Tutorial 3: Determination of General Equilibrium – IS-LM Model

Macroeconomics | COMC 21313

Academic Year – 2019/2020
Department of Commerce and Financial Management | University of Kelaniya

DISCUSSION QUESTIONS

1. Distinguish between the product and money markets and explain the interdependence of
the two markets.

2. Define IS curve and derive it graphically. Explain the relationship between the interest
rates and income.

3. How is the IS curve affected by an increase in marginal efficiency of capital, other things
remaining the same?

4. Define LM curve and derive it graphically. Explain the relationship between the interest
rate and income.

5. How is the LM curve affected by the change in the money supply and the demand for
money?

6. Explain the concept and condition of the general equilibrium. Show graphically why an
economy is in disequilibrium when the product market equilibrium is not consistent with
the money market equilibrium.

7. How does inclusion of the government sector in two-sector model affect the IS-LM model
of equilibrium analysis? What new variables are added to the model and how do they affect
the IS and LM schedules?

8. Explain the factors that determine the slope of the IS and LM curves.

[Date] 1
PRACTICE QUESTIONS

1. Suppose the consumption and investment functions of a two-sector economy are given
as, 𝐶 = 20 + 0.5𝑌 and 𝐼 = 200 − 2000𝑖.
Find the equilibrium level of income at interest rates 8%, 6% and 5%.

2. Derive the LM function from the following monetary sector model of a two-sector
economy.
𝑀! = 0.5𝑌, 𝑀"# = 100 − 1500𝑖, 𝑀" = 150
Give the economic interpretation of the LM curve.

3. Suppose the following functions are given with respect to a two-sector model.
𝐶 = 100 + 0.8𝑌, 𝑆 = −100 + 0.2𝑌, 𝐼 = 120 − 5𝑖 𝑀" = 120
𝑀$ = 0.2𝑌 − 5𝑖

Find;
a) The IS equation
b) The LM equation
c) Income at general equilibrium
d) Interest rate at general equilibrium

4. By using the following functions, find Y and i at general equilibrium.

𝐶 = 15 + 0.5𝑌, 𝐼 = 200 − 2000𝑖 𝑀" = 150 𝑀! = 0.5𝑌
𝑀"# = 110 − 1500𝑖

5. Suppose the structural model for the product market of a three-sector is given as follows.
𝐶 = 100 + 0.8𝑌𝑑, 𝑆 = −100 + 0.2𝑌, 𝐼 = 200 − 1080𝑖, 𝐺 = 100
𝑇 = 50 + 0.20𝑌
Find,
a) Equilibrium equation (G + I = S + T) for the product market
b) Function for IS curve.
c) Shift in IS schedule/curve if deficit-financed DG = 72.
d) Shift in IS schedule/curve if t is raised from 0.20 to 0.25.
e) Shift in IS schedule if DG = 72 and Dt = 0.05
f) Net effect of fiscal policy change on the equilibrium level of income and interest.

6. Suppose money supply and demand for money functions are given below.
𝑀" = 250 and 𝑀$ = 100 + 0.5𝑌 − 2500𝑖
Find,
a) LM function
b) Shift in LM curve if ∆𝑀" = 50

7. For the product market model given in Q 6 and money market model given in Q 7, find
the following.
a) Equation for the IS curve
b) Equation for the LM curve
c) Equation for the general equilibrium

[Date] 2
 d) Income at the general equilibrium
e) Interest rate at the general equilibrium
8. The product market model is given as C = 100 + 0.8Y | S = -100 + 0.2Y | I = 120 -0.5i
and money market equation are Ms = 120 | Md = 0.2Y – 5i. Assuming a change in money
supply as ∆𝑀" = 30, find the level of Y and i at the general equilibrium.

9. The IS and LM schedules are given, respectively, as follows.

𝑌 = 800 − 5000𝑖
𝑌 = 250 + 5000𝑖
Find the level of income and interest rate at the general equilibrium.

10. Suppose the product market model is given as C = 100 + 0.75Y | S = -100 + 0.25Y | I =
120 – 0.5i and the money market model is given as Ms = 150 | Md = 0.2Y – 4i.
Find,
a) Equilibrium Y and i.
b) Assuming a lump-sum tax = 20, find the effect of tax on the equilibrium level of
Y and i.

11. An economy shows the following features.

Consumption 𝐶 = 80 + 0.8𝑌$ (where, 𝑌$ is disposable income)
Tax 𝑇 = 60 + 0.2𝑌 (where, Y is national income)
Investment 𝐼 = 200 − 10𝑖 (where, i is rate of interest, percentage)
Transfers 𝑇% = 40
Government expenditure 𝐺 = 160
Transactional and precautionary demand for money 𝑀! = 0.4𝑌
Speculative demand for money 𝑀"# = 300 − 20𝑖
Money supply 𝑀" = 476
a) Find the equilibrium level of income and interest rate.
b) Is the government budget in surplus or deficit?
c) What is the level of consumption at equilibrium level of income?

12. You are given the following information of a hypothetical economy.

Consumption 𝐶 = 40 + 0.75(𝑌 − 80)
Investment 𝐼 = 140 − 10𝑖 (where, i is rate of interest, percentage)
Government expenditure 𝐺 = 100
Money demand 𝑀$ = 0.2𝑌 − 5𝑖
Money supply 𝑀" = 85
a) Determine the equilibrium level of income and interest rate
b) Suppose the government increases its expenditure on education and health services
by Rs. 65 Bn, what would be the impact on equilibrium income?

13. For the economy with the following specifications;

Consumption 𝐶 = 100 + 0.9𝑌$ (where, 𝑌$ is disposable income)
Income Tax 𝑡 = 1/3𝑌 (where, Y is national income)
Investment 𝐼 = 600 − 30𝑖 (where, i is rate of interest, percentage)
Government expenditure 𝐺 = 300
Transactional demand for money 𝑀! = 0.4𝑌
Speculative demand for money 𝑀"# = −50𝑖

[Date] 3
 Nominal Money supply 𝑀= = 1040
Price level 𝑃=2
Full employment level of income = 2500
a) Derive the IS and LM equations and compute the equilibrium level of income and
rate of interest.
b) Compute the change required in the level of government expenditure to achieve
full employment level of income.
c) Explain the change in position of IS and LM curves if MPC changes to 0.6.
d) What is the budget surplus? Explain why an increase in the government purchases
will reduce the budget surplus by less than increase in government purchases.

14. For the economy with the following specifications,

Consumption 𝐶 = 200 + 0.75𝑌$
Investment 𝐼 = 200 − 25𝑖 (where, i is rate of interest, percentage)
Government expenditure 𝐺 = 200
Taxes 𝑇 = 200
Money demand 𝑀$ = 0.5𝑌 − 100𝑖
Nominal Money supply 𝑀" = 900
Price level 𝑃=2

a) Drive the IS and LM equations and determine the equilibrium level of income and
interest rate.
b) Suppose the government purchases are raised from Rs. 200 to 250 Bn and nominal
money supply to is raised from Rs. 900 to 1,100 Bn, what is the magnitude of shift
in IS and LM curves? What are new equilibrium levels of income and interest rates?
c) With the initial values of fiscal and monetary policy, drive an equation for the
aggregate demand curve.
d) Show the effect of an increase in the government expenditure on income and
budget surplus in a proportional tax model.

[Date] 4