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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