Question

Assume that we have the following data:

Answer 1

Answer:

Answer explained below

Explanation:

(1)

IS Model:

Y = C + I + G + X - M

Y = 100 + 0.5Y + 100 - 20r [G = X = M = 0]

(1 - 0.5)Y = 200 - 20r

0.5Y = 200 - 20r

Y = 400 - 40r ......(1) [IS Equation]

LM Model:

Money demand (Speculative + Transactions demand) = Money supply

100 - 10r + 0.1Y = 80

0.1Y = 10r - 20

Y = 100r - 200 .....(2) [LM Equation]

(2) When IS & LM intersect, from part (1):

400 - 40r = 100r - 200

140r = 600

r = 4.29

Y = 100r - 200 = (100 x 4.29) - 200 = 429 - 200 = 229

(3)

There will be four regions as explained below:

In region I, there is excess supply in both goods and money market, which puts downward pressure on both interest rate and output.

In region II, there is excess demand in goods market, but excess supply in money market, which puts upward pressure on output & downward pressure on interest rate.

In region III, there is excess demand in both goods and money market, which puts upward pressure on both interest rate and output.

In region IV, there is excess supply in goods market, but excess demand in money market, which puts downward pressure on output & upward pressure on interest rate.