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Answer to Question #53143 in Macroeconomics for Godvictor

Question #53143

You 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
Precautionary 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.
1. (b) Discuss clearly any two instruments of monetary policy that the Central Bank can use to meet monetary policy objectives


Expert's answer
C = 50 + 2/5Y, I = 790 – 21r
MDT = 1/6 Y, MDS = 1200 -18r, MS = 1250
(i) In equilibrium Y = C + I and MD = MDT + MDS = MS, so:
50 + 2/5Y = 790 – 21r
1/6 Y + 1200 - 18r = 1250,
2/5Y + 21r = 740
1/6Y - 18r = 50 -> 2/5Y - 43.2r = 120, so if we subtract second equation from the first, we will get:
64.2r = 620
r = 9.66%
Y = (740 - 21*9.66)/0.4 = $1343
So, r = 9.66% and Y = $1343 are the equilibrium levels of income and interest rate for this economy.
(ii) The IS–LM model, or Hicks–Hansen model, is a macroeconomic tool that demonstrates the relationship between interest rates and real output, in the goods and services market and the money market (also known as the assets market).
1. (b) The instruments of monetary policy are of two types: first, quantitative, general or indirect; and second, qualitative, selective or direct. They affect the level of aggregate demand through the supply of money, cost of money and availability of credit. Of the two types of instruments, the first category includes bank rate variations, open market operations and changing reserve requirements. They are meant to regulate the overall level of credit in the economy through commercial banks. The selective credit controls aim at controlling specific types of credit. They include changing margin requirements and regulation of consumer credit.

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