Macroeconomics for Business

Long-run determinants of investment are the factors that influence the desired capital stock and the investment path over a long period, rather than short-term fluctuations:

1. Expected growth of output and income. Higher expected long-run demand requires more capital (accelerator principle).
2. Real interest rate (cost of capital). A lower long-run real interest rate raises the profitability of capital projects.
3. Technology and productivity. New technology raises the marginal product of capital and the return on investment.
4. Savings and availability of finance. A high domestic saving rate and a developed financial system supply funds for investment.
5. Taxes and government policy. Corporate taxes, incentives and depreciation allowances change after-tax returns.
6. Infrastructure, institutions and political stability. Energy, roads, rule of law and secure property rights.
7. Size of the market and openness, including FDI and trade.
8. Population and labour force growth, which require more capital to equip workers.

Financial inclusion means that individuals and businesses have access to useful and affordable financial products and services (accounts, payments, credit, savings, insurance) delivered responsibly and sustainably. Its main determinants are:

1. Income and wealth. Low-income households have less ability to save and use formal financial services.
2. Education and financial literacy. Better knowledge of financial products raises use.
3. Geography and infrastructure. Distance to bank branches, roads, electricity and internet connectivity; rural and hilly areas are more excluded.
4. Cost of financial services. Account fees, minimum balances, high interest rates and transaction charges discourage the poor.
5. Documentation and legal requirements. Identity and collateral requirements exclude people without papers or land titles.
6. Technology. Mobile banking, digital wallets, agent banking and QR payments widen access.
7. Regulatory and policy environment. Central bank directives (branch expansion in unbanked areas, priority sector lending), microfinance regulation, and consumer protection.
8. Trust and social and cultural factors. Confidence in institutions, gender norms, and age.
9. Product design and competition, meaning services suited to low-income customers, and the number and variety of providers (banks, cooperatives, MFIs).

Start from the equilibrium of a closed or open economy with a government. Let $C = a + bY_d$, $Y_d = Y - T$, $I$ and $G$ autonomous, and lump-sum tax $T$.

Government expenditure multiplier. $Y = a + b(Y - T) + I + G \Rightarrow Y(1-b) = a - bT + I + G$ $Y = \frac{a - bT + I + G}{1-b}$ A change in $G$ alone gives $\Delta Y = \frac{\Delta G}{1-b} \Rightarrow k_G = \frac{1}{1-b} = \frac{1}{\text{MPS}}$

Tax multiplier. A change in $T$ alone gives $\Delta Y = \frac{-b\,\Delta T}{1-b} \Rightarrow k_T = \frac{-b}{1-b} = -\frac{\text{MPC}}{\text{MPS}}$ It is negative because a tax increase reduces disposable income and consumption, and it is smaller in size than $k_G$ because only the fraction $b$ of the tax change affects spending in the first round.

Foreign trade multiplier. Let exports $X$ be autonomous and imports $M = m_0 + mY$ where $m$ is the marginal propensity to import: $Y = a + bY + I + G + X - m_0 - mY \Rightarrow Y = \frac{a + I + G + X - m_0}{1 - b + m}$ A change in exports gives $\Delta Y = \frac{\Delta X}{1 - b + m} \Rightarrow k_X = \frac{1}{1-b+m} = \frac{1}{\text{MPS} + \text{MPM}}$ It is smaller than the simple multiplier because part of each extra income leaks out as imports.

Balanced budget multiplier (a useful check): $k_G + k_T = \frac{1}{1-b} - \frac{b}{1-b} = 1$.

Demand-pull inflation occurs when aggregate demand grows faster than the economy's capacity to produce, so "too much money chases too few goods" and the general price level rises.

Principle. The aggregate demand curve $AD = C + I + G + (X-M)$ shifts to the right. In the Keynesian model, once the economy is at or near full employment, output cannot rise further (the aggregate supply curve is vertical or steep), so the excess demand (the inflationary gap) pushes prices up: $P_1 \rightarrow P_2$. Causes of the rise in demand include growth in money supply and credit, higher government spending, tax cuts, increased exports and remittance income, and rising consumer and investor confidence. A price-wage spiral may follow.

Control by monetary policy (reduce money supply and credit)

• Raise the policy rate, bank rate and cash reserve ratio, so loans become costlier and credit shrinks.
• Sell government securities through open market operations to absorb liquidity.
• Impose selective credit controls (higher margin requirements, restrict consumer credit).
• Result: lower consumption and investment, so aggregate demand falls.

Control by fiscal policy (reduce spending, raise taxes)

• Cut government expenditure, particularly unproductive recurrent spending.
• Increase taxes (income, VAT, excise), which reduces disposable income and consumption.
• Run a budget surplus and borrow from the public to mop up purchasing power.
• Encourage saving.

Supplementary measure: raise supply through production incentives, imports and better distribution.

Monetary policy acts faster, while fiscal policy is more direct; both should be coordinated, though contraction carries a cost of lower output and employment.

Consider a four-sector economy with

$C = a + b\,Y_d,\quad Y_d = Y - T,\quad T = T_0 + tY \;\text{(or lump sum)},\quad M = M_0 + mY$

and $Y = C + I + G + X - M$. For the lump-sum tax case ($T = T_0$, $M = M_0 + mY$):

$Y = a + b(Y - T_0) + I + G + X - M_0 - mY$

$Y\,(1 - b + m) = a - bT_0 + I + G + X - M_0$

$Y = \frac{a - bT_0 + I + G + X - M_0}{1 - b + m}$

Government expenditure multiplier

$k_G = \frac{\Delta Y}{\Delta G} = \frac{1}{1 - b + m}$

With a proportional tax $T = T_0 + tY$ the denominator becomes $1 - b(1-t) + m$. If imports are ignored, $k_G = \dfrac{1}{1-b} = \dfrac{1}{s}$.

Tax multiplier

$k_T = \frac{\Delta Y}{\Delta T_0} = \frac{-b}{1 - b + m}$

The tax multiplier is negative, as higher taxes reduce disposable income and consumption, and it is smaller in absolute size than $k_G$ because only the fraction $b$ of the tax change affects spending; the remainder affects saving. (Closed economy without imports: $k_T = -\dfrac{b}{1-b}$.)

Foreign trade (export) multiplier

$k_X = \frac{\Delta Y}{\Delta X} = \frac{1}{1 - b + m}$

Imports leak from the income stream, so $m$ lowers the multiplier.

Balanced budget multiplier: if $\Delta G = \Delta T$, then $\Delta Y = \dfrac{(1-b)\Delta G}{1-b+m}$, and in the case $m = 0$ it equals 1.

Example: with $b = 0.8$ and $m = 0.1$, $k_G = 1/0.3 = 3.33$ and $k_T = -0.8/0.3 = -2.67$.

Concept of demand-pull inflation

Demand-pull inflation is a sustained rise in the general price level caused by aggregate demand exceeding aggregate supply at or near full employment, so "too much money chasing too few goods". The aggregate demand curve shifts rightward along a steep or vertical aggregate supply curve, raising prices.

Causes

• Increase in the money supply and easy credit.
• Rising government expenditure financed by deficit financing or tax cuts.
• Increase in consumption, investment or exports (e.g. remittance-driven demand).
• Population growth and rising incomes, and expectations of higher prices.

Control by monetary policy

Monetary policy (the central bank, Nepal Rastra Bank) aims to reduce aggregate demand by tightening money and credit:

• Raising the bank rate and policy rate (repo rate), which increases the cost of borrowing and reduces investment and consumption loans.
• Increasing the cash reserve ratio (CRR) and statutory liquidity ratio (SLR), which reduce the lending capacity of banks.
• Open market operations: selling government securities to absorb excess liquidity.
• Selective credit controls: higher margin requirements and limits on loans for speculative purposes like real estate and shares.
• Moral suasion and directives to banks to restrict credit.
• A stricter exchange rate and money supply target to prevent excess monetary expansion.

Limitations include time lags, the difficulty of controlling money supply in an open economy, and the possible negative effect on investment and growth, so monetary measures should be complemented by fiscal measures (cutting spending, raising taxes) and increases in supply.

A hotel manager can identify the phase of the business cycle (boom, recession, depression, recovery) and adjust decisions accordingly. In a boom, when incomes and tourist arrivals rise, the manager can raise room rates, hire more staff and expand capacity. In a recession, the manager can cut costs, offer discounts and packages, and postpone expansion to protect profit.

Disposable income is the income left with households after deducting direct taxes and adding transfer payments.

$\text{Disposable income} = \text{National income} - \text{Corporate income tax} - \text{Personal direct tax} + \text{Transfer payments}$

$= 4{,}500 - 1{,}300 - 700 + 1{,}400 = \text{Rs } 3{,}900 \text{ billion}$

• Nominal interest rate is the rate of interest actually charged or paid in money terms, without adjusting for inflation.
• Real interest rate is the nominal rate adjusted for inflation, that is, the true return in terms of purchasing power:

$\text{Real interest rate} = \text{Nominal interest rate} - \text{Inflation rate}$

For example, if the nominal rate is 10% and inflation is 6%, the real rate is 4%.

Gross national disposable income (GNDI) is the total income available to a nation for consumption and saving. It equals gross national income (GDP plus net primary income from abroad) plus net current transfers received from abroad (such as remittances and foreign grants):

$\text{GNDI} = \text{GDP} + \text{Net primary income from abroad} + \text{Net current transfers from abroad}$

Marginal propensity to consume is the change in consumption per unit change in income.

$\text{MPC} = \frac{\Delta C}{\Delta Y} = \frac{3{,}984 - 3{,}066}{4{,}266 - 3{,}915} = \frac{918}{351} \approx 2.62$

The MPC of Nepal for 2021 is about 2.62, which exceeds 1 because consumption (including imports financed by remittances and other inflows) grew faster than GDP.

Four assumptions of Say's law of market ("supply creates its own demand"):

1. There is full employment of resources in the economy.
2. The economy is closed and has no government intervention (laissez-faire).
3. Prices, wages and interest rates are flexible.
4. Money is only a medium of exchange, so all income earned is spent, and any saving is automatically invested (savings equal investment through the interest rate).

In the two-sector model (households and firms, no government or foreign trade), equilibrium national income is reached when aggregate demand equals aggregate supply:

$Y = AD = C + I$

With the consumption function $C = a + bY$ (where $a$ is autonomous consumption and $b$ is MPC) and autonomous investment $I = \bar{I}$:

$Y = a + bY + \bar{I}$

$Y - bY = a + \bar{I}$

$Y = \frac{a + \bar{I}}{1 - b}$

Equivalently, equilibrium is also where saving equals investment, $S = I$.

Four causes of poor inflow of FDI in Nepal:

1. Political instability and frequent changes of government and policy.
2. Poor infrastructure, especially unreliable electricity, roads and transport.
3. Bureaucratic delays, red tape and corruption in approval procedures.
4. Weak labour relations (strikes, bandhs), small domestic market and being landlocked, which raise costs.

Characteristics of a trade (business) cycle:

1. It consists of recurring fluctuations in economic activity (output, income, employment and prices) around the long-run trend.
2. It has four phases: expansion (boom), peak, contraction (recession/depression) and trough, leading to recovery.
3. It is recurrent but not strictly periodic, and its length and intensity vary.
4. It is a feature of capitalist, market-oriented economies.
5. It is contagious and spreads from one sector or country to others.
6. Investment and durable consumer goods industries are affected more than other industries.
7. Output, employment, income, prices and profit move in the same direction in each phase.

The two-sector economy consists only of households and firms; there is no government and no foreign trade. The circular flow shows how income and expenditure move continuously between them.

Real flow. Households own the factors of production (land, labour, capital, entrepreneurship) and supply them to firms. Firms use these factors to produce goods and services and supply them to households.

Money flow. Firms pay rent, wages, interest and profit to households for factor services, so factor income flows from firms to households. Households spend this income on consumption goods and services, so consumption expenditure flows back to firms as revenue.

Equilibrium condition. If households spend all their income, the flow is complete and $Y = C$ Income received by households equals the value of output produced, and also equals expenditure.

Leakages and injections. When households save, part of income leaks out of the flow. Saving ($S$) is a leakage. Firms, however, borrow savings through banks and financial markets and spend them on investment ($I$), which is an injection. The economy is in equilibrium when $S = I$ so that $Y = C + S = C + I$ If $I > S$, income expands; if $I < S$, income contracts.

Thus the circular flow shows that the flow of output, income and expenditure is the same in value, and that financial markets link saving and investment.

Step 1: Corporate profit. Corporate profit before tax is the sum of its three uses: $\text{Corporate profit} = 150 + 115 + 450 = \text{Rs } 715 \text{ billion}$

Step 2: GDP at factor cost (income approach).

Step 3: GDP at market price. $\text{GDP}_{MP} = \text{GDP}_{FC} + \text{Indirect tax} - \text{Subsidy} = 2030 + 250 - 30 = \text{Rs } 2{,}250 \text{ billion}$

So GDP at factor cost is Rs 2,030 billion and GDP at market price is Rs 2,250 billion.

The saving function shows the relationship between saving ($S$) and income ($Y$). Saving is the part of disposable income not consumed, so $S = Y - C$. With $C = a + bY$, $S = -a + (1-b)Y = -a + sY$ where $-a$ is dissaving at zero income and $s = \text{MPS} = 1 - b$ is the marginal propensity to save.

Numerical table (taking $C = 100 + 0.75Y$, so $S = -100 + 0.25Y$, Rs million):

At $Y = 400$ consumption equals income, so saving is zero (break-even point). Below it saving is negative (dissaving), above it saving is positive.

Figure. Plot income on the X-axis and saving on the Y-axis. The saving curve is an upward-sloping straight line that cuts the Y-axis at $-100$ (the intercept $-a$) and cuts the X-axis at $Y = 400$, the break-even point. Its slope is MPS $= 0.25$. To the left of the break-even point the curve lies below the X-axis (dissaving) and to the right above it (saving).

The function shows that saving rises as income rises, and that MPC + MPS = 1.

The labour market is where the demand for labour by firms and the supply of labour by households meet to determine the real wage ($W/P$) and the level of employment.

Demand for labour. Firms hire labour up to the point where the real wage equals the marginal product of labour (MPL). Since MPL diminishes as more labour is employed, the labour demand curve $L_d$ slopes downward: a lower real wage means more labour demanded.

Supply of labour. Households supply more labour at a higher real wage, so the labour supply curve $L_s$ slopes upward.

Equilibrium. The market is in equilibrium where $L_d = L_s$, at the equilibrium real wage $(W/P)^*$ and employment $L^*$.

• If the real wage is above $(W/P)^*$, labour supply exceeds demand, causing unemployment, and competition among workers pushes the wage down.
• If it is below $(W/P)^*$, labour demand exceeds supply, causing a shortage, and firms bid the wage up.

Full employment. In classical theory, flexible wages and prices ensure the labour market clears at full employment, where only frictional and voluntary unemployment exist. In the Keynesian view, wages are rigid downward, so the market can settle at equilibrium below full employment, creating involuntary unemployment.

Shifts. Technological progress, more capital or higher productivity shift $L_d$ right and raise the real wage and employment. Population growth or higher participation shifts $L_s$ right, lowering the real wage and raising employment.

Unemployment is a situation in which people who are able and willing to work at the prevailing wage rate cannot find a job. The unemployment rate is $\text{Unemployment rate} = \frac{\text{Unemployed}}{\text{Labour force}} \times 100$

Costs of unemployment

Economic costs

• Loss of output: the economy produces less than its potential. Okun's law relates a rise in unemployment to a larger fall in real GDP.
• Loss of income and demand: unemployed workers have lower income, so consumption and aggregate demand fall, which can deepen the recession.
• Fall in government revenue and higher spending: lower tax receipts and higher spending on unemployment support and welfare worsen the budget deficit.
• Waste of human capital: skills deteriorate during long unemployment, reducing future productivity.

Social costs

• Poverty, inequality and lower living standards.
• Crime, social unrest, family breakdown and political instability.
• Poor mental and physical health, loss of self-esteem.
• In Nepal, unemployment and under-employment drive large-scale youth migration abroad, causing brain drain and dependence on remittances.

Public private partnership (PPP) is a long-term contractual arrangement between a government agency and a private party under which the private partner finances, builds, operates or maintains a public infrastructure or service, and risks and rewards are shared. Common forms are BOT (build-operate-transfer), BOOT, concession, and management contracts, for example hydropower, highways and airport projects.

How PPP helps efficient resource mobilization

1. Mobilizes private capital. The government's limited revenue and borrowing capacity is supplemented by private funds, so more projects can be undertaken.
2. Reduces fiscal burden. Large infrastructure costs are spread over time and do not fall wholly on the budget or public debt.
3. Improves efficiency. Private management, technology and cost discipline lower construction cost, shorten delays and improve service quality.
4. Risk sharing. Construction, operating and demand risks are transferred to the party best able to bear them.
5. Faster delivery and innovation. Projects are completed on time, with the transfer of skills to the public sector.
6. Allows the government to focus its limited resources on social sectors such as health, education and poverty reduction.

Inflation is a sustained rise in the general price level. In Nepal both demand-pull and cost-push factors operate, along with structural and imported factors.

A. Demand-pull factors (too much money chasing too few goods)

1. Remittance inflows. Remittance is over 20 percent of GDP, raising household income and consumption demand, mostly for imported goods.
2. Expansionary money supply and credit. Rapid growth of bank credit and liquidity increases spending power.
3. Government spending. Rising recurrent expenditure, salary increases and election-time spending raise aggregate demand without matching output.
4. Rising incomes and urbanization increase demand for food, housing and services.

B. Cost-push factors (rise in cost of production)

1. Petroleum and imported input prices. Nepal imports all its fuel, so rises in international oil prices raise transport and production costs.
2. Wage increases without matching productivity growth.
3. Supply disruptions and syndicates. Strikes, bandhs, transport cartels, blockades (such as the 2015 border blockade) and black marketing raise costs and prices.
4. Taxes and duties. Higher customs, excise and VAT are passed on to consumers.
5. Natural disasters and weak agricultural productivity (floods, drought, shortage of fertilizer) raise food prices.

C. Structural and external factors

• Pegged exchange rate with India. The Nepali rupee is pegged to the Indian rupee, so Indian inflation passes into Nepal, because a large share of imports comes from India.
• Weak supply chains and infrastructure, import dependence, hoarding and weak market monitoring.
• Depreciation of the Nepali currency against the dollar raises import prices.

Conclusion. Inflation in Nepal is a mix: demand-pull (remittance, credit, spending) and cost-push (fuel, supply disruption, taxes), reinforced by import dependence on India. Hence both tight monetary policy and improvement in supply (production, infrastructure, market management) are required.

Investment is spending on capital goods (plant, machinery, buildings, inventories). Its main determinants are as follows.

1. Rate of interest. Investment is inversely related to the interest rate, which is the cost of borrowing. A lower rate makes more projects profitable; the investment demand curve slopes downward.
2. Marginal efficiency of capital (MEC). The expected rate of return on a new capital asset. Firms invest as long as MEC exceeds the interest rate, up to the point where $\text{MEC} = i$.
3. Expected profit and business expectations. Optimism about future sales and profits raises investment; uncertainty reduces it (Keynes' animal spirits).
4. Level of national income and output (accelerator effect). Higher income and demand increase the need for capital stock and induced investment.
5. Cost of capital goods and technology. Falling prices of machinery and technological progress raise the profitability of investment.
6. Government policy. Taxes, tax incentives, subsidies, depreciation allowances and public investment affect private investment; public investment in infrastructure can crowd in private investment, while heavy government borrowing can crowd it out.
7. Availability of credit and financial system. Bank lending capacity, liquidity and the depth of capital markets.
8. Political and economic stability. Peace, security, law and order, stable policy and good governance encourage investors; instability, load shedding and corruption discourage them.
9. Infrastructure and availability of resources: electricity, roads, skilled labour and raw materials.
10. Existing stock of capital and capacity utilization. Idle capacity lowers new investment.
11. Foreign investment and exchange rate: openness to FDI and stable exchange rates raise investment.

Thus investment depends on both the cost side (interest rate) and the return side (expected profit, MEC), and on the overall investment climate.

(a) Take 2019 as the base year. Nominal GDP = current output $\times$ current prices; real GDP = current output $\times$ base-year prices (2019: A = Rs 2,000, B = Rs 25).

$\text{GDP deflator} = \frac{\text{Nominal GDP}}{\text{Real GDP}}\times100$

So prices rose in 2020 and 2021, and the price level fell (deflation) in 2022.

(b) Nominal GDP is measured at current prices, so it can rise merely because prices rise, even if no more output is produced. Real GDP is measured at constant base-year prices, so it removes the effect of price changes and shows the actual change in the quantity of goods and services produced. Welfare depends on the goods and services people can actually consume, so real GDP is a better indicator of the change in living standards. For example, from 2021 to 2022 nominal GDP fell by about 4.9 percent while real GDP rose about 2.8 percent, so output, not just price, tells the real story.

Since the values of $G$ and $T$ are not stated, they are kept in the autonomous term. Let $A = 550 - 0.7T + 450 + G = 1000 - 0.7T + G$. For the numerical results, $G$ and $T$ are taken as zero ($A = 1000$).

(a) IS curve. $Y = C + I + G = 550 + 0.7(Y-T) + 450 - 1200i + G$ $0.3Y = A - 1200i \Rightarrow Y = \frac{A - 1200i}{0.3}$ With $A = 1000$: $0.3Y = 1000 - 1200i$.

LM curve. Total money demand: $L = 90 + 0.88Y + 2410 - 800i = 2500 + 0.88Y - 800i$. Setting $L = M_s = 4500$: $0.88Y - 800i = 2000 \Rightarrow i = 0.0011Y - 2.5$

Equilibrium. Substituting in IS: $0.3Y = A - 1200(0.0011Y - 2.5) = A - 1.32Y + 3000$ $1.62Y = A + 3000 \Rightarrow Y = \frac{A+3000}{1.62}$ With $A = 1000$: $Y = 4000/1.62 = \text{Rs } 2{,}469.14$ billion, and $i = 0.0011(2469.14) - 2.5 = 0.216$, i.e. about 21.6 percent.

(b) Money supply falls by 160, so $M_s = 4340$. LM: $0.88Y - 800i = 1840 \Rightarrow i = 0.0011Y - 2.3$. $0.3Y = A - 1200(0.0011Y - 2.3) \Rightarrow 1.62Y = A + 2760$ With $A = 1000$: $Y = 3760/1.62 = \text{Rs } 2{,}320.99$ billion, and $i = 0.0011(2320.99) - 2.3 = 0.2531$, i.e. about 25.3 percent.

(c) Effect of the contractionary monetary policy. Income falls by about Rs 148.15 billion (from 2,469.14 to 2,320.99) and the interest rate rises by about 3.7 percentage points (21.6 to 25.3 percent). The LM curve shifts left: with less money, people compete for it and the interest rate rises; higher interest rates reduce investment, and through the multiplier national income falls. Contractionary monetary policy therefore curbs inflation but at the cost of lower output and employment.

(a) Sources of economic development of Nepal

Economic development means sustained growth in output together with improvement in living standards, equity and structural change. The main sources are:

1. Natural resources: water resources and hydropower potential, forests, minerals, agriculture land and biodiversity, tourism assets. The case says Nepal is rich in them.
2. Human resources: a young, large working-age population; education and health raise productivity. The case notes sufficient human resources, though skill levels are low.
3. Capital formation: domestic saving (including remittance), public and private investment, FDI and foreign aid. The capital formation rate must be raised.
4. Technological change and innovation: moving from primary agriculture to productive modern sectors; Nepal is far behind in technology.
5. Infrastructure: roads, energy, irrigation, communications and social infrastructure (schools, hospitals).
6. Institutions and values: good governance, rule of law, political stability, efficient institutions and a development-oriented culture.
7. Entrepreneurship, trade and structural transformation from agriculture to industry and services.

(b) Are the 2022/23 monetary and fiscal policies able to achieve 8 percent growth?

Fiscal policy. The Rs 1,793.83 billion budget has 42 percent current expenditure (about Rs 753 billion), 21.2 percent capital (about Rs 380 billion), 12.8 percent financing and 24 percent fiscal transfers. Only about one fifth goes to capital expenditure, the part that raises output; the rest is recurrent, transfers or debt financing. Capital expenditure is also usually under-spent and delayed by weak implementation.

Monetary policy. The policy is cautiously tight: the bank rate is raised to 6.5 percent, the policy rate to 7 percent and the CRR to 4 percent. Private-sector credit growth is cut to 12.6 percent from 18 percent and money supply growth to 12 percent from 18 percent. Higher interest rates and slower credit increase the cost of borrowing and discourage private investment, which is contrary to the growth objective.

Critical argument. The two policies pull in different directions: the budget is expansionary while monetary policy is contractionary for stability. Past growth has averaged only 4.2 percent, and in view of tight credit, low capital spending, import dependence, and weak absorptive capacity, 8 percent growth looks unlikely to be achieved. Stability may be achieved, but not the growth target, unless capital expenditure is executed efficiently and private investment is encouraged.

(c) Is the current pace sufficient for the long-term vision?

The Fifteenth Plan needs an average of 10.5 percent growth to reach a per capita income of US$ 12,100 and graduate to a middle-income country, while Nepal's long-run average is only 4.2 percent and the 2022/23 target is 8 percent. Even 8 percent is lower than 10.5. At 4 to 5 percent, growth is far too slow to double income quickly. The conclusion is that the present pace is not sufficient. To reach the vision, Nepal must increase capital formation, develop infrastructure and hydropower, modernize agriculture, encourage industry, improve governance, boost productivity and technology, and effectively use its natural and human resources, thus transforming the structure of the economy.

A four-sector economy consists of households, firms, government and the foreign (rest of the world) sector. It is called an open economy because it trades goods, services and capital with other countries through exports and imports. Equilibrium is $Y = C + I + G + (X - M)$, where $X - M$ is net exports, and the economy is open to international flows, unlike a closed (three-sector) economy with no foreign trade.

Green GDP is GDP adjusted for environmental costs. It is calculated as conventional GDP minus the monetary value of natural resource depletion and environmental degradation (pollution, deforestation, loss of biodiversity): $\text{Green GDP} = \text{GDP} - \text{Environmental depletion and degradation costs}$ It shows the sustainable level of economic output and gives a truer measure of welfare than ordinary GDP.

Operating surplus (profits and property income) is the sum of corporate profit, rental income and interest. Undistributed profit and dividend are already included in corporate profit, so they are not added again: $\text{Operating surplus} = 60 + 25 + 45 = \text{Rs } 130 \text{ million}$

Income is either consumed or saved: $Y = C + S$ Take a change in income: $\Delta Y = \Delta C + \Delta S$ Divide both sides by $\Delta Y$: $1 = \frac{\Delta C}{\Delta Y} + \frac{\Delta S}{\Delta Y} = \text{MPC} + \text{MPS}$ Hence $\text{MPC} + \text{MPS} = 1$.

Inflation is an economic phenomenon because it arises from economic causes and has economic effects. It is a rise in the general price level caused by an excess of aggregate demand over supply (money supply, spending, credit) or by a rise in production costs. It affects output, income distribution, saving, investment, interest rates, exchange rates and employment, and it is controlled by economic policies (monetary and fiscal). Hence it is called an economic phenomenon.

The capital account of the balance of payments records transactions in assets and capital transfers. Its components are:

1. Direct investment (foreign direct investment into and out of the country).
2. Portfolio investment (purchase and sale of shares and bonds).
3. Other investment, i.e. loans and borrowings (long- and short-term), trade credits, currency and deposits.
4. Capital transfers, such as foreign grants for capital projects and debt forgiveness.
5. Changes in reserve assets of the central bank (sometimes shown separately).

Sources of economic growth:

1. Natural resources (land, water, minerals, forests).
2. Human resources (labour force, education, health, skills).
3. Capital formation (saving and investment).
4. Technological progress and innovation.
5. Entrepreneurship and management.
6. Institutions, good governance and political stability.
7. Infrastructure and trade/international integration.
8. Productivity improvement and structural change.

$\text{Inflation rate} = \frac{405 - 375}{375}\times100 = \frac{30}{375}\times100 = 8\%$

The consumption function is $C = a + bY$. The intercept $a$ is autonomous consumption, the consumption that takes place even when income is zero (people meet basic needs by using past savings, borrowing or selling assets). At $Y = 0$, $C = a > 0$, so the consumption curve starts from a positive point on the Y-axis rather than from the origin.

Income method

Expenditure method $\text{GDP}_{MP} = C + I + G + (X - M) = 5164 + 1340 + 1630 + (150 - 284) = 8{,}000$ $\text{GNP}_{MP} = 8000 + (-200) = 7{,}800$ $\text{NNP}_{MP} = \text{GNP}_{MP} - \text{CCA} = 7800 - 878 = \text{Rs } 6{,}922 \text{ billion}$

Both methods give NNP$_{MP}$ = Rs 6,922 billion.

Say's law of market (J.B. Say, classical economists): "supply creates its own demand." Production generates an equal amount of income (wages, rent, interest, profit), and this income is spent on buying the output. Therefore total demand always equals total supply, and general overproduction is impossible.

Savings do not cause a shortfall because they are equal to investment through the adjustment of the interest rate: if $S > I$, interest falls, investment rises and $S = I$ again. Flexible wages and prices ensure full employment.

Implications

1. The economy is always at full employment; only temporary frictional unemployment exists.
2. General overproduction and long-term involuntary unemployment cannot occur.
3. The economy is self-adjusting, so government intervention is unnecessary (laissez-faire).
4. Money is only a medium of exchange; it is neutral and not held as idle balances.
5. Saving is a virtue and is automatically invested.
6. Fiscal policy is ineffective, and the focus is on supply-side growth.

Keynes criticized the law, pointing out that demand can be deficient, saving and investment are done by different people, wages are rigid, and the Great Depression showed prolonged unemployment.

Exchange rate is the price of one country's currency in terms of another currency, for example Rs 133 per US dollar. It shows the rate at which currencies are exchanged.

Determination by demand-supply approach. Under a flexible exchange rate regime, the rate is determined by the interaction of the demand for and supply of foreign currency in the foreign exchange market.

• Demand for foreign currency (say, US dollars) comes from imports of goods and services, travel abroad, remittances sent abroad, foreign investment and debt repayment. When the rupee price of a dollar rises, imports become dearer, so quantity of dollars demanded falls. The demand curve slopes downward.
• Supply of foreign currency comes from exports, tourism receipts, remittance inflows, foreign investment and aid. When the rupee price of a dollar rises, Nepali exports become cheaper for foreigners, so more dollars are supplied. The supply curve slopes upward.

Equilibrium. The exchange rate is determined at the point where the demand curve and supply curve of foreign currency intersect, at which quantity demanded equals quantity supplied.

• If demand for dollars increases (more imports), the demand curve shifts right, the dollar appreciates and the rupee depreciates.
• If supply of dollars increases (more exports or remittance), the supply curve shifts right, the rupee appreciates.

Nepal, however, pegs the rupee to the Indian rupee (INR 1 = NPR 1.6), so the NPR/USD rate follows the INR/USD market.

Macroeconomics studies the economy as a whole: national income, output, employment, the price level, money, growth and the balance of payments. The economic environment is the set of external economic conditions (economic system, policies, institutions, resources, infrastructure, and global conditions) in which firms and households operate.

Relationship

1. Macroeconomics explains the economic environment. Measures such as GDP growth, inflation, unemployment, interest rate and exchange rate describe the state of the economy within which businesses decide.
2. The environment affects macro variables. Natural resources, technology, political stability, demographic change, laws and global events (oil prices, recessions) alter output, prices and employment.
3. Policy links the two. Monetary and fiscal policy, trade policy and regulation reshape the economic environment, for example interest rates affect investment, and taxes affect demand.
4. Business decisions depend on macro conditions. Managers study the business cycle, inflation, exchange rates and government policy to plan production, pricing, investment and employment.
5. Feedback. The decisions of households, firms and government together create the aggregate outcomes, which then become the changed environment.

Thus macroeconomics provides the tools to analyze and forecast the economic environment, and the environment determines the scope and results of macroeconomic policy.

Monetary policy is the central bank's (Nepal Rastra Bank) control of money supply and interest rates through instruments such as the policy rate, bank rate, cash reserve ratio (CRR), statutory liquidity ratio (SLR), open market operations and standing liquidity facility.

Full employment. In a recession with unemployment, the central bank follows an easy (expansionary) policy: lowering the policy rate, bank rate and CRR, and buying securities. Money supply rises, interest rates fall, credit becomes cheaper, investment and consumption rise, aggregate demand increases and output and employment expand toward full employment.

Price stability. When inflation is high, the central bank follows a tight (contractionary) policy: raising the policy rate, CRR and SLR, and selling securities. Money supply and credit shrink, interest rates rise, spending falls and demand-pull inflation is controlled. Stable money growth keeps prices stable.

Balancing the two. The central bank must weigh the trade-off (Phillips curve) between inflation and unemployment. Policy is expansionary in a slump and contractionary in a boom, to keep the economy near full employment with low and stable inflation, usually with an inflation target (about 5 to 6.5 percent in Nepal).

Product (value-added) method. GDP by the product method is the market value of all final goods and services produced within a country in a year. It is computed by summing the value added by each producing sector (or by adding the value of final goods only): $\text{GDP} = \sum \text{Value added} = \sum (\text{Value of output} - \text{Intermediate consumption})$

Steps

1. Divide the economy into sectors: primary (agriculture, forestry, mining), secondary (manufacturing, construction, electricity) and tertiary (trade, transport, banking, education, other services).
2. For each firm or sector, find the value of output and subtract the cost of intermediate goods bought from other producers.
3. Add the value added of all sectors. This is GDP at market price (add indirect tax and subtract subsidy to move between factor cost and market price).

Example (wheat to bread)

GDP = sum of value added = Rs 100 = the value of the final good (bread) alone.

Double counting. Adding the sales of all stages (Rs 200) would count the wheat and flour again and again. The product method avoids double counting because it either counts only the final goods (Rs 100) or counts only the value added at each stage; the sum of value added equals the value of final output. Intermediate goods are excluded. Hence this method avoids the problem of double counting.

(a) Initial equilibrium

Disposable income: $T = 80 + 0.2Y$, so $Y - T = 0.8Y - 80$. $C = 200 + 0.75(0.8Y - 80) = 140 + 0.6Y$

IS curve: $Y = 140 + 0.6Y + 200 - 2000i + 300 \Rightarrow 0.4Y = 640 - 2000i \Rightarrow Y = 1600 - 5000i$

LM curve: $0.5Y + 100 - 1000i = 400 \Rightarrow Y = 600 + 2000i$

Equating: $1600 - 5000i = 600 + 2000i \Rightarrow 7000i = 1000 \Rightarrow i = 0.1429 \ (14.29\%)$ $Y = 600 + 2000(0.1429) = \text{Rs } 885.71 \text{ million}$

(b) After $M_s = 600$ and $G = 500$

IS: $Y = 140 + 0.6Y + 200 - 2000i + 500 \Rightarrow 0.4Y = 840 - 2000i \Rightarrow Y = 2100 - 5000i$

LM: $0.5Y + 100 - 1000i = 600 \Rightarrow Y = 1000 + 2000i$

Equating: $2100 - 5000i = 1000 + 2000i \Rightarrow 7000i = 1100 \Rightarrow i = 0.1571 \ (15.71\%)$ $Y = 1000 + 2000(0.1571) = \text{Rs } 1{,}314.29 \text{ million}$

Output rises by Rs 428.57 million (885.71 to 1,314.29), and the interest rate rises by 1.43 percentage points (14.29 to 15.71 percent).

(c) Do the policies remove the recession?

Yes, partly. Output rises by about 48 percent, which indicates that combined expansion helps recovery, so unemployment would fall. The IS curve shifts right (higher $G$) and LM shifts right (higher $M_s$). Expansionary monetary policy alone would lower the interest rate, while expansionary fiscal policy alone would raise it and crowd out private investment; together the interest rate rises only slightly, so crowding out is small and the policy mix is effective. However, the interest rate still rises slightly, so some private investment is crowded out, and the rise in government spending increases the budget deficit and may be inflationary near full employment. In practice, lags and implementation capacity also matter.

(a) Investment multiplier

Let $C = a + bY$ and $Y = C + I$. Then $Y = a + bY + I \Rightarrow Y = \frac{a + I}{1-b}$ If investment changes by $\Delta I$ (with $a$, $b$ constant), $\Delta Y = \frac{\Delta I}{1-b} \Rightarrow k = \frac{\Delta Y}{\Delta I} = \frac{1}{1-b} = \frac{1}{\text{MPS}}$ Reason: the initial investment becomes income, of which a fraction $b$ is spent again, and so on: $\Delta I(1 + b + b^2 + \dots) = \Delta I/(1-b)$.

(b)(i) Equilibrium income

$C = 200 + 0.7(Y - 500 - 0.2Y) = 200 + 0.7(0.8Y - 500) = -150 + 0.56Y$ $Y = C + I + G + X - M = -150 + 0.56Y + 200 + 400 + 100 - 50 - 0.1Y$ $Y = 500 + 0.46Y \Rightarrow 0.54Y = 500 \Rightarrow Y = \text{Rs } 925.93 \text{ million}$

(ii) Effect of $G$ rising by 20 and tax rate rising by 10 percentage points (0.20 to 0.30)

$G = 420$, $T = 500 + 0.3Y$: $C = 200 + 0.7(0.7Y - 500) = -150 + 0.49Y$ $Y = -150 + 0.49Y + 200 + 420 + 100 - 50 - 0.1Y = 520 + 0.39Y$ $0.61Y = 520 \Rightarrow Y = \text{Rs } 852.46 \text{ million}$

Equilibrium income falls by about Rs 73.47 million (925.93 to 852.46). The higher tax rate reduces disposable income and the multiplier (from $1/0.54$ to $1/0.61$), which more than offsets the extra government spending.

(a) Major issues in the case

1. Government revenue is not enough to cover expenditure, especially recurrent expenditure (65.19 percent of the Rs 1,751.315 billion budget).
2. A widening budget deficit and resource gap, financed by loans (50 percent foreign loans, 40 percent domestic loans and 10 percent grants).
3. Heavy debt servicing (Rs 330.36 billion, about 18 percent of the budget), a threat to debt sustainability and macroeconomic stability.
4. Dependence on foreign aid and loans for development spending, and low capital expenditure (17.24 percent).
5. Heavy dependence on a few taxes (income tax, VAT, customs, excise: over 87 percent of tax revenue), and the larger spending needs after federalism.

(b) Major sources of government revenue in Nepal

• Tax revenue:
  • Direct taxes: income tax of individuals and corporations, capital gains and profits (about 26 percent).
  • Indirect taxes: value added tax (about 28 percent), customs duty on imports (about 22 percent), excise duty (about 14 percent).
  • Property and registration taxes, vehicle tax.
• Non-tax revenue: royalties (hydropower, mountaineering, natural resources), dividends from public enterprises, fees, fines and service charges, interest, tourism fees.
• Foreign grants and, outside revenue, borrowing (domestic and foreign).

(c) Causes of the resource gap and how it is filled

Causes: limited tax base and narrow tax net; large informal economy; tax evasion and leakage; low productivity and slow economic growth; weak performance of public enterprises; rapidly growing recurrent expenditure (salaries, pensions, social security, subsidies); the cost of federalism (three tiers of government); heavy debt servicing; and expensive, delayed development projects that need large investments.

How the gap is filled:

1. Foreign loans from multilateral and bilateral partners (50 percent of the deficit).
2. Domestic borrowing through treasury bills and development bonds (40 percent).
3. Foreign grants (10 percent).
4. Also by improving revenue, reducing unproductive spending, PPP and private investment, and remittance-driven consumption taxes.

(d) Difficulties of revenue mobilization and suggested fiscal measures

Difficulties: import dependence of revenue (fluctuates with trade, exchange rate and nominal GDP); a large informal and cash economy; tax evasion, under-invoicing, smuggling and corruption; weak tax administration and administrative capacity; narrow tax base and many exemptions; low agricultural taxation and dependence on foreign aid; weak coordination among the federal, provincial and local governments; slow growth of productive sectors.

Fiscal measures:

1. Broaden the tax base: bring informal sector, agriculture and digital services into the tax net.
2. Strengthen tax administration through digital systems (e-filing, e-billing), better auditing and effective control of evasion and smuggling.
3. Rationalize tax rates and exemptions; make taxes simple and fair.
4. Increase non-tax revenue by commercializing public enterprises and royalties from natural resources.
5. Control recurrent spending; prioritize productive capital expenditure and improve project implementation.
6. Mobilize domestic resources and PPP; manage debt prudently and shift to concessional loans.
7. Promote exports and domestic production to reduce import dependence, and strengthen federal fiscal coordination.

Scope of macroeconomics:

1. Theory of national income (measurement and determination of output and income).
2. Theory of employment.
3. Theory of money and general price level (inflation and deflation).
4. Theory of economic growth and development.
5. Theory of international trade and the balance of payments.
6. Theory of business cycles.
7. Macroeconomic policies (monetary and fiscal policy).
8. Theory of distribution and public finance.

Disposable income is the income that households have available to spend or save after paying personal direct taxes, i.e. personal income minus personal taxes: $Y_d = Y - T + \text{Transfers}$ It is divided between consumption and saving: $Y_d = C + S$.

Equilibrium requires $Y = C + I$: $Y = 160 + 0.75Y + 240 \Rightarrow 0.25Y = 400 \Rightarrow Y = \text{Rs } 1{,}600 \text{ million}$ $C = 160 + 0.75(1600) = 160 + 1200 = \text{Rs } 1{,}360 \text{ million}$

With $C = a + b(Y - T)$ and $Y = C + I + G$ (lump-sum tax $T$): $Y = a + bY - bT + I + G \Rightarrow Y = \frac{a - bT + I + G}{1-b}$ If $G$ changes by $\Delta G$, with other things constant, $\Delta Y = \frac{\Delta G}{1-b} \Rightarrow k_G = \frac{\Delta Y}{\Delta G} = \frac{1}{1-b} = \frac{1}{\text{MPS}}$

The essence of inflation is a sustained and continuous rise in the general price level, which reduces the purchasing power of money. It happens when aggregate demand exceeds aggregate supply (too much money chasing too few goods) or production costs rise. A one-time price rise or the rise in the price of a single good is not inflation; it must be a general and persistent rise.

A flexible (floating) exchange rate system is one in which the exchange rate of a currency is determined freely by the forces of demand and supply in the foreign exchange market, without the central bank fixing or defending a particular rate. When demand for a currency rises, it appreciates; when supply rises, it depreciates. The central bank may intervene only occasionally (managed float) to smooth sharp fluctuations.

Deficit financing means meeting a budget deficit (expenditure exceeding revenue) by means other than current tax revenue. The main methods are:

• Borrowing from the public: issuing treasury bills, development bonds and national savings certificates.
• Borrowing from the central bank: the government draws overdraft or sells securities to the central bank, which creates new money (monetisation of the deficit).
• Borrowing from commercial banks: sale of government securities to banks.
• External borrowing and foreign aid: loans and grants from foreign governments and international institutions.
• Drawing down accumulated cash balances or selling public assets (privatisation).

Fiscal federalism is the division of taxing and spending powers among federal, provincial and local governments. Its main components are:

• Expenditure assignment: which level of government is responsible for which functions (e.g. defence and foreign affairs at the federal level, basic education and health at the local level).
• Revenue assignment: which taxes and non-tax revenues each level can levy (e.g. customs and VAT federal; land and house registration, vehicle tax provincial; property and business taxes local).
• Intergovernmental fiscal transfers: equalisation grants, conditional grants, complementary grants and special grants to fill vertical and horizontal gaps.
• Revenue sharing: sharing of VAT, excise duty and natural resource royalties among the three levels.
• Sub-national borrowing and debt management: rules on how lower levels may borrow.
• Fiscal institutions: bodies such as the National Natural Resources and Fiscal Commission that recommend sharing formulas and ensure coordination.

Value added method (product method)

National income is computed by summing the value added by every producing unit in the economy during a year. Value added by a firm is the value of its output minus the value of intermediate goods purchased from other firms:

$\text{Value added} = \text{Value of output} - \text{Intermediate consumption}$

The steps are:

1. Classify the economy into sectors (primary, secondary, tertiary) and producing units.
2. Find the gross value of output of each unit (sales plus change in stocks).
3. Subtract the intermediate goods used to get gross value added at market prices (GVA$_{mp}$).
4. Add up GVA of all units to get GDP$_{mp}$.
5. Subtract depreciation to get NDP$_{mp}$, subtract net indirect taxes (indirect taxes minus subsidies) to get NDP$_{fc}$, and add net factor income from abroad to get national income (NNP$_{fc}$).

Avoiding double counting

Double counting arises when the same output is counted more than once, e.g. wheat counted as a farmer's output and again within flour and bread. By counting only the value added at each stage, each stage's contribution is counted exactly once.

Example: farmer sells wheat for Rs 100 (value added Rs 100); miller sells flour for Rs 150 (value added Rs 50); baker sells bread for Rs 220 (value added Rs 70). Sum of value added $= 100+50+70 =$ Rs 220, which equals the final value of bread. Summing total sales ($100+150+220 = 470$) would overstate output.

Meaning

Investment is the addition to the stock of real capital in an economy during a period, such as the purchase of machinery, construction of buildings and factories, and increase in inventories. It is spending on goods that are used to produce more goods in the future, not the purchase of financial assets.

Types of investment

• Gross and net investment: gross investment is total expenditure on new capital goods; net investment is gross investment less depreciation (replacement investment).
• Autonomous and induced investment: autonomous investment does not depend on income or profit (e.g. public infrastructure, social investment); induced investment is motivated by rising income, demand or profit.
• Private and public investment: private investment is made by households and firms for profit; public investment is made by the government for social welfare and infrastructure.
• Fixed (business) investment, residential investment and inventory investment: spending on plant and equipment, on housing construction, and on changes in stocks of goods respectively.
• Planned (ex-ante) and unplanned (ex-post) investment: planned investment is what firms intend to make; unplanned investment arises from unintended changes in inventories.
• Domestic and foreign investment: investment within the country versus investment abroad (or foreign direct investment inside the country).

(i) Equilibrium income

In a four-sector economy, $Y = C + I + G + (X - M)$.

$Y = 200 + 0.7\,(Y - 500 - 0.2Y) + 100 + 500 + 100 - (15 + 0.1Y)$

$Y = 200 + 0.56Y - 350 + 100 + 500 + 100 - 15 - 0.1Y$

$Y = 535 + 0.46Y$

$0.54\,Y = 535 \;\Rightarrow\; Y = \frac{535}{0.54} \approx \text{Rs } 990.74 \text{ billion}$

(ii) Effect of $\Delta G = 50$ and tax rate falling from 20% to 15%

New $G = 550$ and $T = 500 + 0.15Y$:

$Y = 200 + 0.7\,(Y - 500 - 0.15Y) + 100 + 550 + 100 - 15 - 0.1Y$

$Y = 200 + 0.595Y - 350 + 100 + 550 + 100 - 15 - 0.1Y = 585 + 0.495Y$

$0.505\,Y = 585 \;\Rightarrow\; Y = \frac{585}{0.505} \approx \text{Rs } 1158.42 \text{ billion}$

Equilibrium income rises by $1158.42 - 990.74 \approx$ Rs 167.68 billion, because higher government spending and lower tax rate both raise aggregate demand, and the multiplier increases from $1/0.54 \approx 1.85$ to $1/0.505 \approx 1.98$.

Taking 2022 as the base year (prices of 2022 for real GDP).

Nominal GDP $= \sum P_t Q_t$

• 2022: $900\times300 + 80\times1000 = 270{,}000 + 80{,}000 = 350{,}000$
• 2023: $1000\times350 + 120\times1300 = 350{,}000 + 156{,}000 = 506{,}000$
• 2025: $1200\times375 + 140\times1700 = 450{,}000 + 238{,}000 = 688{,}000$

Real GDP $= \sum P_{2022} Q_t$

• 2022: $350{,}000$
• 2023: $900\times350 + 80\times1300 = 315{,}000 + 104{,}000 = 419{,}000$
• 2025: $900\times375 + 80\times1700 = 337{,}500 + 136{,}000 = 473{,}500$

GDP deflator $= \dfrac{\text{Nominal GDP}}{\text{Real GDP}}\times100$

• 2022: $100$
• 2023: $\dfrac{506{,}000}{419{,}000}\times100 \approx 120.76$
• 2025: $\dfrac{688{,}000}{473{,}500}\times100 \approx 145.30$

Inflation rate $= \dfrac{\text{Deflator}_t - \text{Deflator}_{t-1}}{\text{Deflator}_{t-1}}\times100$

• 2023 over 2022: $\dfrac{120.76-100}{100}\times100 = 20.76\%$
• 2025 over 2023 (the previous year given): $\dfrac{145.30-120.76}{120.76}\times100 \approx 20.32\%$

The prosperity (boom) phase is the peak stage of the trade cycle, when the economy operates at or above full employment and aggregate demand is very high.

Main features

• High output and employment: production runs at full capacity and unemployment is at its lowest.
• Rising prices and money wages: demand exceeds supply of many goods, so inflation emerges, and costs, wages and rents rise.
• High profits and optimism: business expectations are bright, which encourages heavy investment and new ventures.
• Expansion of credit: banks lend freely, interest rates tend to rise, and stock prices and property values soar.
• Rising consumption and investment: incomes are high, so consumption, investment and the multiplier effects reinforce each other.
• Speculation and over-investment: shortages of labour and raw materials, rising costs and overconfidence create imbalances.

Why it ends

Rising costs squeeze profit margins, credit becomes expensive and scarce, and bottlenecks appear. Entrepreneurs cut orders, and the economy turns to recession, which marks the end of prosperity.

Labour market equilibrium and full employment (classical view)

The labour market consists of the demand for labour by firms and the supply of labour by households, with the real wage $W/P$ as the price.

• Demand for labour slopes downward: firms hire labour up to the point where the real wage equals the marginal product of labour, $W/P = MP_L$. A lower real wage increases the quantity demanded.
• Supply of labour slopes upward: a higher real wage induces more people to work.

Equilibrium occurs at the real wage $(W/P)^*$ where the quantity of labour demanded equals the quantity supplied, at employment $N^*$. At this point there is no involuntary unemployment, so the economy is at full employment. Only frictional and voluntary unemployment remain, which is the natural rate of unemployment.

Process of adjustment

• If the real wage is above equilibrium, supply exceeds demand, creating unemployed workers who bid down the money wage, so the real wage falls and employment rises until $N^*$ is reached.
• If the real wage is below equilibrium, demand exceeds supply, firms compete for labour, the wage rises and the market returns to equilibrium.

Because wages and prices are flexible in the classical model, the labour market clears automatically. Output is then determined by the aggregate production function, $Y = f(K, N^*)$, giving full-employment output.

Keynesian qualification

If wages are sticky downward (due to unions, contracts, minimum wages), the labour market may not clear, so involuntary unemployment persists, and employment is determined by aggregate demand. Government action to raise demand, or reforms that make wages flexible, are then needed to reach full employment.

Concept

Cost-push inflation is a sustained rise in the general price level caused by an increase in the cost of production, which reduces aggregate supply and shifts the aggregate supply curve leftward, while demand is unchanged. Output falls and prices rise, so it is also called supply-side inflation or stagflation when combined with unemployment.

Causes

• Wage-push: powerful trade unions obtain wage increases greater than productivity growth, raising unit labour costs.
• Profit-push: firms with monopoly power raise their profit margins and prices.
• Rising raw material and energy prices: e.g. petroleum price shocks or higher import prices.
• Supply shocks and shortages: natural disasters, blockades, strikes and transport disruptions.
• Higher indirect taxes and administered prices: VAT, excise or fuel price rises increase costs.
• Currency depreciation: makes imported inputs more expensive.

Control by monetary policy

• Raise the bank rate, policy rate and cash reserve ratio, and conduct open market sales to restrain credit, so firms and households cannot easily finance higher prices and wages.
• Selective credit controls and a stable exchange rate to prevent imported cost pressures.
• Monetary policy is only partly effective, because tightening it reduces output and employment further when the problem lies on the supply side.

Control by fiscal policy

• Reduce indirect taxes, fuel duties and tariffs on essential inputs, and give subsidies to producers to lower costs.
• Cut wasteful government expenditure to reduce overall pressure on resources.
• Increase public investment in infrastructure, energy and productivity-raising activities to expand supply.
• Wage and price controls or an incomes policy, and anti-monopoly measures against profit-push.
• Support imports of essential raw materials and build buffer stocks.

The best remedy combines these demand-side tools with supply-side measures that raise productivity.

Meaning

The balance of payments (BOP) is a systematic record of all economic transactions between the residents of a country and the rest of the world during a period, usually a year. It is based on double-entry bookkeeping, so total credits equal total debits and the BOP always balances in an accounting sense. Deficits or surpluses refer to particular sub-accounts.

Components

1. Current account records trade in goods and services and income flows:

• Trade in goods (visible trade): merchandise exports (credit) and imports (debit); the difference is the balance of trade.
• Trade in services (invisibles): transport, tourism, insurance, banking and communication.
• Primary income: compensation of employees, interest, dividends and profit.
• Secondary income (unilateral transfers): remittances, grants and gifts.

2. Capital account records capital transfers such as debt forgiveness and the acquisition or disposal of non-produced, non-financial assets (e.g. patents, land purchases by embassies).

3. Financial account records the net acquisition and disposal of financial assets and liabilities:

• Direct investment (FDI).
• Portfolio investment (shares and bonds).
• Other investment (loans, trade credits, bank deposits).
• Reserve assets (changes in foreign exchange reserves, gold, SDRs).

4. Errors and omissions is the balancing item that takes care of statistical discrepancies.

Overall balance: Current account + Capital account + Financial account (including reserves) + Errors and omissions $= 0$. A surplus in the current and capital accounts adds to foreign reserves; a deficit is financed by drawing down reserves or by borrowing from abroad.

a. Equilibrium income and interest rate

IS curve (goods market): $Y = C + I + G$

$Y = 300 + 0.8\,(Y - 120 - 0.2Y) + 350 - 4500i + 400$

$Y = 300 - 96 + 0.64Y + 350 - 4500i + 400 = 954 + 0.64Y - 4500i$

$0.36Y = 954 - 4500i \;\Rightarrow\; Y = 2650 - 12{,}500\,i$

LM curve (money market): $M_s = M_t + M_{sp}$

$600 = 0.7Y + 250 - 4200i \;\Rightarrow\; Y = 500 + 6000\,i$

Equating IS and LM:

$2650 - 12{,}500i = 500 + 6000i \;\Rightarrow\; 18{,}500\,i = 2150 \;\Rightarrow\; i \approx 0.1162 = 11.62\%$

$Y = 500 + 6000(0.1162) \approx \text{Rs } 1197.30 \text{ billion}$

b. New equilibrium ($G = 600$, $M_s = 1000$)

IS: $0.36Y = 300 - 96 + 350 + 600 - 4500i = 1154 - 4500i$, so $Y = 3205.56 - 12{,}500i$.

LM: $1000 = 0.7Y + 250 - 4200i$, so $Y = 1071.43 + 6000i$.

$3205.56 - 12{,}500i = 1071.43 + 6000i \;\Rightarrow\; 18{,}500\,i = 2134.13 \;\Rightarrow\; i \approx 0.1154 = 11.54\%$

$Y = 1071.43 + 6000(0.11536) \approx \text{Rs } 1763.58 \text{ billion}$

c. Analysis

• Expansionary fiscal policy shifts the IS curve right, raising income but also raising the interest rate, which partly crowds out private investment.
• Expansionary monetary policy shifts the LM curve right, raising income and lowering the interest rate, thereby encouraging investment.
• Used together, the two effects on the interest rate nearly offset, so income rises strongly (by about Rs 566 billion, from 1197.30 to 1763.58) with almost no change in the interest rate, and crowding out is avoided. This is the policy mix that gives the largest output gain.

a. GNP at market price

Expenditure method: $\text{GNP}_{mp} = C + I_g + G + (X - M) + \text{Net factor income from abroad}$

• Consumption $C = 47{,}772$
• Gross private domestic investment = net fixed capital formation + capital consumption allowance + change in stocks $= 6{,}684 + 2{,}832 - 12 = 9{,}504$
• Government purchases $= 2{,}000 + 1{,}028 = 3{,}028$
• Net exports $= 4{,}192 - 6{,}160 = -1{,}968$
• Net factor income from abroad (net receipts) $= -360$

$\text{GNP}_{mp} = 47{,}772 + 9{,}504 + 3{,}028 - 1{,}968 - 360 = \text{Rs } 57{,}976 \text{ million}$

Income method: first find domestic factor incomes:

$\text{Compensation of employees} = 36{,}000 + 744 = 36{,}744$

$\text{Domestic income} = 36{,}744 + 3{,}784 + 2{,}728 + 8{,}236 + 1{,}056 = 52{,}548$

(wages and employer's contribution, proprietor's income, rent, corporate profit, net interest).

$\text{GDP}_{mp} = 52{,}548 + 2{,}956 \text{ (net indirect taxes)} + 2{,}832 \text{ (CCA)} = 58{,}336$

$\text{GNP}_{mp} = 58{,}336 - 360 = \text{Rs } 57{,}976 \text{ million}$

Both methods give the same figure.

b. Personal disposable income

National income $= 52{,}548 - 360 = 52{,}188$

Personal income = National income $-$ undistributed corporate profit and corporate taxes $-$ social security contributions $+$ transfers

• Corporate profit not paid out $= 8{,}236 - 1{,}836 = 6{,}400$
• Social security contributions $= 744 + 4{,}000 = 4{,}744$
• Transfers $= 12{,}000 + 728 = 12{,}728$

$PI = 52{,}188 - 6{,}400 - 4{,}744 + 12{,}728 = 53{,}772$

$PDI = PI - \text{Personal direct tax} = 53{,}772 - 1{,}652 = \text{Rs } 52{,}120 \text{ million}$

(a) Major issues in the case

1. Large income and development gap: Country A's per capita income is $55,556 against only$4,737 in Country B, although B has a comparable population (38 million against 45 million).
2. Weak infrastructure in B: only 35% have reliable internet, electricity cuts occur almost daily, roads are poor and the two small ports are congested.
3. Underdeveloped financial system: B has only 25 listed companies, days with no trading, and bank lending rates of 15-18%.
4. Macroeconomic instability: B has inflation of 8-15% (caused by excess money printing), a budget deficit of 8%, public debt of 85% of GDP, 18% unemployment and low growth of 1-2%.
5. Policy and institutional uncertainty: high tax rates (40%), frequently changing trade policy and a still-developing government system.
6. Low foreign reserves and currency instability: only $8 billion in reserves, which discourages investors.
7. Very unequal FDI inflows: $150 billion for A against$5 billion for B.

(b) Demand-side and supply-side business environment for FDI

Demand side (market size, purchasing power and stability of demand)

A offers a large, rich market with strong purchasing power and stable prices. B offers a large population but low income, weak demand and unstable prices and currency.

Supply side (cost and availability of inputs, productivity)

• Government policy: A has debt at 45% of GDP, a balanced budget, 25% corporate tax, free trade agreements and heavy investment in education and research. B has deficits of 8%, debt at 85%, a 40% tax rate and politically driven trade policy, raising the cost and risk of doing business.
• Infrastructure: A has 24-hour electricity, modern ports, smooth highways and high-speed internet, which cuts logistics and production costs. B's power cuts, bad roads and port delays raise costs.
• Banking and finance: A offers loans at 4-5% and deep capital markets (800+ listed companies) for raising capital and exit. B's interest rates of 15-18% and thin stock market make finance expensive and exits difficult.
• Human resources: A's workforce is educated and English-speaking, which makes operations easy for foreign firms.

Overall, Country A has a strong demand-side and supply-side environment, while B is weak on both, offering only a large population and presumably low wages.

(c) Recommendation

I would recommend Country A.

Benefits: a rich, large market ($2.5 trillion economy); stable institutions for decades; reliable infrastructure that lowers operating costs; cheap credit at 4-5%; low and stable inflation; a liquid stock market for raising capital; skilled English-speaking labour; and a lower tax rate (25% against 40%) with free trade agreements.

Costs and risks: higher wages and land costs; intense competition; high entry barriers; and the need to compete with established firms.

Country B: the benefits are a potential market of 38 million people, probable low labour cost and the possibility of high returns in a less-competitive market. But the risks are severe: 8-15% inflation, 15-18% interest rates, 40% tax, frequent policy changes, power cuts, port delays, the risk of currency collapse with only $8 billion in reserves, and 18$150 billion against $5 billion FDI also shows that investors judge A safer.

Therefore, for a new venture, A's predictable environment and lower risk outweigh B's cheaper inputs. B could be considered only for a small, low-cost, export-oriented or resource-based project with risk-hedging after reforms take hold.

Macroeconomics is the branch of economics that studies the economy as a whole, dealing with aggregate variables such as national income, output, employment, general price level, inflation, money supply, interest rate, investment, and the balance of payments, and with the policies used to manage them.

Personal income is the total income actually received by individuals and households from all sources before payment of personal direct taxes in a year. It is obtained from national income by deducting undistributed corporate profits, corporate taxes and social security contributions, and by adding transfer payments:

$PI = NI - \text{Undistributed profit} - \text{Corporate tax} - \text{Social security contributions} + \text{Transfer payments}$

The paradox of thrift states that if all people try to save more at the same time, total saving in the economy does not rise (it may even fall). Higher saving reduces consumption and aggregate demand, which lowers output and income, and the lower income reduces the amount that can actually be saved. What is a virtue for an individual is thus harmful for the economy as a whole.

Unemployment is the situation in which people who are able and willing to work at the prevailing wage rate, and who are actively seeking work, cannot find a job. The unemployment rate is:

$\text{Unemployment rate} = \frac{\text{Number of unemployed}}{\text{Labour force}} \times 100$

Inflation is the percentage rate of change in the general price level over a period, measured through a price index such as the consumer price index (CPI) or the GDP deflator:

$\text{Inflation rate} = \frac{P_t - P_{t-1}}{P_{t-1}} \times 100$

where $P_t$ is the index in the current year and $P_{t-1}$ the index of the previous year. For CPI, the price of a fixed basket of goods is compared with that of the base year.

The main objectives of fiscal policy are:

• Achieving full employment and reducing unemployment.
• Stabilising prices and controlling inflation or deflation.
• Promoting economic growth and capital formation.
• Reducing inequality in income and wealth through taxes and transfers.
• Maintaining stability in the business cycle (counter-cyclical policy).
• Mobilising resources for public goods and balanced regional development.
• Maintaining balance of payments equilibrium.

An automatic stabilizer is a feature of the fiscal system that automatically reduces fluctuations in national income without any new government decision. Progressive income taxes, corporate taxes and unemployment benefits are examples: in a boom, tax revenue rises and spending on transfers falls, which dampens demand; in a recession, tax revenue falls and transfers rise, which cushions demand.

Gross private domestic investment has three components:

1. Business (non-residential) fixed investment: spending by firms on plant, machinery, equipment and structures.
2. Residential investment: construction of new houses and apartments.
3. Change in inventories: the net change in stocks of finished goods, work in progress and raw materials.

It is gross because it includes replacement of depreciated capital.

Leakages that reduce the value of the investment multiplier are:

1. Saving: the part of income not spent on consumption (higher marginal propensity to save).
2. Taxes: income paid to the government reduces the amount available for spending.
3. Imports: spending on foreign goods that leaves the domestic income stream.
4. Undistributed corporate profit (retained earnings) and holding of idle cash balances.

Say's Law of Markets

Propounded by the French economist J.B. Say and accepted by classical economists, the law states that "supply creates its own demand." Every act of production generates an equal amount of income (wages, rent, interest, profit) through payments to factors, and this income is spent on buying the output produced. Hence total demand always equals total supply and general overproduction or involuntary unemployment cannot occur.

Assumptions

• Full employment of resources and perfect competition.
• Flexible wages, prices and interest rates.
• No government intervention (laissez-faire) and a closed economy.
• Money is only a medium of exchange, not a store of value, so there is no hoarding.

Explanation

• People produce in order to consume other goods; money is only a link in barter-like exchange.
• If part of income is saved, it does not leak from the system: saving is invested because the rate of interest adjusts to equate saving and investment. A rise in saving lowers the interest rate, raising investment.
• If there is temporary excess supply of a particular good, its price falls and the market clears; general overproduction is impossible, and unemployment is only temporary or voluntary.
• Wage flexibility ensures that any unemployment disappears as wages fall.

Criticisms

• Keynes argued that demand does not automatically equal supply: saving and investment are done by different people, so a gap can occur and cause under-employment equilibrium.
• Wages and prices are rigid downward; money can be hoarded.
• The Great Depression of the 1930s disproved the law, and Keynes proposed that "demand creates its own supply" in the short run, requiring government intervention.

A trade (business) cycle consists of recurrent fluctuations in aggregate economic activity (output, employment, income, prices) around the long-run trend. It passes through four phases.

1. Expansion (recovery) Following the trough, demand, investment, output and employment begin to rise. Confidence returns, banks lend more, prices and profits slowly increase, and the economy moves toward full employment.

2. Prosperity (boom/peak) Output and employment are at their highest, with full or over-full use of capacity. Prices, wages, profits, interest rates and credit are high, and optimism is strong. Costs rise, bottlenecks appear, and inflation emerges. This phase contains the seeds of its own reversal as profit margins shrink.

3. Recession (contraction) Demand falls, firms cut orders and investment, and layoffs begin. Banks restrict credit, stock prices drop and prices and profits fall. If sharp and long, it becomes a depression.

4. Depression (trough) Output, employment, income, prices and interest rates are at their lowest, with heavy unemployment, idle capacity, bankruptcies and pessimism. Eventually, depreciated stock must be replaced, costs and interest rates are low, and investment revives, so recovery begins again.

The cycle is repeated, though phases differ in length and intensity. Governments use monetary and fiscal policy to moderate cycles.

Macroeconomics studies the behaviour of the economy as a whole, and its significance in understanding the economic environment lies in the following:

• Understanding the functioning of the economy: it explains how national income, output, employment and prices are determined, which shows the overall health and nature of the economy.
• Formulation of economic policy: it provides the theories (Keynesian, classical, monetarist) behind fiscal, monetary and trade policy used to stabilise the economy.
• Controlling business cycles: it helps identify the causes of booms and recessions and the policy tools to manage them.
• Solving inflation and unemployment: it analyses their causes and the trade-off between them, as shown by the Phillips curve.
• Economic growth and development planning: it helps measure growth, set targets, and examine the role of saving, investment and capital formation.
• Understanding international linkages: balance of payments, exchange rates, trade and capital flows are all macroeconomic matters.
• Business decision-making: managers need to assess interest rates, inflation, demand conditions and government policy before investing, pricing or expanding.
• Measurement and comparison: national income accounts allow comparison of living standards across time and countries, and help detect structural problems.
• Understanding the paradoxes of aggregate behaviour, such as the paradox of thrift, which are not visible at the micro level.

Economic growth is therefore necessary but not sufficient for economic development, and development includes growth along with better living standards for the majority.

Concept

A public-private partnership (PPP) is a long-term contractual arrangement between a government agency and a private-sector firm in which the private party finances, builds, operates or maintains public infrastructure or provides public services, sharing the risks, costs and rewards. The aim is to combine the public sector's social objectives and regulatory authority with the private sector's capital, efficiency, technology and management skill.

Common models

• BOT (build-operate-transfer), BOOT (build-own-operate-transfer), BOO and BLT.
• Design-build-finance-operate, concession, lease and management contracts, joint ventures.

Features

• Long-term contract with clear allocation of risk between the parties.
• The private partner gets paid through user fees, tolls, or government payments (availability payment, viability gap funding).
• The public sector retains ownership or final control and sets service standards.

Advantages

• Mobilises private capital when public budgets are limited.
• Faster completion and better efficiency, quality and innovation.
• Risk transfer to the party best able to manage it.
• Frees public funds for other priorities.

Limitations

• High transaction and contract costs, possible cost overruns and renegotiation.
• Users may pay higher charges; risk of private monopoly.
• Needs a strong legal framework and regulatory capacity.

Nepal context: Nepal's PPP and Investment Act, 2019 encourages PPP in hydropower (e.g. Kulekhani-III and Upper Tamakoshi-type private investment), airports, roads, tunnels and urban services under the Investment Board Nepal.

The final product (expenditure-based) method measures GDP by adding the market value of all final goods and services produced within a country in a year, either at the point of sale to final users or as total spending on them. Intermediate goods are excluded to avoid double counting.

Steps

1. Identify all final goods and services produced in the economy and classify them by the users (households, firms, government, foreigners).
2. Multiply the quantity of each final good by its market price: $\sum P_i Q_i$.
3. Add the final expenditures of the four sectors:

$GDP_{mp} = C + I + G + (X - M)$

• $C$: consumption expenditure of households on durables, non-durables and services.
• $I$: gross private domestic investment (fixed investment plus change in inventories).
• $G$: government purchases of goods and services (transfer payments excluded).
• $X - M$: net exports.

4. The result is GDP at market prices. To obtain other measures:
   • GDP at factor cost $= GDP_{mp} - \text{Net indirect taxes}$
   • NDP $= GDP - \text{Depreciation}$
   • GNP $= GDP + \text{Net factor income from abroad}$