TECNOLGICO DE MONTERREY CAMPUS GUADALAJARA ESCUELA DE NEGOCIOS Y HUMANIDADES MACROECONOMICS EC-1000-30 Dr.

Pablo de la Pea Snchez 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: _____

2.

3.

4.

5.

Dr. Pablo de la Pea S.

II.

The IS-LM Model

The IS-LM Model helps us to understand the dynamism in the whole economic system. Both the IS as well as the LM show the equilibrium between the production in the economy (Y) and the interest rate. We know that the production in the economy is measure by the GDP, 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, and vice versa. The IS curve shows a negative or inverse relationship between production and interest rate, this means that the higher the interest rate the lower the production. 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. The IS stands for Investment and Savings, 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. The interest rate represents the cost of borrowing money, or the opportunity cost. Thus, higher interest rates will inhibit investors to increase their production capacity. This is why during high interest rates period, private investment is low, and therefore production in the economy may also be low. In order to increase the level of investment so we can have higher levels of production, we need to have low interest rates. However, low interest rates do not attract people willing to save their money to make deposits. Remember that Banks use those deposits to make loans. So, it may well be the case in which companies are willing to borrow large quantities of money because interest rates are low, but Bank, on the other hand do not have deposits because people in the economy are not finding attractive those low interest rates. People will be willing to increase their deposits if they find the interest rate attractive, a relatively high interest rate that represents a future gain on their savings. Thus, the Central Bank has the challenge to maintain a relatively low interest rate to motivate companies to borrow money, so they can invest in more production capacity and then, production in the economy keeps growing. But, on the other hand, Central Bank has also the challenge to maintain a relatively high interest rate, to attract people willing to make deposits.

Interest rate (r )

Investment (I )

Production (Y)

Interest rate (r )

Production (Y)

IS

Now, the LM stands for Liquidity and Money, and it also shows a relationship between interest rate and production, but it shows a positive relationship. This is because the LM depicts the relationship between the Demand for Money (L), the Production level (Y) and the interest rate. Specifically, 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). Remember that the Demand for Money (L) is a function of the interest rate and Income (Y), which is coming from the GDP, or the level of production in the economy. Thus, if the GDP is growing, there will be more income in the economy; thus, people may be willing to increase their demand for money (liquidity) this is (L) so they can buy more goods and services. If people increase their demand for money (L) will see a shift in the Demand for Money curve up to the right, if the central bank decides to keep its current level of Money Supply (Ms) with no change, then we will see an increase in the interest rate along the Money Supply vertical line, up to a point in which crosses with the new Demand for Money (L) curve. Then, after this process, we have a higher interest rate, and a higher Demand for Money due to an

Dr. Pablo de la Pea S.

increase in the level of production or income (Y). Thus the positive relationship between the interest rate and the production level in the LM curve.

Production (Y)

Demand for Money (L)

Interest rate

Production (Y)

Interest rate

LM

(IS) Example. 1. Suppose we have the following information: L = Lo + kY hr, 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. r is the interest rate we also know that equilibrium is given by Ms = L, then Ms 1 = 1,950 million dollars Y = 8,500 million dollars L1 = 200 + 30%Y 20,000r a. Calculate the interest rate of equilibrium.

L1 = 200 + 0.30(8,500) 20,000r 1,950 = 200 + 2,550 20,000r 20,000 r = 2,750 1,950 r = (800 / 20,000 ) = ( 0.40 ) *100 r = 4%

b.

Assume the Aggregate Demand is given by Y = Co + cY + I + G + X M, lets assume that the marginal propensity to consume is after taxes, so MPC = 0.70%, and we have that the equation for Investment is: I = Io br, where Io represents the autonomous investment, (b) is the slope and (r ) is the interest rate. Then we have the full Aggregate Demand equation as:

Dr. Pablo de la Pea S.

Y = Co + 0.70Y + Io - br + G + X M we know that the Aggregate Expenses are all of those variables do not depending on interest rates, or Income, so: AE = Co + Io + G + X M, then we can rewrite the equation as: Y1 = AE + 0.70Y br So, according to our example we have that the equation in equilibrium should be: Y1 = 3,350 + 0.70Y 20,000r we know is the equilibrium because

Y1 = 3,350 + 0.70Y 20,000 (0.04) Y1 (1 0.70) = 3,350 20,000(0.04) Y1 = (3,350 800) / ( 1- 0.70) Y1 = (2,550) / ( 1- 0.70) Y1 = 8,500 c. Now, suppose the economy grows 5% to the next year. We know this will affect the demand for money, and assuming the Central Bank does not change its Money Supply, then we will have: %Y = 10% Y = (0.05) (8,500) = 425 Y2 = Y1 + Y = 8,500 + 425 Y2 = 8,925 this is also the same as having: Y1 ( 1 + 0.05) = 8,500 ( 1.05) Now, 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. L2 = 200 + 0.30(8,925) 20,000r we know that the money supply remains the same at 1,950 millions dollars. Then 1,950 = 200 + 0.30(8,925) 20,000r 20,000 r = 200 + 2,677.5 1,950 r = 927.5/ 20,000 = 0.0464 then r = 4.6% d. solving for r

We know that the a higher interest rate will negatively impact Investment and thus the Aggregate Demand. Then, we can now calculate the new level of production (Y) after the increase in the interest rate, using once again the Aggregate Demand equation. Y2 = AE + 0.70Y br but we have now a higher interest rate, and assuming the Aggregate Expenses remain the same, we have: Y3 = 3,350 + 0.70Y3 20,000r Y3 = 3,350 + 0.70Y3 20,000(0.046) Y3 (1 0.70) = 3,350 920 Y3 = 2,430 / (1 0.70)

Dr. Pablo de la Pea S.

Y3 = 8,100

As we can see, an increase in the interest rate from 4% to 4.6% will reduce the production level 9.24%, this is %Y = [ (8,100 / 8,925) 1 ] * 100

(LM) example. Using the previous example as departing point. a. As we do not want reductions in the level of production in the economy, the Central Bank should need to do something in order to avoid this 9.24% reduction in Y. Then, suppose the Central Bank decides to make an Open Market Operation in order to reduce the interest rate from 4.6% to 4% once again. This means that the Central Bank should put more money in the market, to do so, it will buy bonds. But the real question is how much bonds should the Central Bank buy in order to reduce the interest rate to 4%, considering there is a multiplier effect. Lets suppose the reserve required ratio is 25%. First, 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. Remember that the demand for money that took the interest rate up to 4.6% was one with a level of production of 8,925 which was 10% higher than the original (Y).

Ms2 = 200 + 0.30(8,925) 20,000r because the target interest rate is 4%, we have: Ms2 = 200 + 0.30(8,925) 20,000 (0.04) Ms2 = 200 + 2,677.5 800 Ms2 = 2,077.5 This should be the new Money Supply, but the question is how much Bonds should the Central Bank needs to buy in order to take the Money Supply up to 2,077.5 from 1,950? Ms = Ms2 Ms1 Ms = 127.5 Assuming that the reserve required ratio is 25%, then the multiplier is: Multiplier = (1 / 0.25) = 4 Then, the Central Bank should buy bonds for 31.875 million dollars so that by the multiplier effect the Money Supply will be increased up to 2,077.5 million. Ms = 2,077.5 1,950

Answers to Questions: 1 (D); 2 (B); 3 (C); 4 (A); 5 (D)

Dr. Pablo de la Pea S.

Money Market Equilibrium: IS-LM Model Graphs

Original level of equilibrium between interest rate at 4%, Money Supply at 1,950 and Production at 8,500 r

AD
Y1 = AE + 0.70Y1 - br

r1
L1 = Lo +kY1 - hr

AE
Y1 8,500

An increase of 5% in the level of production w ill take GDP to $8,925, shifting the demand for money to the righ. Keeping the same level of Money Supply the interest rate should go up.

AD
b

r
Y2 = AE2 + 0.70Y2 - br Y1 = AE + 0.70Y1 - br

r2 r1
a

AE2 AE

L2 = Lo +kY2 - hr L1 = Lo +kY1 - hr

Y1 Y2 8,500 8,925

The increment in the interest rate will reduce the investment level, and in turn it will reduce the level o f production. r AD
Y2 = AE2 + 0.70Y2 - br

r2 r1

a b a

Y1 = AE + 0.70Y1 - br Y3 = AE + 0.70Y3 br2

I = Io - br

AE2 AE1 AE3

Y3
8,100

I2

I1

Y1
8,500

Y2
8,925

In order to avoid this reduction in the economy, the Central Bank should reduce its interest rate. To do so, the Central Bank should buy bonds in the opem market, so it will put more money into the economy. Using the 4% interest rate as target, the Central Bank should buy bonds for 31.875 million dollars so by the multiplier effect, it will take the Money Supply up to 2,077.5 where it finds its equilibrium with the new money demand at Y2, and with the target interest rate of 4%.

r2 r1
a

b c L2 = Lo +kY2 - hr L1 = Lo +kY1 - hr

1,950 2,077.5

Dr. Pablo de la Pea S.