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INFORMATION AND COMMUNICATIONS UNIVERSITY
SCHOOL OF HUMANITIES
INTERMEDIATE MACROECONOMICS II
An assignment submitted in partial fulfillment of the requirements for
the BA Degree in Economics and Finance
Assignment No. :
2
Student details : PHILLIP MIYOBA - 1206377925
Lecturer’s Name : MR. MUKONDA
Year
2016
1 a) Suppose that there is a stock market crash in the economy. Use the IS-LM model to explain
the effects of that crash. How monetary policy can be used to reduce the effects of the crash?
Explain.
A stock market crash is a rapid and often unanticipated drop in stock prices on the stock market
like LuSE. A stock market crash can be the result of major catastrophic events, economic crisis
or the collapse of a long-term speculative period as was the case in the 2008 stock market crash.
However, in this module we have learnt that public panic is a major contributor.
Movements in the stock market can have a profound economic impact on the economy and
everyday people. A collapse in share prices has the potential to cause widespread economic
disruption. In the diagram below, during a stock market crash, the IS curve moves from IS1 to
IS2, this causes a reduction in interest rates from R2 to Rs and a reduction in Y from Y1 to Y2.
IS2
IS1
LM
R1
R2
IS2
Y2
IS1
Y1
Reducing effects of stock market crash using monetary policy.
The government has control of the stock market through the Securities and Exchange
Commission in Zambia. It is therefore an extension of the government in times of need when this
free market, demand and supply driven market is faced with a crash. The government can use
monetary policy to reduce the effects of the crash. Expansionary monetary policy can be
introduced. The aims are to increase aggregate demand and economic growth in the economy.
Expansionary monetary policy involves cutting interest rates or increasing the money supply to
boost economic activity. Expansionary monetary policy could also be termed a ‘loosening of
monetary policy’. It is the opposite of tight monetary policy.
If the Bank of Zambia cuts interest rates, it will tend to increase overall demand in the economy.
The following are the economic facts that would play out;

Lower interest rates make it cheaper to borrow; this encourages firms to invest and
consumers to spend.

Lower interest rates reduce the cost of mortgage interest repayments. This gives households
greater disposable income and encourages spending.

Lower interest rates reduce the incentive to save.

Lower interest rates reduce the value of the Pound, making exports cheaper and increases
export demand.
In addition to cutting interest rates, the Bank of Zambia could pursue a policy of quantitative
easing to increase the money supply and reduce long term interest rates. Under quantitative
easing, the Central bank creates money. It then uses this created money to buy government bonds
from commercial banks. in theory, this should increase monetary base and cash reserves of
banks, which should enable higher lending and reduce interest rates on bonds which should help
investment. In theory, expansionary monetary policy should cause higher economic growth and
lower unemployment. It will also cause a higher rate of inflation. To some extent, the
expansionary monetary policy of 2008, helped economic recovery.
b) According to the monetarist view, money is not a close substitute of interest bearing assets
only but it is a substitute of all possible assets. This implies that money demand is not very
sensitive to the interest rate. Moreover investments are believed to be very sensitive to the
interest rate. Using diagrams to illustrate your answer discuss the effectiveness of fiscal and
monetary policy in such a case using the IS-LM model. Compare your results with the ones in a).
The IS curve represents equilibrium in the goods market where fiscal policy is applicable. It is
given by the equation;
Y=C(Y-T)+ Ir+ G
The LM curve represents money market equilibrium where monetary policy is applicable. It is
given by the equation;
M
= L (r,Y)
P
The intersection determines the unique combination of Y and r that satisfies equilibrium in both
markets. We can therefore use the IS-LM model to analyse the effects of the fiscal and monetary
policies. At equilibrium, the Model will look as below.
IS1
LM
R1
Equilibrium
LM
IS1
Y1
However, it is true to say that investments are highly sensitive to interest rates. In the diagram in question
one, we saw that a reduction in the government expenditure due to the stock market crash causes a
reduction in income and interest rates and this causes a reduction in investment as economists have
predicted in this model. The IS curve moves to the left showing a reduction in economic activity.
Expansionary monetary policy and the principle of crowding out come on board as government start to
spend more using borrowed o r reducing taxes. This will then lead to this situation below.
IS1
IS2
LM
R2
R1
IS1
IS2
The IS curve will move to the left and raises money demand, causing interest rates to rise. This
reduces investment and the total change in government expenditure is less. The IS-LM model is
a very effective tool in measuring, determining and predicting economic activity.
QUESTION 2
C = 150+ 0.5(Y-T)
T=G=300
I=150+0.3Y-10,000p
p= i+x
M
P
=2Y – 20,000i
M = 2600
P
a) Assume that the spread x is zero. Derive the IS relation and find the equilibrium level of
output (Y) and the interest rate (i) implied by the IS-LM model.
b) Now assume that there is a fall in the firm’s capital with the result that x is increased to 0.5%.
What happens to the cost of bank loans? Calculate the new equilibrium in the IS-LM model.
Briefly explain your findings.
a) Y = C+I+G
Y = 150+0.5(Y-300)+300
Y = 150+0.5Y-150+300
Y = 150 + 0.5(Y-T)+I+G
Y = 150+0.5(Y-300)+150+0.3Y-10,000p+300
Y = 150+0.5Y-150+150+0.3Y-10,000p+300
Y = 150-150+150+3000+0.5Y+0.3Y-10,000p
Y = 3150+0.8Y-10,000p
Y – 0.8Y = 3150 – 10,000p
0.2Y = 3150 – 10,000p
0.2
0.2
Y = 15,750 – 50,000p - IS Equation
Md = Ms
2Y – 20,000i = 2,600
2Y= 2,600 + 20,000
2
2
Y = 1,300 + 10,000i – LM Equation
IS = LM
15,750 – 50,000p = 1,300 + 10,000i
15,750 – 1,300 = 50,000 – 10,000i
14,450 = 60,000i
60,000 60,000
i = 0.24
3 a) Consider an economy where investment are not responsive to the interest rate and suppose
that there are not wealth effects. Explain what those assumptions imply for the aggregate demand
curve.
The implications of this situation are that there will be no movement in the IS curve despite the
change in the interest rate. The IS curve will be a straight vertical line as demonstrated in the
graph below.
IS
r2
r1
0
Y
b) Consider an increase in government expenditure in an economy where both the interest rate
and the aggregate price level are assumed to be endogenous. Represents the effects of such
increase in government expenditure using the: i) IS-LM model; ii) AD-AS model with a
horizontal short-run aggregate supply; in both cases assume that you start at the natural level of
output.
The IS Curve
LM2
IS2
IS1
LM1
R1
Equilibrium
LM2
LM1
IS2
IS1
Y1
Yd
This increases the aggregate demand for goods and the IS curve shifts up and to the right. The
level of demand is determined by the intersection between IS and LM and this is denoted Yd. At
the higher level of government spending the aggregate demand for goods is greater than the
aggregate supply of goods, Y1. Firms will see their inventory of goods fall and they will respond
by increasing prices. Also, workers will bargain for higher nominal wages to keep their real
wage constant. As overall prices and wages rise, the LM curve will shift up and to the left and
the real interest rate will rise.
As r increases, interest sensitive spending (consumption and investment) falls as we move along
the IS curve toward the new general equilibrium at r2. At the new equilibrium, output is again Y1
but the real interest rate and the price level are higher. Also, the higher amount of government
spending has crowded out some private consumption and investment expenditure due to the
higher real interest rate. The end result of the increased level of government spending is no
increase in real output but the composition of demand has changed: more government spending
and less private spending.
The Demand and Supply reaction
D1
D2
S2
S1
P1
P2
D1
Q1
Q2
D2
In this situation as government expenditure increases, the following happens:
1. Quantity increases from Q1 to Q2, this is as a result of the shift in the supply curve from
S1 to S2
2. The shift in the supply curve pushes prices downwards from P1 to P2