IS LM Model Exercise and Solution

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Macroeconomics of Finance Exercises on IS/LM model Ex 1 Consider the following economy: C = 0.75Yd C = consumption Yd = disposable income T = 0.2Y T = tax revenue I = 800 − 1500i I = investment i = interest rate G = 760 G = government spending Ld = 0.1Y − 500i L d = demand for money Central Bank Balance Sheet Assets Liabilities Gold 55 Currency 60 Loans to commercial banks 35 Commercial bank reserves 100 Government bonds 70 Banking System Balance Sheet Assets Liabilities Reserves 100 Checkable deposits 260 Loans 195 Loans from the central bank 35 All amounts above are expressed in real terms. a) Determine the equilibrium levels of output and of the interest rate. In addition, determine the government budget deficit under the assumption that the government finances its deficit spending by selling bonds to private investors. b) How do previous results change if we assume that the government forces the central bank to buy the newly issued bonds in order to finance the deficit spending? (Assume that households and firms do not alter their preferences about holding cash and deposits.) Ex 2 To protect the domestic producers from international competition, the government of the Republic of Maradagàl decided to cease all economic relationships with the rest of the world. However, current national output is 8% below its potential and the government wants to increase spending in order to bring the economy to full employment. Consider that: a) The central bank has the following balance sheet (in real terms): Assets Liabilities Gold 20 Currency 400/3 Bonds 160 Required reserves 200/3 Credit 20 b) The required reserve ratio is 0.1, while the amount of free reserves is negligible. c) The real demand for money isLd = 0.25Y − 500i . d) The labour force is 7000 and average labour…