Answer to Question #306905 in Macroeconomics for Don

Question

1You are given the following information about the commodity and money markets of a closed economy without government intervention.

The commodity market

Consumption function;

C = 50 + 2/5Y

Investment function:

I = 790 – 21r

The Money Market

Precautions and Transactions demand for money

MDT = 1/6 Y

Speculative demand for money

MDS = 1200 – 18r

Money supply

MS = 1250

Required:

i.Determine the equilibrium levels of income and interest rate for this economy.

ii.Using a well labelled diagram, illustrate the equilibrium condition in part (i) above.

Answer 1

i.Determine the equilibrium levels of income and interest rate for this economy.

Y = C + I

Substituting for C and I we have

Y = 50 + 2/5 Y + 790 – 21r

Y = 1400 – 35r ……………….(1)

The money market will be in equilibrium where

M_D = M_S

$\frac{1}{6}$ Y + 1200 – 18r = 1250

Y = 108r + 300 ……………..(2)

Thus by equating functions (1) and (2) we have:

108r + 300 = 1400 – 35r

143r = 1100

∴ r = 7.69 (Equilibrium level of interest rate) 

ii. Using a well-labeled diagram, illustrate the equilibrium condition in part (i) above.