UNIVERSITI TEKNOLOGI MARA, JOHOR

BACHELOR IN BUSINESS ADMINISTRATION WITH HONORS

(FINANCE)

ECO 551
MONETARY ECONOMICS

PAST SEM APRIL 2010 (QUESTION 6)

PREPARED FOR:
EN BAZRI BIN ABU BAKAR

PREPARED BY:

MAZIATUL RAIHAN BINTI ZAKARYA 2009252682

MAZWANA BINTI BADRI 2009745579
NOR NIYANA BINTI RAMLI 2009100453
KHAIRULNIZAM BIN AHMAD YASID 2009135705

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A). Using the ISLM model, show graphically and explain the effects of a
monetary expansion combined with a fiscal contraction. How do the
equilibrium level of output and interest rate change?

The increase in the money supply is fully anticipated, and then the demand for
money rises by more than if the change had been unanticipated. (Again note
that the demand for money shifts when there is a change in the price level. So
when the price level raises the demand for money rises.)

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 i L-M1
LM1
LM2

i0

i1

y
y0

The LM curve shifts to the right from LM1 to LM2 when the money supply
increase. The equilibrium of interest rate falls as effect of the output is
constant at y0.

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 The monetary expansion shifts the LM curve to the right, from LM to
LM′ , and the fiscal contraction shifts the IS curve to the left, from IS to
IS′ . The equilibrium interest rate definitely falls, while the effect on
output is uncertain. The graph below shows Y increasing, but that result
depends on the way the graph is drawn. We should know the outcome
cannot be determined definitely.

- Include diagrams + explanation on IS (i.e. Keynes Cross Diagram, IS

curve)

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B) The effect of a fiscal expansion when the demand for money is
completely insensitive to changes in interest rate. What is this effect
called?

Fiscal policy refers to the government's handling of the budget. Usually fiscal
policy is about spending as much as possible, thereby stimulating the
economy and increasing votes, without raising taxes. This has led to an
ongoing budget deficit and a huge debt. Like any budget, fiscal policy guides
two components: income and spending.

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 AD AD = y

AD2 [r= 5%]

AD1 [r=10%]

AD0 [r=15%]
Figure (a)

y
r

15%

10%
Figure (b)

5%

y
y0 y1 y2
I-S

Figure (a) indicates that falls in the rate of interest from 15% to 10% to 5% create
increases in investment resulting in aggregate demand rising from AD0 to AD1 to
AD2. These increases in AD cause equilibrium output to rise from y0 to y1 to y2.

Figure (b) sets out the relationship between r and y. As r falls investment increases
driving up equilibrium output, via the multiplier, from y0 to y1 to y2 Note:- Every point
along the I-S schedule represents a possible equilibrium level of national
income/output

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Figure (c) This is the total trading crowding effect. The LM curve is vertical, so any
shift of the IS curve affects only interest rates. The level of output is constant at Y.
The fiscal expansion shift the IS curve rightward, increasing the interest rate from i
to i’.

OK

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