Question

20 POINTS 3) Given the following information, and assuming fixed prices: C = 50+ 0.9Yd I* = 30 +0.5/ G=75 T=t=0 Ms = 410 Md -0.20NP + 2/1 a) Solve for: i) the equilibrium rate of interest ii) the desired level of investment iii) the equilibrium level of national product.

Answer 1

(a)

In goods market equilibrium, NP = Y = C + I*

Y = 50 + 0.9Y + 30 + (0.5/i)

0.1Y = 80 + (0.5/i)

Y = 800 + (5/i).........(IS equation)

In money market equilibrium, MD = MS.

0.2Y + (2/i) = 410

0.2Y = 410 - (2/i)

Y = 2050 - (10/i).......(LM equation)

In general equilibrium, IS = LM.

800 + (5/i) = 2050 - (10/i)

1250 = 15/i

(i) i = 0.012

(ii) I* = 30 + (0.5/0.012) = 30 + 41.67 = 71.67

(iii) NP = Y = 800 + (5/0.012) = 800 + 416.67 = 1216.67

(b)

In money market equilibrium, MD = New MS.

0.2Y + (2/i) = 610

0.2Y = 610 - (2/i)

Y = 3050 - (10/i).......(New LM equation)

Setting IS = New LM,

800 + (5/i) = 3050 - (10/i)

2250 = 15/i

(i) i = 0.0067

(ii) I* = 30 + (0.5/0.0067) = 30 + 75 = 105

(iii) NP = Y = 800 + (5/0.0067) = 800 + 750 = 1550

(c)

(I) MD-MS model

Increase in money shifts money supply curve rightward. In following graph, MD0 and MS0 are initial money demand and supply curves intersecting at point A with initial interest rate r0 (= 0.012) and quantity of money Q0 (= 410). As money supply rises, MS0 shifts left to MS1, intersecting MD0 at point B with lower interest rate r1 (= 0.0067) and higher quantity of money M1 (= 610).

MS MS IMDO Mo M M

(II) IS-LM model

Higher money supply shifts LM curve rightward. In following graph, IS0 and LM0 are initial IS and LM curves intersecting at point A with initial interest rate r0 (= 0.012) and output Y0 (= 1216.67). Higher money supply shifts LM0 rightward to LM1, intersecting IS) at point B with lower interest rate r1 (= 0.0067) and higher output Y1 (= 1550).