This action might not be possible to undo. Are you sure you want to continue?
Pablo de la Peña Sánchez April, 2012 MONEY MARKET, IS-LM MODEL Exercises
I. 1. Warming up questions. Which of the following statements is not correct? a. Investment is negatively related with the interest rate. b. An increase in the Money Supply “Ceteris Paribus” will increase the interest rate of equilibrium. c. During a recession the Demand for Money (L) will shift to the right. d. None of the above. R: ____ Which of the following statements is not correct? a. Taxes will reduce consumption and in turn production (Y) will reduce its equilibrium with the Aggregate Demand (A.D.) b. An Open Market Operation in which the Central Bank sells bonds, it will increase the Money Supply (Ms) c. A zero required reserve ratio implies that Banks can lend all of their deposits. d. None of the above. R: _____ The difference between M1 and M2 is a. M2 is money for everyday transactions. b. M2 includes travelers checks and M1 does not. c. M2 includes savings accounts. d. None of the above R: _____ Chapala Bank has deposits for 300 million dollars, with a required reserve ratio of 30%, the Central Bank allows Chapala Bank to lend up to a. 210 million dollars b. 90 million dollars c. 3.3. times its amount of deposits. d. None of the above R: _____ An open market operation in which the Central Bank buys bonds for 500 million dollars, knowing that the required reserve ratio in the economy is 15%, the Central Bank is reducing the Money Supply (Ms): a. 3,335 million dollars b. 75 million dollars c. 425 million dollars d. None of the above R: _____
Dr. Pablo de la Peña S.
we have a higher interest rate. and we know that “investors” – which are usually companies – will be willing to borrow money to invest in increasing their production capacity only if the interest rate is relatively low. and it also shows a relationship between interest rate and production. on the other hand do not have deposits because people in the economy are not finding attractive those low interest rates. But. the LM stands for Liquidity and Money. so they can invest in more production capacity and then. 2 . and vice versa. which is coming from the GDP. to attract people willing to make deposits. a relatively high interest rate that represents a future gain on their savings. the LM shows the changes in the interest rate due to changes in the Demand for Money caused by changes in the production level or income (Y). Then. or the level of production in the economy. and a higher Demand for Money due to an Dr. This relationship between Production (Y) and interest rate (r) in the IS can be better understood by analyzing the relationship between interest rate and investment. In order to increase the level of investment so we can have higher levels of production. the Production level (Y) and the interest rate. production in the economy keeps growing. Remember that the Demand for Money (L) is a function of the interest rate and Income (Y). Remember that Banks use those deposits to make loans. So. Interest rate (r ) Investment (I ) Production (Y) Interest rate (r ) Production (Y) = IS Now. the Central Bank has the challenge to maintain a relatively low interest rate to motivate companies to borrow money. Central Bank has also the challenge to maintain a relatively high interest rate. it may well be the case in which companies are willing to borrow large quantities of money because interest rates are low. we need to have low interest rates. on the other hand. but Bank.II. This is why during high interest rates period. this means that the higher the interest rate the lower the production. The IS curve shows a negative or inverse relationship between production and interest rate. then we will see an increase in the interest rate along the Money Supply vertical line. We know that the production in the economy is measure by the GDP. If people increase their demand for money (L) will see a shift in the Demand for Money curve up to the right. private investment is low. However. if the central bank decides to keep its current level of Money Supply (Ms) with no change. This is because the LM depicts the relationship between the Demand for Money (L). Thus. but it shows a positive relationship. there will be more income in the economy. Specifically. Thus. Both the IS as well as the LM show the equilibrium between the production in the economy (Y) and the interest rate. The IS-LM Model The IS-LM Model helps us to understand the dynamism in the whole economic system. and the importance of analyzing its relationship with the interest rate is because the Goods and Services Market is strongly related to whatever happen in the Money Market. or the opportunity cost. higher interest rates will inhibit investors to increase their production capacity. thus. if the GDP is growing. and therefore production in the economy may also be low. people may be willing to increase their demand for money (liquidity) this is (L) so they can buy more goods and services. up to a point in which crosses with the new Demand for Money (L) curve. after this process. Pablo de la Peña S. People will be willing to increase their deposits if they find the interest rate attractive. The interest rate represents the cost of borrowing money. The IS stands for “Investment and Savings”. Thus. low interest rates do not attract people willing to save their money – to make deposits.
000r 20.950 = 200 + 2.000r 1. L1 = 200 + 0. Assume the Aggregate Demand is given by Y = Co + cY + I + G + X – M.000 r = 2. let’s assume that the marginal propensity to consume is after taxes. r is the interest rate we also know that equilibrium is given by Ms = L.increase in the level of production or income (Y). Suppose we have the following information: L = Lo + kY – hr. Then we have the full Aggregate Demand equation as: Dr.500) – 20. (b) is the slope and (r ) is the interest rate.30(8.950 million dollars Y = 8. Thus the positive relationship between the interest rate and the production level in the LM curve. 1. where Io represents the autonomous investment. and we have that the equation for Investment is: I = Io – br. so MPC’ = 0. Production (Y) Demand for Money (L) Interest rate Production (Y) Interest rate = LM (IS) Example.950 r = (800 / 20.000r a. Calculate the interest rate of equilibrium.000 ) = ( 0. Pablo de la Peña S. where: Lo is the autonomous demand for money k is the proportion we use from our income as liquid money Y is the production level or GDP or National Income h is the slope between L and interest rate.500 million dollars L1 = 200 + 30%Y – 20.40 ) *100 r = 4% b.550 – 20. 3 .70%. then Ms 1 = 1.750 – 1.
500 c. we take this new level of production (Y) and use it to calculate the new interest rte with the new demand for money (L2) due to this increase in Y.950 r = 927.350 – 920 Y3 = 2. then we will have: Δ%Y = 10% ΔY = (0.500) = 425 Y2 = Y1 + ΔY = 8.04) Y1 = (3.0464 then r = 4.70) Y1 = (2.950 millions dollars.6% d.000(0. 4 . using once again the Aggregate Demand equation. and assuming the Central Bank does not change its Money Supply.000r Y3 = 3.000 (0. according to our example we have that the equation in equilibrium should be: Y1 = 3.70Y – br but we have now a higher interest rate. Then.000 r = 200 + 2.br + G + X – M we know that the Aggregate Expenses are all of those variables do not depending on interest rates.70Y + Io .000 = 0. We know this will affect the demand for money.000(0. Now.70) = 3.70Y – 20.925 this is also the same as having: Y1 ( 1 + 0. Pablo de la Peña S. we have: Y3 = 3.350 + 0.05) = 8.70) Dr.925) – 20.30(8.500 ( 1.350 + 0.350 + 0.70) Y1 = 8.350 + 0.0.05) (8.046) Y3 (1 – 0.70Y – br So.350 – 20.0.70Y3 – 20.677.70) = 3. so: AE = Co + Io + G + X – M. L2 = 200 + 0.925) – 20.000r we know that the money supply remains the same at 1.000r 20.950 = 200 + 0.500 + 425 Y2 = 8.Y = Co + 0. Then 1.550) / ( 1. then we can rewrite the equation as: Y1 = AE + 0.350 – 800) / ( 1. or Income. Y2 = AE + 0.30(8. solving for “r” We know that the a higher interest rate will negatively impact Investment and thus the Aggregate Demand.5 – 1. suppose the economy grows 5% to the next year. and assuming the Aggregate Expenses remain the same. we can now calculate the new level of production (Y) after the increase in the interest rate.70Y3 – 20.000r we know is the equilibrium because… Y1 = 3.04) Y1 (1 – 0.70Y – 20.5/ 20.05) Now.430 / (1 – 0.
we have: Ms2 = 200 + 0.950? ΔMs = Ms2 – Ms1 ΔMs = 127.077.30(8. we need to calculate the final money supply that will find its equilibrium with a 4% interest rate and with the money demand that cause the increase in the interest rate.5 – 800 Ms2 = 2. 5 . But the real question is how much bonds should the Central Bank buy in order to reduce the interest rate to 4%. a.000r because the target interest rate is 4%.5 – 1. This means that the Central Bank should put more money in the market. but the question is how much Bonds should the Central Bank needs to buy in order to take the Money Supply up to 2. considering there is a multiplier effect.925) – 20.5 This should be the new Money Supply. suppose the Central Bank decides to make an Open Market Operation in order to reduce the interest rate from 4. Using the previous example as departing point.6% to 4% once again. As we do not want reductions in the level of production in the economy.950 Answers to Questions: 1 (D).077.875 million dollars so that by the multiplier effect the Money Supply will be increased up to 2.000 (0. the Central Bank should need to do something in order to avoid this 9.925) – 20.677. to do so.Y3 = 8. Then.5 from 1. this is Δ%Y = [ (8.925 which was 10% higher than the original (Y).5 million. 4 (A).25) = 4 Then. Let’s suppose the reserve required ratio is 25%.925) – 1 ] * 100 (LM) example. the Central Bank should buy bonds for 31.04) Ms2 = 200 + 2.077.30(8. it will buy bonds. an increase in the interest rate from 4% to 4.077. First.24%. 2 (B). 5 (D) Dr. Remember that the demand for money that took the interest rate up to 4.100 As we can see. ΔMs = 2. then the multiplier is: Multiplier = (1 / 0.24% reduction in Y. 3 (C).6% will reduce the production level 9. Pablo de la Peña S.5 Assuming that the reserve required ratio is 25%.100 / 8.6% was one with a level of production of 8. Ms2 = 200 + 0.
950 and Production at 8.925 Y M s Q m The increment in the interest rate will reduce the investment level. Keeping the same level of Money Supply the interest rate should go up.70Y1 -‐ br r1 L1 = Lo +kY1 -‐ hr AE Y1 8.950 2. the Central Bank should buy bonds in the opem market.Money Market Equilibrium: IS-‐LM Model Graphs Original level of equilibrium between interest rate at 4%.70Y1 -‐ br r2 r1 a b AE2 AE a L2 = Lo +kY2 -‐ hr L1 = Lo +kY1 -‐ hr Y1 Y2 8.077. and in turn it will reduce the level o f production. it will take the Money Supply up to 2. r AD Y2 = AE2 + 0.500 r AD Y1 = AE + 0.70Y2 -‐ br Y1 = AE + 0.500 Y2 8. r r2 r1 a b c L2 = Lo +kY2 -‐ hr L1 = Lo +kY1 -‐ hr M s M s 1. Money Supply at 1. 6 .5 where it finds its equilibrium with the new money demand at Y2.500 M s Q m Y An increase of 5% in the level of production w ill take GDP to $8. and with the target interest rate of 4%. AD b r Y2 = AE2 + 0.500 8. To do so.925. the Central Bank should reduce its interest rate. shifting the demand for money to the righ.100 c I2 I1 I Y1 8. Pablo de la Peña S. so it will put more money into the economy.077.875 million dollars so by the multiplier effect. the Central Bank should buy bonds for 31.70Y2 -‐ br r2 r1 a b a b Y1 = AE + 0.925 Y In order to avoid this reduction in the economy.70Y3 – br2 I = Io -‐ br AE2 AE1 AE3 Y3 8.70Y1 -‐ br Y3 = AE + 0.5 Q m Dr. Using the 4% interest rate as target.
This action might not be possible to undo. Are you sure you want to continue?
We've moved you to where you read on your other device.
Get the full title to continue reading from where you left off, or restart the preview.