Question

4. Suppose that money demand is given by

   Md =$Y(.25−i)
   where $Y is $100. Also suppose that the supply of money is $20.

   1. (a) What is the equilibrium interest rate?

   2. (b) If the Federal Reserve wants to increase i by 10 percentage points (e.g., from 2% to 12%), at what level should it set the supply of money?

5. Show the changes on short run equilibrium real GDP and the equilibrium nominal interest rate in the IS-LM model from each of the following policies/economic situations. Briefly explain any economic reactions (i.e. what is occurring in the goods and/or money markets. One graph is necessary for each part. Clearly label your graph for full credit.

   (a) A decrease in taxes
   (b) An increase in the money supply (c) A decrease in consumer confidence

Answer 1

Md = Y(.25 - i), Y = $100

Ms = 20

(a) At Equilibrium, Md = Ms

=> 100(.25 - i) = 20

=>25 - 100i = 20

=> i = 0.05 = 5%

(b) If Fed wants ti ncrease i by 10 percentage points

i = 5 +10 = 15%

Ms = 100(.25 -.15) = 10

IS-LM MODEL

(a) Decrease in Taxes

A decrease in taxes only shifts the IS₁ curve to the right and there is no change in the LM curve. The Equilibrium point changes from A to B. This causes the interest rate to rise from i to i', and the Output, to increase from Y to Y'.

(b) An increase in the Money Supply

An increase in the money supply shifts the LM curve downward and there is no change in the IS curve. The Equilibrium changes from A to B. The shift in the Lm curve decrease the interest rate from i to i' and increases the Output from Y to Y'.

(c) A decrease in consumer confidence

The consumer confidence depends on the consumption of an individual, So a decrease in consumer confidence means a decrease in the consumption expenditure, which in turn affects the IS curve. It shifts the IS curve leftward and the equilibrium moves from A to B. The interest rate decrease from i to i' and the Output decreases from Y to Y'.