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LM and IS model

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SUPPOSE THAT C = 60 + 0.8 Yd, I = 150-10r, G= 250, T = 200, Ms = 100, Md = 40 + 0.1Y - 10r

1.a. write the equations for the IS and LM schedules.
b. Find the equilibrium values for income (Yo) and the interest rate (Ro)

2. suppose we change the model in problem 1 such that investment is assumed to be completely interest inelastic: investment does not depend on the rate of interest and we have I=150.
A. write the new equations for the IS and IM schedules. Show the schedules graphically.
B. find the new equilibrium values for income and the interest rate.

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Solution Preview

1.
a
The IS schedule is where total spending (Consumer spending + planned private Investment + Government purchases + net exports) equals an economy's total output:
Y = C + I + G
Filling in values we have
Y = 60 + 0.8 Yd + 150-10r + 250
and we know by definition:
Yd = Y -T = Y -200 ...

Solution Summary

Use of the LM and IS model to find equilibrium interest rates and income.

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IS-LM-BP

Consider the IS-LM-BP model of an open economy with sticky price levels in local currency, perfect asset substitutability, perfect capital mobility and static expectations. The economy is in both internal and external equilibrium initially.

(a) Explain why the BP curve is a horizontal line at i = i*, where i is the domestic nominal interest rate and i* is the foreign nominal interest rate.

(b) Define respectively the internal equilibrium and external equilibrium of the economy.

(c) Suppose now that the domestic government reduces its money supply, M.

i. What are the initial effects of this monetary policy on the goods market, the money market, the foreign exchange market and the balance of payments of the domestic economy? Which curve(s) will shift?

ii. What is the adjustment mechanism under a fixed exchange rate regime? Illustrate and explain which curve(s) will shift during the adjustment, and then compare the new equilibrium with the initial equilibrium.

iii. What is the adjustment mechanism under a flexible exchange rate regime? Illustrate and explain which curve(s) will shift during the adjustment, and then
compare the new equilibrium with the initial equilibrium.

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