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Intermediate Macroeconomic Qn
Intermediate Macroeconomic Qn.
Question One
a) The commodity and money markets of Juja farm, a hypothetical economy is 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.
(ii) Derive the equilibrium level of Income and rate of interest.
(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?
b) Discuss any three anti-inflationary policy measures that can be used to contain inflation in Kenya.
c) Discuss the motives of holding money according to liquidity preference theory.
Expert Solution
ANS) Given
Y = C + I
C = 1000 + 0.8Y
I = 2000 – 0.75r
a) (i) IS Equation:
Equilibrium condition-
Y(output)= AD (Aggregate demand)
Where, AD = C +I
So,
Y = C +I
Put the given C,and I function
Y = 1000 + 0.8Y + 2000 – 0.75r
Y - 0.8Y = 3000 – 0.75r
0.2Y = 3000 – 0.75r
Y = 15000 - 3.75r ---------------------------------------------Required IS equation
Hence, the required IS equation would be, Y =15000 - 3.75r
LM EQUATION
AS GIVEN,
Lt = 0.25Y (Transactions and precautionary demand for money function)
Ls = 1000 – 0.5r (Speculative demand for money function)
Ms = 3200 (Money supply function)
Money demand function = 0.25Y (Transactions and precautionary demand for money function) + 1000 – 0.5r (Speculative demand for money function)
Money demand function = 0.25Y + 1000 - 0.5r
Equilibrium condition-
Money demand function = Money supply function
0.25Y + 1000 - 0.5r = 3200
0.25Y = 2200 + 0.5r
Y = 8800 + 2r....................................................................-Required LM equation
(ii) equilibrium level of Interest rate
put Y = 15000 - 3.75r in LM equation
15000 - 3.75r = 8800 + 2r
6200 = 5.75r
r = 1078.26..................is the required level of Interest rate
put r = 1078.26 in Y = 15000 - 3.75r
Y = 15000 - 3.75 ( 1078.26)
Y = 15000 - 4043.475
Y = 10,956.525.....................is the reqired equilibrium level of income
(iii) If the money supply is increased by 80, then money supply function = 3280
Money demand function = 0.25Y + 1000 - 0.5r
Equilibrium condition-
Money demand function = Money supply function
0.25Y + 1000 - 0.5r = 3280
0.25Y = 2280 + 0.5r
Y = 9120 + 2r....................................................................-Required New LM equation
NOW
put Y = 15000 - 3.75r in LM equation
15000 - 3.75r = 9120 + 2r
5880 = 5.75r
r = 1022.61..................is the required level of Interest rate
put r = 1022.61 in Y = 15000 - 3.75r
Y= 15000 - 3.75 ( 1022.61)
Y = 15000 - 3834.787
Y = 11,165.213 ....................is the reqired equilibrium level of income
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