of loan policy. Special funds are provided to the investors for the completion of projects. The banks provide a guarantee for industrial loan from international agencies. The foreign capital flows to developing countries for investment in projects. Besides normal banking the banks perform agency services for the client. The banks buy and sell securities, make rent payments, receive subscription funds and collect utility bills for the Government departments. Thus these banks save time and energy of busy peoples. Banks arrange foreign exchange for the business transaction with other countries. The facility of foreign currency account has resulted in an increase of foreign exchange reserves. By opening a letter of credit the banks promote foreign trade. The banks are not simply collecting funds but also serve as a guide to the customer investment of their funds. The policy of banks is an instrument in wide dispersal of credit in country.

Question No: 02 Explain the main factors which influence consumption function.
Definition: Consumption function refers to the functional relationship between aggregate consumption and aggregate income C = f(y). The schedule shows the various amount of consumption at various levels of income. This shows that when income increases, consumption also increases, but in a lesser proportion (i.e.) the proportion of income spent on consumption goes on falling as income increases. A part of additional income is not consumed and is therefore saved. As a result of the increase in national income (a) Consumption expenditure increases at a diminishing rate. (b)Savings increases at an increasing rate. This show that as income increases, propensity to consume increases in a lesser proportion and propensity to save increases, in a greater proportion. (A) Objective factors influencing the consumption function:
First

of all the households consumption expenditure depends on their income

level. The consumption expenditure can be partly autonomous and partly dependent on disposable income. Disposable income is income minus personal or direct taxation. Thus C = f (Yd) where C = Consumption, Yd = disposable. Keynes psychological law status that as income increases, consumption also increases - but less than proportionately. Every increased income is generally divided into consumption and savings.

 Secondly

consumption depends upon the distribution of national income. If

the national income is properly distributed, then people's income that is the per capita income will be high and they will consume more.

Price level: The consumption pattern of the individuals not only depend upon the money income, but also the price level. Thus, during inflation, their consumption power is less and vice versa.

Wages: The consumption pattern largely depends upon the wages also, whether their remuneration is received in the form of cash or in kind.

Unexpected profits and losses: If the individuals are self employed people or business man, then their consumption pattern mostly depends on their profit and loss. Unexpectedly, if they gain more, then their consumption pattern is high.

Liquidity preference: If people prefer to hold more and more liquid cash, then their present consumption will be low.

Rate of Interest: If the interest is high, then people will forgo the present consumption and postpone it for a future date. Higher the rate of interest payable, lesser will be purchasing power. This will certainly reduce the consumption.

Future expectations: If the demand for cash to make speculative gains is more, then the present consumption will be low.

Permanent income: The people who have permanent income either from earned or unearned income, there consumption will be more.

Advertisement: If the advertisement and publicity can induce the people more effectively, then the consumption of the people for such commodities will be more.

Credit facilities: If goods can be purchased by taking loans, individuals spend more on consumption.

(B) Subjective factors influencing consumption function: There are some psychological motives which encourage savings and discourage consumption. They are as follows: (a) Motive of precaution: The desire to save for meeting unforeseen emergencies in future. (b) Motive of foresight: The desire to build reserves for meeting old age needs. (c) Motive of calculation: The desire to save for earning interest. (d) Motive of improvement: The desire to save for future progress. (e) Motive of independence: The desire to save for attaining self reliance. (f) Motive of pride: The desire to save for possessing wealth. (g) Motive of enterprise: The desire to save for establishing business assets. Motive which encourage savings among corporate sector: (a) Motive of enterprise: The desire to create additional resources for further investment. (b) Motive of liquidity: The desire to keep more liquid assets for meeting future emergencies. (c) Motive of improvement: The desire to enjoy rising income. (d) Motive of financial prudence: To arrange sufficient funds against depreciation.

Question No: 03 Draw a diagram and explain the reserves operation of investment multiplier.

Multiplier and Accelerator Effects The multiplier and the accelerator, both of which help to explain how we move from one stage of an economic cycle to another The multiplier process An initial change in aggregate demand can have a much greater final impact on the level of equilibrium national income. This is commonly known as the multiplier effect and it comes about because injections of demand into the circular flow of income stimulate further rounds of spending in other words one persons spending is anothers income and this can lead to a much bigger effect on equilibrium output and employment. Consider a 300 million increase in business capital investment for example created when an overseas company decides to build a new production plant in the UK. This will set off a chain reaction of increases in expenditures. Firms who produce the capital goods that are purchased will experience an increase in their incomes and profits. If they in turn, collectively spend about 3/5 of that additional income, then 180m will be added to the incomes of others. At this point, total income has grown by (300m + (0.6 x 300m). The sum will continue to increase as the producers of the additional goods and services realize an increase in their incomes, of which they in turn spend 60% on even more goods and services. The increase in total income will then be (300m + (0.6 x 300m) + (0.6 x 180m). The process can continue indefinitely. But each time, the additional rise in spending and income is a fraction of the previous addition to the circular flow. Multiplier effects can be seen when new investment and jobs are attracted into a particular town, city or region. The final increase in output and employment can be far

greater than the initial injection of demand because of the inter-relationships within the circular flow. The Multiplier and Keynesian Economics The concept of the multiplier process became important in the 1930s when John Maynard Keynes suggested it as a tool to help governments to achieve full employment. This macroeconomic demand-management approach, designed to help overcome a shortage of business capital investment, measured the amount of government spending needed to reach a level of national income that would prevent unemployment. The higher is the propensity to consume domestically produced goods and services, the greater is the multiplier effect. The government can influence the size of the multiplier through changes in direct taxes. For example, a cut in the basic rate of income tax will increase the amount of extra income that can be spent on further goods and services. Another factor affecting the size of the multiplier effect is the propensity to purchase imports. If, out of extra income, people spend money on imports, this demand is not passed on in the form of extra spending on domestically produced output. It leaks away from the circular flow of income and spending.

The construction boom and multiplier effects The study provides compelling evidence on the multiplier effects of major capital investment projects. 'One characteristic of construction activity is that it feeds through to many other related businesses. It has "backward linkages" into the likes of building materials; steel, architectural services, legal services and insurance, and most of these linkages tend to result in jobs close to home. This makes a boom in construction peculiarly powerful in fuelling expansion in the economy - for a given lift in building orders, the multiplier effect may be well over two. Planned capital investment by private sector businesses is linked to the growth of demand for goods and services. When consumer or export demand is rising strongly, businesses may increase investment to expand their production capacity and meet the extra demand. This process is known as the accelerator effect. But the accelerator effect can work in the other direction! A slowdown in consumer demand can create

excess capacity and may lead to a fall in planned investment demand.

Question No: 04 Critically examine the main defects of following approaches A- Cash transaction Approach. B- Cash Balance Approach.

The Transaction Approach: Fishers transaction approach to the Quantity Theory of Money may be explained with the following equation of exchange. MV = PT Where, M is the total supply of money V is the velocity of circulation of money P is the general price level T is the total transactions in physical goods. This equation is an identity, that is, a relationship that holds by definition. It means, in an economy the total value of all goods sold during any period (PT) must be equal to the total quantity of money spent during that period (MV). Fisher assumed that (1) at full employment total physical transactions T in an economy will be a constant, and (2) the velocity of circulation remain constant in the short run because it largely depends on the spending habits of the people. When these two assumptions are made the Equation of Exchange becomes the Quantity Theory of Money which shows that there is an exact, proportional relationship between money supply and the price level. But it cannot explain normal peace time inflation. This shortcoming has been modified by the Cambridge version or the Cash-Balance Approach.

The Cash-Balance Approach: The Cash-Balance Approach to the Quantity Theory of Money may be expressed as: = kR/M (1)

Where = the purchasing power of money k = the proportion of income that people like to hold in the form of money; R = the volume of real income; and M = the stock of supply of money in the country at a given time. This equation shows that the purchasing power of money or the value of money () varies directly with k or R, and inversely with M. Since is the reciprocal of the general price level; that is = 1/P, the equation, = kR/M can be expressed alternatively as: 1/P = kR/M ..........(2) or M = kRP ...(3) If we multiply the volume of real income (R) by the general price level(P), we have the money national income(Y). Therefore, M = kY .........(4) where Y is the countrys total money income. We can also write equation (3) in terms of the general price level thus: P = M/kR ...........(5) This equation implies that the price level (P) varies inversely with k or R and directly with M. In the Cash Balance approach k was more significant than M for explaining changes in the purchasing power (or value) of money. This means that the value of money depends upon the demand of the people to hold money.

SUPERIORITY OF THE CASH BALANCE APPROACH The Cash Balance approach to the Quantity Theory of Money is superior to the Transaction Approach on the following grounds. 1. The Transaction approach emphasizes the medium of exchange function of money only. On the other hand, the Cash Balance approach stresses equally the store of value function of money. Therefore, this approach is consistent with the broader definition of money which includes demand deposits. 2. In its explanation of the determinants of V, the Transaction approach stresses the mechanical aspects of the payments process. In contrast, the Cash Balance approach is more realistic as it is behavioral in nature which is built around the demand function for money. 3. As to the analytical technique, the Cash Balance approach fits in easily with the general demand-supply analysis as applied to the money market. This feature is not available in the Transaction approach. 4. The Cash Balance approach is wider and more comprehensive as it takes into account the income level as an important determinant of the price level. The Transaction approach neglected income level as the determinant of the price level. 5. According to the Transaction approach, the change in P is caused by change in M only. In the Cash Balance approach P may change even without a change in M if k undergoes a change. Thus k, according to the Cash Balance approach is a more important determinant of P than M as stressed by the Transaction approach. 6. Moreover, the symbol k in the Cash Balance approach proves to be a better tool for explaining trade cycles than V in Fishers equation.