University of Dhaka

Department of International Business

Midterm Examination 2
Course Code: IB-207

Prepared by:
Md. Sakib Hossain
ID No. SM-030-113
Section: B
Department of International Business
University of Dhaka

Prepared for:
Mohammad Monirul Islam
Assistant Professor
Department of International Business
University of Dhaka

Date of submission: April 10, 2021

Question No. 1
Explain the effects of these three shocks (separately) on the US economy using IS-
LM curve.
Answer: These three shocks on the US economy be explained with the effects of IS-LM
curve are given below:

r LM1

E1
r1 E2

r2
IS1
IS2
Y2 Y1

Shock 1: Stock Market Crash

The fall in the market reduced household wealth and thus consumer spending. In addition, the
declining perceptions of the profitability of the new technologies led to a fall in investment
spending. In the language of the IS-LM model, the IS curve shifted from IS1 to IS2, a left
shift.
We assume that economy is in equilibrium at E1. Here, E1 represents the level of income and
interest. Because of the stock market crash consumers cut their spending thus cut their
investment in the economy. Therefore, IS1 shifted to the left at IS2. This resulted in a
reduction in the level of income in the U.S. economy. Shifting from Y1 to Y2.
Shock 2: 9/11 Incident
In the week after the attacks, the stock market fell another 12 percent. The attacks increased
uncertainty about what the future would hold. Uncertainty can reduce spending because
households and firms postpone some of their plans until the uncertainty is resolved.
We assume that economy is in equilibrium at E1. Here, E1 represents the level of income and
interest. Because of the 9/11 Incident firms and households hold their money to spend later
depending on the future situation thus cut their present investment in the economy. Therefore,
IS1 shifted to the left at IS2. This resulted in a reduction in the level of income in the U.S.
economy. Shifting from Y1 to Y2.
Shock 3: Accounting Fraud
This third shock was a series of accounting scandals at some of the nation’s most prominent
corporations. The result of these scandals was
• Bankruptcy of some companies that had fraudulently represented themselves as more
profitable than they truly were,
• Criminal convictions for the executives who had been responsible for the fraud, and
• New laws aimed at regulating corporate accounting standards more thoroughly.
We assume that economy is equilibrium at E1. Here, E1 represents the intersection of the
level of income and interest. Because of Accounting Fraud firms were discouraged to invest
in the business. Therefore, IS1 shifted to the left at IS2. This resulted a reduction in the level
of income in the U.S. economy. Shifting from Y1 to Y2.

Question No. 2
Explain the short run and long run effects of these shocks on the economy using IS-
LM and AD-AS curve.

Answer: The short run and the long run effects of these shocks on the economy are explained
below using IS-LM curve and AD-AS curve.

r LRAS P LRAS
LM(P1)

P1 SRAS1

IS1
22 AD1
IS2
22 AD2

Y bar Y Y bar Y
barb
ar

From the shocks of the stock market crash, the incident of 9/11, and accounting Fraud of the
companies’ households and firms didn’t invest in the market. In the short run, investment
goes down means the aggregate demand curve goes down with it. In the IS-LM model, the IS
curve shifted from IS1 to IS2, changing downwards. As money supply reduced, aggregate
demand also decreased. Shifting from AD1 to AD2. As a result, the national income or GDP
of the U.S. reduced from Y to Y bar.
 r LRAS P LRAS
LM(P1)

P1 SRAS1

IS1
22 AD1
IS2
AD2
22

Y bar Y Y bar Y

In the short run, the price level is generally sticky. Here the price stuck at P1. In the long run,
the price level adjusts so that the economy is at the natural level of output. As the IS curve
shifts to the left the aggregate demand curve also shifts in the same manner. IS curve reduces
the interest level and output. The aggregate demand curve reduced the price level in the long
run. The incident of 9/11 and Accounting fraud reduced investment in the market. Which
leads to a reduction in the money supply in the long run. Price will be lower than before due
to the lower demand for goods and services.
In the ISLM model, IS and LM shocks are exogenous changes in the demand for goods and
services, in the demand for money respectively. As the price is fixed in the short run a change
in the price will shift LM and affect the output. Aggregate demand also moves the same. IS
curve shifts to the left which led to decreasing interest rate planned expenditure and income.

Question No. 3
How monetary and fiscal policy of the US government help to combat the effects of
the shocks.
Answer: Fiscal and monetary policymakers responded quickly to these events. Congress
passed a major tax cut in 2001, including an immediate tax rebate, and a second major tax cut
in 2003. One goal of these tax cuts was to stimulate consumer spending.
Congress increased government spending by appropriating funds to assist in U.S. economic
recovery. As a result, fiscal measures shifted the IS curve to the right. The government
purchases in the Keynesian cross says that this change in fiscal policy raises the level of
income at any given interest rate by the change in G / (1- MPC). Therefore, IS curve shifts to
the right by this amount. The equilibrium of the economy moves from point A to point B. the
increase in government purchases raises both income and interest rates.
Monetary policy also helps to combat the effects of the shocks, share market fell, less share
price needed the money growth. Monetary policy accelerated money growth and interest rates
fell. We know that a change in the money supply or demand alters the interest rate that
equilibrates the money market for any given level of income and thus shifts the LM curve.
The IS-LM curve model shows how a shift in the LM curve affects income and interest rates.
For any given level of income, an increase in real money balances leads to a lower interest
rate. Therefore, the LM curve shifts downward and the equilibrium moves from point A to
point B. The increase in the money supply lowers the interest rate and raises the level of
income. Again, a lower interest rate stimulates planned expenditures, production and income
Y which means IS curve moves right also.