Question

Given the following economic information for Country A (in RM billion):

Saving (S) = –500 + 0.3Yd

Investment (I) = 400 – 200r

Government spending (G) = 500

Taxes (T) = 200

Nominal money supply (Ms ) = 4000

Money demand for transactions (Md t/P) = 0.2Y

Money demand for speculations (Md s) = 1600 – 500r

Price (P) = 2 di mana Y dan r adalah masing-masing mewakili tingkat pendapatan dan kadar bunga.

where Y and r represent the levels of income and interest rate, respectively. Based on the above information,

i) . Derive an expression for the IS and LM curve (four decimal point) in Y says.

ii) . Calculate the equilibrium levels of income and interest rate (three decimal point).

iii) Suppose that the autonomous investment increased by RM100 billion. Find the new equilibrium levels of income and interest rate.

iv) Demonstrate and explain your answers to parts (ii) and (iii) using an appropriate diagram

Answer 1

The answer provided below has been developed in a clear step by step manner.

 

Step: 1

i)

The equilibrium of an economy’s goods market is achieved for a combination of output and interest rate for which the aggregate demand(AD) is equal to the aggregate supply(AS). IS or investment-savings curve is a locus of all the combinations of output and interest rate for which the goods market is in equilibrium. AD consists of consumption, investment, government expenditure etc. The equation of savings is given here and we know people save a part of their disposable income nad spend the rest. So, we have,

 

The IS equation is: 

 

The equilibrium of an economy’s money market is achieved for a combination of output and interest rate for which the demand for real money balance and supply of the same. The supply of real money is fixed by a country’s central bank or monetary authority. LM curve is a locus of all the combinations of output and combinations of output and interest rate for which the money market is in equilibrium. The total demand for money is:

 

Explanation: Please refer to solution in this step.

 

Step: 2

ii)

An economy is in equilibrium when for any set of income nad interest rate the goods market and the money market equilibrium is achieved. To find the equilibrium rate of interest equate the value of Y in  1 and 2:

 

Explanation: Please refer to solution in this step.

 

Step: 3

 

iii)

Suppose, the autonomous investment increased by RM100 billion. We can represent this change by taking total derivative of 1 and 2: 

iv)

Suppose, the autonomous investment rise by RM100 billion. The AD of the economy rises which shifts the AD curve to the right. The rise in AD means, more demand for money which raises the interest rate in economy. The equilibrium income also rises. As the interest rate rises, some of the investment programs becomes less profitable. So, some investment crowded out. So, the rise in income is less in equilibrium than the initial rise in investment.

 

So, we can see that, as the AD curve shifts rightward, the equilibrium r rises by 0.03 and the equilibrium income rises by RM 80 billion.

So, we can see that, as the AD curve shifts rightward, the equilibrium r rises by 0.03 and the equilibrium income rises by RM 80 billion.