Macroeconomics of Finance

Exercises on IS/LM model

Ex 1
Consider the following economy:

C = 0.75Yd C = consumption Yd = disposable income

T = 0.2Y T = tax revenue
I = 800 − 1500i I = investment i = interest rate
G = 760 G = government spending
d
L = 0.1Y − 500i Ld = demand for money

Central Bank Balance Sheet

Assets Liabilities
Gold 55 Currency 60
Loans to commercial banks 35 Commercial bank reserves 100
Government bonds 70
Banking System Balance Sheet
Assets Liabilities
Reserves 100 Checkable deposits 260
Loans 195 Loans from the central bank 35

All amounts above are expressed in real terms.

a) Determine the equilibrium levels of output and of the interest rate. In addition, determine the government
budget deficit under the assumption that the government finances its deficit spending by selling bonds to
private investors.
b) How do previous results change if we assume that the government forces the central bank to buy the newly
issued bonds in order to finance the deficit spending? (Assume that households and firms do not alter
their preferences about holding cash and deposits.)

Ex 2
To protect the domestic producers from international competition, the government of the Republic of Maradagàl
decided to cease all economic relationships with the rest of the world. However, current national output is 8%
below its potential and the government wants to increase spending in order to bring the economy to full
employment. Consider that:
a) The central bank has the following balance sheet (in real terms):

Assets Liabilities
Gold 20 Currency 400/3
Bonds 160 Required reserves 200/3
Credit 20

b) The required reserve ratio is 0.1, while the amount of free reserves is negligible.
c) The real demand for money is Ld = 0.25Y − 500i .
d) The labour force is 7000 and average labour productivity is 0.5.
e) The income multiplier is equal to 2 while investments increase by 2 units if the interest rate falls by 1%.

Determine:
1) The interest rate associated with the initial equilibrium.
2) The variation in government spending that is required to reach full employment.

1
Solution 1
a) At equilibrium income is 3600, the interest rate is 8%, the budget deficit is 40.
b) In this case the central bank cannot manage the money supply independently. At the new equilibrium
income is 3726.31, the interest rate is 4.63%, the budget deficit is 14.73.

Solution 2
1) The initial interest rate is 0.01%.
2) ∆G = 168.