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INFORMATION AND COMMUNICATIONS UNIVERSITY SCHOOL OF HUMANITIES Course name Intermediate Macroeconomics 2 An assignment submitted in partial fulfillment of the requirements for the BA Degree in Economics and Finance Assignment No. 2 Student details David Syamutondo Lecturer’s Name: Mr. Joshua Mabeta Year: 2016 Question 1 a) Effects of Stock market crash using IS-LM model Stock market crash will result in a sudden decline of stock prices in the market and hence affect the internal financing of the business and hamper its growth contributing to low economic activity in the market IS-LM Model Showing Effects of Stock Market Crash Interest rates LM2 LM1 r2 r1 E1 E2 IS Y2 Y1 (Output) Y, Investment A sudden fall in prices for stocks will reduce the investment in the economy from E1 to E2 thus decreasing the demand for money since the interest rates increase as shown above. These will be the effects of the stock market crash which will affect output by decreasing it from Y1 to Y2. Monetary policy by the government can be used to resolve the stock crash problem by increasing the money supply in the economy which will lower the interest rates from r2 to r1 in the diagram above thus increasing the investment and the output in the economy b) Use of fiscal and monetary policy in the economy to resolve the stock crash problem is illustrated by the diagrams below; In this diagram the assumption is the monetary policy used is the increase of the supply of money in the economy which leads to lowering the interest rates thus increasing investment as shown from the movement of the equilibrium from E1 to E2. This measure will resolve the stock market crash by facilitating an increase in investment in the economy. The use of fiscal policy has a negative impact on investment because as government spending increases or tax is reduced which increases consumption, the interest rate is pushed up which lowers the investment in the economy thus fiscal policy is not very effective in resolving a market stock crash. The diagram below shows the effects of fiscal policy. The increase in interest rate shifts the LM curve to the right from LM1 to LM2 and the equilibrium moves from E2 to E1 showing a crowding out effect in terms of investments Comparing the two policies of fiscal and monetary, it is clear that monetary policy is the best approach in resolving a stock crash and attracts investment in the economy as shown by the ISLM model diagrams IS-LM Model Showing Effects of Fiscal Policy Interest rates LM2 r2 LM1 E1 E2 r1 IS Y2 Y1 (Income) Y, Investment Question 2 a) (M/P)D = 2Y – 20,000i E=C+I+G M/P = 2,600 E = 150+0.5(2600-300)+150+0.3(2600)-10000(0.13)+300 M/P = (M/P)D = Y E = 150+1150+150+780-1300+300 2600 = 2(2600) – 20,000i E = 1,230 2600 = 20,000i I = 2600/20000 I = 0.13 = 13% P = 0.13+0 = 0.13 b) P= i+x P = 13%+0.5% = 13.5% Cost of bank loans increase by 0.5% E = C+I+G E = 150+0.5(2600-300)+150+0.3(2600)-10000(0.135)+300 E = 600+1150+780-1350 E = 1,180 Question 3 When Investment is not responsive to interest rate and there are no wealth effects, the increase in money supply as a monetary policy will not have any effect on the IS curve as output will remain constant due to the vertical IS curve. However a fiscal policy will shift the IS curve thus increasing output by the same change in the shift of the IS curve Question 4 Increase in government spending increases the planned expenditure which in turn increases the income thus causing the IS curve to shift outwards as shown below from IS1 to IS2 Increase in government expenditure will increase the planned expenditure and thus shift the aggregate demand to the right to a new equilibrium from A to B as income increases.