Soalan 1

At the interest rate r0, r1, r2, investment levels will be I0, I1, I2 in part a. To generate saving S0,
S1 and S2 equal to these levels of investment, income must be at Y0, Y1 and Y2 respectively.
Therefore, interest-rate-income combinations (r0, Y0), (r1, Y1) and (r2, Y2) are point (A, B, C)
along the IS schedule in part b.
The condition for equilibrium in the product market is :
Y = C + I + G ----------- (1.1)
An equivalent statement of this equilibrium condition is :
I + G = S + T ------------ (1.2)
We construct the product market equilibrium schedule, termed the IS Schedule, from
this second from of the equilibrium condition, althought the same results could be derived
from equation.
We proceed by finding the set of interest-rate and income combinations that produces
equilibrium for the product market. Next, we examine the factors that determine the slope and
position of this product market equilibrium schedule.
To begin, we consider a simplified case that omits the government sector (i.e. G and T
equal zero). For this simple case, we can rewrite (1.2) as
I (r) = S (Y) -------------(1.3)
Equation (3) also indicates that investment depends on the interest rate and saving
depends on income. Our task is to find combinations of the interest rate and income that
equate investment with saving.
Figure above illustrates the construction of the IS schedule for this case. In Figure 1
(i) investment is plotted as a negatively sloped function of the interest rate; a decline in the
interest rate will increase investment expenditures. Saving is depicted as a positively sloped
function of income, the slope being the positive marginal propensity to save (MPS).
Consider an interest rate of r0. For this level of the interest rate, investment is the
amount I0, as shown along the investment schedule. An amount of saving just equal to I 0 is
shown as S0 along the saving function. This level of saving result if income is at Y 0. Thus, for
the interest rate r0, a point of product market equilibrium will be at Y 0. This interest-rate-
income combination (r0, Y0) is one point on the IS Schedule, shown as point A in Figure 1(ii).
Now consider a higher value of the interest rate, such as r 1. At interest rate r1,
investment will be I1, a smaller amount than at r0. For equilibrium, saving must be at S 1,
lower than S0. This saving level is generated by income level Y 1, which is lower than Y 0.
Thus a second point on the IS schedule will be at r 1 and Y1, point B on Figure 1(ii). Notice
that for the higher interest rate, the corresponding equilibrium income level is lower. The IS
schedule has a negative slope. By choosing additional interest rate value such as r 2 in Figure
1(i) and finding the corresponding income level for equilibrium Y 2, where I2=S2, we can find
additional points on the IS schedule in Figure 1(ii), such as point C. In this way we trace the
complete set of combinations of income and interest-rate levels that equilibrate the product
market.
Soalan 2
In Figure 2 (i), increase in income from Y 0 to Y1 to Y2 shift the money demand
schedule from Md (Y0) to Md (Y2). Equilibrium in the money market requires successively
higher interest rates r0, r1, r2 at higher levels of income Y0, Y1, Y2.
In Figure 2 (ii), the LM schedule shows combinations of income (Y) and the interest
rate (r) that equilibrate the money market. Equilibrium combinations such as (r 0, Y0), (r1, Y1)
and (r2, Y2) from part a are points along the LM schedule (A, B, C). As we see in part a, at
higher levels of income, higher interest rates are required for money market equilibrium; the
LM schedule slopes upward to the right.
Money demand in the Keynesian model depands positively on income because of the
transactions demand. Money demand also varies inversely with the rate of interest, owing to
the speculative demand for money and because the amount of transaction balances held at
any income level declines as the interest rate (the opportunity cost of holding such balances
increases. We expressed this relationship as

Md = L ( Y, r ) --------------- (2.1)

or, in linear form

Md = c0 + c1Y - c2r c1 > 0, c2 > 0 --------------- (2.2)
Now we wish to find all the combinations of r and Y that equilibrate money demand
with a fixed money supply, denoted MS 0. The schedule of such points is termed the LM
schedule because, along this schedule, money demand, for which we use the symbol L
[equation (2.1)], is equal to the money supply (M). For simplicity, we discuss the case in
which money demand is given by the linear form (2.2). For this case, the condition that must
be satisfied for money market equikibrium, the LM schedule equation, can be written as
MS0 = Md0 = c0 + c1Y - C2r --------------- (2.3)
We have already considered the nature of equilibrium in the money market. In Figure
2 (i), for example, three separate demand-for-money schedules are drawn, corresponding to
three successively higher levels of income, Y0, Y1 and Y2. As income increases from Y0 to Y1
and then from Y1 to Y2, the money demand schedule shifts to the right when plotted against
the interest rate. The points where these money demand schedules interest the vertical line,
giving the value of the fixed money supply, are points of equilibrium for the money market.
Income-interest-rate combinations at which equilibrium occurs, (Y0, r0), (Y1, r1) and (Y2, r2)
are points along the LM, or money equilibrium, schedule. These points are plotted in Figure
2(ii). Proceeding in this manner, we can find the equilibrium value of the interest rate for
each level of income and construct the complete LM schedule shown in Figure 2(ii).
 The LM schedule slopes upward to the right. At higher levels of income, equilibrium
in the money market occurs at higher interest rates. The reason for the positive slope for the
LM schedule is the following. An increase in income [e.g., from Y 0 to Y1 in Figure 2(i) and
2(ii)] increase money demand at a given interest rate, because the transactions demand for
money varies positively with income. Restoring demand to a level equal to the fixed money
supply requires that the interest rate be higher [r 1 instead of r0 in Figures 2(i) and 2(ii)]. The
higher interest rate results in a lower speculative demand for money and lowers the
transactions component corresponding to any level of income. The interest rate must rise until
this decline in money demand is just equal to the initial income-induced increase in
transactions demand.
To complete our discussion of the LM schedule, we consider two questions. First we
want to know what determines the value of the slope of the LM schedule. We know that the
schedule is upward-sloping, but is it steep or relatively ? The slope of the LM schedule is
important for our later question 4 and 5 discussion of policy effects. The second question
concerns the position of the LM scedule: What factors shift the schedule?