QUESTION ONE (45 MARKS) BEEQ 2013 A181

A two-equation model below represents goods sector and monetary sector

equilibrium for a hypothetical economy:

𝐿0 > 0, 𝑓 > 0, 𝑔 < 0, 𝑒 > 0.

As usual, 𝑌 is aggregate income, 𝑟 is the interest rate, 𝐼0 is the autonomous

investment, and 𝐿0 is the level of money supply.

i) List down the endogenous variables and the exogenous variables of the
model. (2
marks)
Endogenous variables: Y, r
Exogenous variables: 𝐼0, 𝐿0
ii) Which equation represents the IS and which represents the LM? (2
marks)
I b L −e g
Y= 0 + ⋅r Y = 0 − ⋅r
1−c 1−c represents the IS ; f f represents the
LM.

iii) Justify your answers found in ii). (4

marks)
I b
Y= 0 + ⋅r
1−c 1−c represents the IS as it shows negative relationship
between Y and r. Where b less than zero, it is negative, hence the gradient
for this equation is negative. When r increases, Y decreases.
L0 −e g
Y= − ⋅r
f f represents the LM as it shows positive relationship
between Y and r. Where g less than zero, it is negative, hence the gradient
for this equation is positive. When g increases, Y increases.

iv) Find the equilibrium of the economy. (6

marks)
I b L0 −e g
Y= 0 + ⋅r Y= − ⋅r
1−c 1−c f f
I0 b L −e g
+⋅r = 0 − ⋅r
1−c 1−c f f
I 0 + br L0 −e−gr
=
1−c f
fI 0 +bfr=L 0−e−gr −cL0 +ce +cgr
 bfr+gr −cgr=L 0−e−cL0 +ce−fI 0
L −e−cL0 + ce−fI 0
r¿= 0
bf + g−cg
L0 −e
g L0 −e−cL0 + ce−fI 0
Y =
¿
f f
− (
bf + g−cg )
bfL0 + gL0 −cgL0 −bef −eg+ ceg−gL0 + eg+cgL0 −ceg+ fgI 0
= f ( bf + g−cg)
bfL0 −bef + fgI 0
= f ( bf + g−cg )
bL0 −bf + gI 0
= bf + g−cg

v) Suppose now, the monetary authority decides to increase the quantity of

money supply to a new level, evaluate the effect of such changes to the economy.
(8 mark)
¿
∂Y (bf +g−cg )(b )−(bL0 −bf +gI 0 )(0 )
= 2
∂ L0 (bf + g−cg )
(bf +g−cg )(b)
2
= ( bf +g−cg )
b
= bf +g−cg
(−)
=
(−)+(−)−(−)
=(+)sign
b
L0
An increase of one unit of will cause Y*increase bf +g−cg unit.
∂ r (bf +g−cg )(1−c )−( L0 −e−cL0 +ce−fI 0 )(0 )
¿
= 2
∂ L0 (bf + g−cg )
(bf + g−cg )(1−c )
= (bf + g−cg )2
1−c
= bf +g−cg
(+)
=
(−)+(−)−(−)
=(−)sign
1−c
L0
An increase of one unit of will cause r*decrease bf +g−cg unit.
vi) Now, rewrite the equation (1) and (2) respectively in their implicit-forms
equivalence. (2
marks)
I b L0 −e g
Y= 0 + ⋅r Y = − ⋅r
1−c 1−c f f
fY =L0 −e−gr
Y (1−c )=I 0 +br
1 F2 (Y ¿ , r ¿ ; I 0 , L 0 )=0
F (Y ¿ , r ¿ ; I 0 , L0 )=0
F2 =fY −L0 +e + gr=0
F1 =Y (1−c )−br −I 0=0

vii) Since, the solution in iv) above, shows that the equilibrium for the
economy does exist, now, apply the total differentiation to each of the two
equations just found in vi).
(4 marks)

1 1 1 1
∂F ¿ ∂F ¿ ∂F ∂F
¿⋅dY + ¿ ⋅dr + ⋅dI 0 + ⋅dL =d (0 )
∂Y ∂r ∂ I0 ∂ L0 0
2 2 2 2
∂F ¿ ∂F ¿ ∂F ∂F
¿⋅dY + ¿ ⋅dr + ⋅dI 0 + ⋅dL =d (0)
∂Y ∂r ∂ I0 ∂ L0 0
1 1 1
∂F ¿ ∂F ¿ ∂F
¿⋅dY + ¿ ⋅dr =− ⋅dI
∂Y ∂r ∂ I0 0
2 2 2
∂F ¿ ∂F ¿ ∂F
¿⋅dY + ¿ ⋅dr =− ⋅dL
∂Y ∂r ∂ L0 0

viii) Rewrite the finding in vii) in the 𝐽𝑥 = 𝑏 form. (2 marks)

J x= b
∂ F1 ∂ F1 ∂ F1

[ ][ ] [ ]
∂Y
¿

∂ F2
∂Y
¿
∂r
¿

∂ F2
∂r
¿
dY
dr
¿ =
¿
−

−
∂ I0
∂ F2
∂ L0
⋅dI 0

⋅dL0

∂ F1

[ 1−c
f
−b dY
g ][ ]
dr
¿ =
¿

[ ]
−

−
∂ I0
∂ F2
∂ L0
⋅dI 0

⋅dL 0
ix) Next, like what you did in v) above, evaluate the effect of a change (in
particular an increase) in the quantity of money supply to the economy.
(10
marks)
Let d I 0 = 0 ; d L0 ≠ 0
∂ F1 dI 0
¿
dY

[1−cf −b
g ] [ ][ ]
dL0
dr
dL0
¿
=
−

dY
⋅
∂ I 0 dL0
∂ F 2 dL0
⋅
∂ L0 dL0
¿

[1−cf −b
g
[]
|J|=( g)(1−c)−(−b)( f )
dL0
] dr =[ 01 ]
¿

dL0

=(−)(+)−(+)(+)
=(−)sign

[ J 1 ]= 01 −b ∂Y |J 1|
¿

[ g ] =
∂ L0 |J|
|J 1|=(0)( g)−(1)(−b) |J 1| b
=
=b |J| g−cg+bf
=(−sign) (−)
=
(−)
=(+)sign

[ J 2 ]= 1−c 0 ∂ r |J 2|
¿

[ f 1 ] =
∂ L0 |J|
|J 2|=(1−c)(1)−(0)(f ) |J 2| 1−c
=
=1−c |J| g−cg+bf
=(+sign ) (+)
=
(−)
=(−)sign
b
L0
An increase of one unit of will cause Y*increase bf +g−cg unit.
1−c
L0
An increase of one unit of will cause r*decrease bf +g−cg unit.

x) Provide some comments on your findings in both ix) and v). (5

marks)
¿
∂Y
= b
The answer in ix) and v) are same where ∂ L 0 bf +g−cg ;
 ¿
∂r 1−c
= L0
∂ L0 bf +g−cg . The Y*shows positive relationship with while
r* has negative relationship with L0.