Mathematical approach to the macroeconomic general equilibrium and the application of IS-LM model

Given:

C = 102 + 0.7Y. I = 150 – 100r.M = 300, L = 0.25F + 124 – 200r of which kPY = 0.5y and hr = 124 – 200r.
Find (a) the equilibrium level of income and the equilibrium rate of interest, and (b) the level of C, I, and
L when the economy is in equilibrium.

Solution, (a) Commodity market equilibrium (IS) exists where

Y=C+I

=102+0.2Y+150+100r

Y-0.7Y=252-100r

0.3Y+100r-252=0.....(1)

Money market equilibrium (LM) exists where

300=0.25Y-200=300-124

0.25Y-200r=300-124

0.25-200r-176=0......(2)

Simultaneous equilibrium in both market requires that

0.3Y+100r-252=0.......(1)

0.25Y-200r-176=0......(2)

Multiply equation 1 by 2 and equation and equation two by 1

0.6Y-200r-504=0.........(3)

0.25Y-200r-176=0......(4)

Add equation 3 and equation 4 to eliminate r

0.85Y=680

Divide both sides by 0.85 in order to make Y the subject

Y=680/0.85

Y=800

Substitute Y=800 in equation 1 or equation 2

0.25Y=200r-176=0

0.25(800)-200r-176=0
 200-200r-176=0

-200r=-24

Divide both sides by -200 in order to make r the subject

r=-24/-200

r=0.12

b. At Y=800 and r=0.12

C=102+0.7Y

C=102+0.7(800)

C=102+560

C=662

I=150-100r

I=150-100(0.12)

I=150-12

I=138

L=0.25Y+124-200(r)

L=0.25(800)+124-200(0.12)

L=200+124-24

L=200+100

L=300

And C+I=Y

662+138=800

2. If the money supply increases by 17 (a) what will happen to the equilibrium level of income and
interest?

b. What are C,I, kY and hr at new equilibrium?

a. If the money supply increases by 17, the LM equation becomes

Ms=L

300+17=317

Therefore, 317=0.25Y+124-200r

0.25Y-200r=317-124
 0.25Y-200r-193=0......(1)

The IS equation remains unchanged;

0.3Y-100r-252=0..........(2)

Multily equation 1 by 1 and equation2 by 2

0.25Y-200r-193=0.......(3)

0.6Y+200r-504=0.........(4)

Add equation 3 and equation 4 to eliminate r

0.85Y=697

Divide both sides by 0.85 in order to make Y the subject

Y= 697/0.85

Y=820

Substitute Y=820 in equation one or equation one to solve for r

0.3Y+100r=252

0.3(820)+100r-252=0

246+100r-252=0

100r=6

Divide both sides by 100 in order to r the subject

r=6/100

r=0.06

NOTE: An increase in the money supply, ceteris paribus, leads to an increase in the equilibrium level of
income and a fall in interest rate.

b. When Y=820 and r=0.06

C=102+0.7Y

C=102+0.7(820)

C=102+574

C=676

I=150-100r

I=150-100(0.06)

I=150-6
 I=144

kY=0.25Y

kY=0.25(820)

kY=205

hr=124-200r

hr=124-200(0.06)

hr=124-12

hr=112

and C+I=Y

676+144=820

APPLICATION OF THE IS-LM MODEL

Assume the following structural equations that describe behavior in the economys goods market and
money market during the current period (i.e. given exogenous effects).

Yp = C + I + G + NX

C = Ca - d r + c (Y T)

T = To + t Y

I = Io f r

NX = NXo - e Y

G = Go

(M/P)d = (M/P)s

(M/P)d = k Y g r

(M/P)s = (Mo/Po)

Assume known parameter values of c, t, e, and k that are the marginal propensity to consume, to tax, to
import, and to demand money, respectively, that are induced from a change in income. Also assume
known parameter values of d, f, and g that are the marginal responsiveness of consumption, investment,
and money demand, respectively, that are induced from a change in the interest rate.

I. Evaluate the influence of the each of the following (other things equal) on the interest rate, bond
prices, real income, real consumption, real investment, and real net exports: (Specify any behavior
assumptions that you are applying in your analysis,)

Note: Bond prices always move inversely to current market interest rates.

A political campaign creates a wave of pessimism that sweeps across the land.

This will shift the IS curve to the left as pessimism reduces consumption and investment at every level of
income. When the IS curve shifts to the left, the interest rate and income decrease. This results in
higher bond prices and higher net exports as induced imports decrease (acts as an automatic stabilizer).

Members of the baby boom generation, now well into adulthood, become increasingly concerned about
having a comfortable retirement.

The IS curve will shift to the left as more people save more and consume less at every level of income.
(Effects of r, bond prices, income, and NX the same as above).

The administration reduces the income tax rate.

The IS curve will flatten out. This will increase Y and r as consumption increases due to higher income
multiplier, but it will crowd out investment and net exports.

A change in the nominal interest rate and exchange rate is matched by a change in the expected rate of
inflation.

No change, as the real interest rate remains the same. The supply and demand for real money balances
is unchanged.
Government spending increases because of war.

The IS curve shifts to the right as government spending increases; increasing income, interest rates, and
consumption through the multiplier effect, but reducing investment (crowding out effect) and net
exports (higher induced imports).

The Fed purchases Treasury Bills in the open market.

The LM curve will shift to the right as purchasing T-Bills in the open market increases the money supply;
lowering the interest rate. The lower interest rates will increase investment, consumption and income.
The higher income will reduce net exports due to higher induced imports.

The demand for money becomes more sensitive to changes in the interest rate.

An increased sensitivity to interest rates in the demand for money will flatten out the LM curve, causing
the interest rates to fall and income to rise. Bond prices will rise, investment and consumption will
increase, but net exports will decrease due to higher induced imports.

People begin to expect a decline in the near future of the interest rate on bonds.

The demand for money falls as the demand for bonds increases, The LM curve shifts to the right as
people expect capital gains, causing a self fulfilling prediction to occur. Interest rates will decrease,
investment and consumption will increase causing higher real income. Net exports decrease due to
higher induced imports.

A new law is passed to make automatic teller machines illegal.

The LM curve shifts to the left as people demand more money at every level of income. The interest
rate rises, income falls, investment and consumption fall, net exports rise, and bond prices fall due to a
lower demand for bonds.

People are able to move funds more easily between their bond accounts to their checking account.
The LM curve shifts to the right, as the velocity of money will increase (people economize on their
money balances, holding less money at every level of income). Bond prices rise as the interest rate falls,
investment and consumption rise, net exports fall.

The public is less sensitive to changes in interest rates on their willingness to hold money.

The LM curve will become steeper, while maintaining the same intercept on the income axis. The
interest rate will rise causing investment and consumption to decrease, net exports to increase, and
bond prices to fall unless the money supply is increased.

The aggregate price level falls.

The supply of real money balances increases, causing the LM curve to shift to the right. Income will rise,
the real interest rate falls, investment and consumption rise, net exports fall.

The real opportunity cost of holding money increases. (Note the real interest rate is an endogenous
variable.)

Since the real interest rate is endogenous it may temporarily increase above its equilibrium level. At the
same level of income in the good market the rate of injection would be less than the rate of leakage,
reducing causing the interest rate to decrease to decrease the injection rate back to equilibrium. At the
same level of income in the money market, the higher interest rate would result in a demand for money
below the supply of money, causing the interest rate to fall to raise the demand for money until
equilibrium was reestablished.

II. The Effectiveness of Macroeconomic Stabilization Policy

How would the effectiveness of fiscal policy be influenced if the demand for money is insensitive to a
change in the interest rate?

This results in a completely vertical LM curve. Fiscal policy is completely offset by the effect of higher
interest rates on investment unless the money supply is increased.
How would the effectiveness of monetary policy be influenced if the demand for money is insensitive to
a change in the interest rate.

Monetary policy is completely effective with all new money used for transactions.

Assume that the Federal Reserve has decided to maintain the current level of real GDP and Congress
votes for a tax cut. What happens to interest rates and the composition of output in the economy?

The tax cut shifts the IS curve to the right with a partial crowding out if the money supply is unchanged.
To keep the level of income constant the Fed lowers the money supply, shifting the LM curve to the left,
further increasing the interest rate until investment and consumption spending decrease to completely
crowd out the initial stimulus on consumption of the tax cut.

What is likely to happen to interest rates if a fiscal policy deficit occurs and the Fed does not act to
change the money supply?

Under normal IS and LM slopes, a fiscal policy deficit shifts the IS curve to the right increasing income
and the interest rate. Without more money, the interest rate rises to partially crowd out public
spending by reduced investment spending.

What happens to the slope of the IS curve?

The IS curve becomes flatter, i.e. more sensitive to a change in the interest rate. Now a lower interest
rate not only leads to more domestic investment, but it adds to net exports, increasing domestic
spending in the goods market.

Is monetary policy more or less effective in changing real output?

Other things equal, monetary policy is more effective, since a change in interest rates resulting from Fed
policy has a greater effect on the goods market. (Note that the central bank can lower the exchange
rate by either buying domestic bonds, adding to the money supply, or buy selling dollars to buy foreign
currencies, also adding to the domestic money supply.)