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Functions

of Money

Primary Secondary Contingent


MUa MUb MUc
  M
Pa Pb Pc
Demand for
money

Classical Neo-classical Modern


Approach Approach Approach

Cash Liquidity
Cash Balance
Transaction Preference
Approach
Approach Theory

Transactionary Precautionary Speculative


MV=PT M=KPY
motive motive motive
IS-LM Model
Equilibrium level
of National
Income & Interest
Rate

Product Market Money Market


Liquidity
Preference

Equilibrium
Level of
Investments Savings
Income &
Employment

Money
Supply
IS Curve
Aggregate Demand Y=C
AD2
E2

AD1
E1

O Y1 Y2 National Income

A
R1
Rate of Interest

B
R2

IS

O Y1 Y2 National Income
Slope of IS Curve
Rate of Interest
Rate of Interest

R1

R2

R1
IS

R2

IS

O Y1 Y2 O Y1 Y2
National Income National Income
Shift in IS Curve
Rate of Interest

IS0 IS1 IS2

O
National Income
LM Curve
MS

LM

E2 R2 D
R2
Rate of Interest

Rate of Interest
LP2
E1 C
R1
R1
LP1

O O Demand for O Y1 Y2 National


& Supply of Income
Money
Slope of LM Curve
LM

Rate of Interest
Rate of Interest

LM
R2
R2

R1

R1

O Y1 Y2 O Y1 Y2
National Income National Income
Shift in LM Curve
Rate of Interest

LM0 LM1 LM2

O
National Income
Equilibrium Level of Interest & National Income
Rate of Interest

LM

R E

IS

O Y
National Income
IS-LM Model & Monetary Policy
Rate of Interest

LM
LM1

R E

R1 E1

IS

O Y Y1
National Income
IS-LM Model & Fiscal Policy
Rate of Interest

LM

R1 E1

R E

IS

IS

O Y Y1
National Income
Crowding Out Effect
In economics, crowding out is a phenomenon that
occurs when increased government involvement in a
sector of the market economy substantially affects the
remainder of the market, either on the supply or
demand side of the market.
One of the most common forms of crowding out
takes place when a large government increases its
borrowing. The sheer scale of this borrowing can lead
to substantial rises in the real interest rate, which has
the effect of absorbing the economy's lending
capacity and of discouraging businesses from making
capital investments.
Numericals
Question 1:
Based on the table below answer the following
questions:
Savings function -25 +0.25Yd
Disposable income Yd = Y – T
Transfer Payments 40
Tax Function 0.2Y
Investment demand function 500-15i
Government purchase 400
Exports 225
Imports 10+0.1Y
Transaction demand for money 0.25Y
Speculative demand for money 125-50i
Supply of money 250
a) What is equilibrium income and interest rate?
b) What is the budget deficit of the economy at
equilibrium income?
c) Calculate consumption and trade balance at
equilibrium.
d) If government plans to give a stimulus to the
economy through expenditure of 345 units what
will be the impact on income and interest rates?
e) Compute crowding out and suggest measures to
avoid crowding out.
Question 2:
In an economy, the investment function is given as I =
2500 – 100i. If the government expenditure increases
by 625MUC which increases interest rates by 5%,
what is the amount of crowding out?
Question 3:
For an economy, the savings function is S= -300+0.2Y
and the investment function is I=200-5i. When
equilibrium income is 2250MUC, interest rate in the
economy is __________.
Question 5:
The following relationships are specified for an
economy :
Consumption Function 60+0.75Yd

Investment Function 250-200i

Government expenditure = T 24

Transaction demand for Money 0.25Y

Speculative demand for Money 134-500i

Money Supply 250

When there is an autonomous decrease in money


supply of 50, what is new equilibrium investment?
Question 4:
The following relations are derived for an economy:
Savings Function -1140+0.5Yd+12i
Investment Function 900+0.1Y-100i
Tax Function 0.30Y
Transfer payments 600
Government expenditure 3440
Transaction demand for Money 0.25Y
Speculative demand for Money 1050-150i
Exports 1636
Import Function 150+0.15Y
If the equilibrium income (Y) is 9580, what is the
money supply in the economy?