FACULTY OF COMMERCE AND LAW

DEPARTMENT OF BANKING AND FINANCE

JANUARY 2020 ASSIGNMENT

INTERMEDIATE MACROECONOMICS BBFH208

INTAKE 32, PART 2, SEMESTER 2

ASSIGNMENT 1

1. (a) With the aid of a clearly labelled diagram, discuss the effects of an

expansionary fiscal policy within the IS – LM framework. [13]

(b) Using a clearly labelled diagram, discuss the effects of an expansionary

monetary policy in a fixed exchange rate regime with perfect capital mobility.

[12]

2. Discuss in detail five factors that influence consumption expenditure in Zimbabwe.

(a) With the aid of a clearly labelled diagram, discuss the effects of an expansionary

fiscal policy within the IS – LM framework. [13]

Investment (I) is the most volatile and important component of private and government spending.

However, unpredictable variations in investment in spending can send macro economics tremors

to economic growth, unemployment and inflation rates. Fiscal Policy involves the use of

government taxation and expenditure policies in order to influence economic activities. Thus it is

the government’s mandate to strengthen and monitor its fiscal policy so as to raise the National

Gross Domestic Product.

Fiscal Policy is defined by Beard Shaw (2002) as the regulation of the economy through

government spending and taxes. Fiscal regime can be either contractionary or expansionary. IS

or Invstment - savings model is a real (good) market equilibrium curve while LM – Is a monetary

sector equilibrium curve. Thus the merged model is the so called IS-LM Model

Fiscal and Monetary Policies and IS-LM Curve Model

This is illustrated in the diagram below. Increase in Government expenditure which is of

autonomous nature raises aggregate demand for goods and services and thereby causes an

outward shift in IS curve, as indicated in the diagram where increase in Government

expenditure leads to the shift in IS curve from IS1 to IS2.

The horizontal distance between the two IS curves is equal to the increase in government

expenditure times the government expenditure multiplier, that is, change in G x 1/1-MPC

which shows the increase in national income equal to the horizontal distance EK that occurs in

Keynes’ multiplier model. However, in IS-LM model actual increase in national income is not

equal to EK caused by the working of Keynesian multiplier.

This is because with the rightward shift in IS curve rate of interest also rises which causes

reduction in private investment. It will be seen from the diagram that, with the LM curve

remaining unchanged, the new IS2 curve intersects LM curve at point B. Thus, in IS-LM model

with the increase in Government expenditure (change in G), the equilibrium moves from point

E to B and with this the rate of interest rises from r1 to r2 and income level from Y1 to Y2.

Income equal to CK has been wiped out because of rise in interest causing a decline in private

investment. Thus CK represents crowding-out effect of increase in government expenditure

Thus, IS-LM model shows that expansionary fiscal policy of increase in Government

expenditure raises both the level of income and rate of interest.

It is worth noting that in the IS-LM model increase in national income by Y1 Y2 in the diagram

is less than EK which would occur in Keynes’ model. This is because Keynes in his simple

multiplier model assumes that investment is fixed and autonomous, whereas IS-LM model
takes into account the fall in private investment due to the rise in interest rate that takes place

with the increase in Government expenditure. That is, increase in Government expenditure

crowds out some private investment.

Likewise, it can be illustrated that the reduction in Government expenditure will cause a

leftward shift in the IS curve, and given the LM curve unchanged, will lead to the fall in both

rate of interest and level of income. It should be noted that Government often cuts expenditure

to control inflation in the economy.

Expansionary Fiscal Policy: Reduction in Taxes:

An alternative measure of expansionary fiscal policy that may be adopted is the reduction in

taxes which through increase in disposable income of the people raises consumption demand

of the people. As a result, cut in taxes causes a shift in the IS curve to the right as is shown in

the second diagram from IS1 to IS2.

It may however be noted that in the Keynesian multiplier model, the horizontal shift in the IS

curve is determined by the value of tax multiplier times the reduction in taxes (change in T),

that is, change in T x MPC/1-MPC and causes level of income to increase by EH.

However, in the IS-LM model, with the shift of the IS curve from IS1 to IS2 following the

reduction in taxes, the economy moves from equilibrium point E to D and, as is evident from

the second diagram, rate of interest rises from r1 to r2 and level of income increases from Y1 to

Y2. Income equal to LH has been wiped out because of crowding-out effect on private

investment as a result of rise in interest rate.

On the other hand, if the Government intervenes in the economy to reduce inflationary

pressures, it will raise the rates of personal taxes to reduce disposable income of the people.

Rise in personal taxes will lead to the decrease in aggregate demand. Decrease in aggregate

demand will help in controlling inflation. This case can also be shown by IS-LM curve model.
(b) Using a clearly labelled diagram, discuss the effects of an expansionary

monetary policy in a fixed exchange rate regime with perfect capital mobility.

[12]

Below is a clearly labelled diagram that shows the effects of an expansionary monetary policy

in a fixed exchange rate regime with perfect capital mobility.

An expansionary monetary policy will shift the LM curve to LM’, which makes the equilibrium

go from point E0 to E1. However, since we are below the BP curve, we know the economy has

a balance of payments deficit. Since exchange rates are fixed, government intervention is

required. Thus, the government will purchase domestic currency and sell foreign currency,

which will drop the money supply and therefore shift the LM’ curve to its original position

(which makes the equilibrium go to E2). Monetary policy, which in Zimbabwe in issued by the

Reserve Bank of Zimbabwe, has therefore no effect under these circumstances.

An expansionary fiscal policy will shift the IS curve to IS’, moving the equilibrium form point

E0 to point E1. Since the economy has now a balance of payments surplus, and because the

exchange rate is fixed, government will intervene in the exact opposite way. Thus, they will

purchase foreign currency and sell domestic currency. This will increase the money supply,

shifting the LM curve to the right. The final equilibrium is reached at point E2 where, at the

same interest rate, production has increased greatly: fiscal policy works perfectly under these

circumstances.
 2. Discuss in detail five factors that influence consumption expenditure in Zimbabwe.
THE INTEREST RATES

It has long been supposed that an increase in the rate of interest would lead to an increase in

savings and, therefore, a reduction in consumption. Other things remaining the same, the lower

the real interest rate, the greater is the amount of consumption expenditure and the smaller is

the amount of saving. The real interest rate is the opportunity cost of consumption.

This opportunity cost arises regardless of whether a person is a borrower or a lender. For a

borrower, increasing consumption this year means paying more interest next year. For a lender,

increasing consumption this year means receiving less interest next year. The effect of the real

interest rate on consumption expenditure is an example of the principle of substitution. If the

opportunity cost of an action increases, people substitute other actions in its place. In this case,

if the opportunity cost of current consumption and substitute future consumption in its place.

EXPECTED FUTURE INCOME

The higher a household’s expected future income, other things remaining the same the greater

is its consumption expenditure. That is, if two households have the same disposable income on

consumption goods and services. If the disposable income increases the consumer will either

increase expenditure of the same goods or add another variety which previously they could not

afford.

SALES EFFORT

An increase or decrease in the amount of sales effort may affect the total volume of consumer

expenditures, given the level of income. Advertising has the effect of shifting demand from

one product to another. But, as Ackley has put it, whether as a result of advertising, aggregate
consumption, expenditure will fall or not is debatable. It is the matter of empirical (statistical)

test and verification

CONSUMER CREDIT

The terms of consumer credit have often been important in influencing consumption behavior

in respect of durable goods for example TV sets and solar systems among others.

The extent to which consumers can borrow to finance purchases may affect their levels of

consumption. A high level of debt may dampen consumer demand, because repayment in the

future will be necessary, making less funds available for current consumption. In addition,

interest rate levels, the maximum time period for repayment, down-payment requirements, and

the ease of access to financial institutions may cause consumer spending for durable goods to

increase or decrease. In Zimbabwe, with the current prevailing macro-economic challenges,

the consumers will prefer to increase debt now. Thus increasing expenditure.

FISCAL POLICY

Tax and transfer payments also affect consumption for example the unpopular 2% tax

introduced by the Finance Minister in Zimbabwe. An increase in indirect taxes raise

commodity prices and may lead to a fall in the demand for the taxed commodity. Likewise, an

increase in income tax may reduce the disposable income of individuals and may lower total

consumption expenditure.