Answer to Question #318304 in Economics of Enterprise for PMN

Question

The commodity and money markets of Juja farm, a hypothetical economy are as

given below:

Commodity Market

Y = C + I

C = 1000 + 0.8Y

I = 2000 – 0.75r

Money Market

Lt = 0.25Y (Transactions and precautionary demand for money function)

Ls = 1000 – 0.5r (Speculative demand for money function)

Ms = 3200 (Money supply function)

Required:

i) Mathematically derive both IS and LM curves. (6 marks)

ii) Derive the equilibrium level of Income and rate of interest.

(4 marks)

iii) If the money supply is increased by 80, what would be the effect on the equilibrium level of income and rate of interest in Juja farm economy?

Answer 1

i)

IS= Y = C + I

Y=1000 + 0.8Y+2000 – 0.75r

0.2Y= 3000-0.75r

Y= 15000-3.75r

Ms= Md=

0.25Y+1000 – 0.5r=3200

0.25Y=2200+0.5r

Y= 8800+2r

ii)LM=IS

8800+2r= 15000-3.75r

5.75r= 6200

r= 1,078.26

Y= 8800+2(1078.26)

Y= 10,956.52

iii) If money supply increased by 80

the new Money supply= 3280

$\therefore$ 0.25Y+1000 – 0.5r=3280

0.25Y= 2280+ 0.5r

Y= 9120+2r

LM=IS

9120+2r= 15000-3.75r

5.75r= 5880

r= 1,022.61

Y= 9120+2(1022.61)

Y= 11,165.22