More Examples of Equilibrium Analysis1

EC 115 Lecture Notes

This supplementary lecture notes for the chapter on Equilibrium Analysis will familiarize the
students with more examples of economic models as well as modifications to the Market Model
and to the National Income Model. This should allow the student to review and understand
more deeply the processes behind Equilibrium Analysis. Put simply, this must provide students
with more confidence in using Matrix Algebra in solving for equilibrium values in a given set
of equations.

A. One-Commodity Market Model

Say that the demand and supply response for a candy bar every hour in a convenience store as
well as the market-clearing condition for this market are given by the following set of equations
in (2.1). How do we therefore solve for the equilibrium values of price and quantity?

𝑄𝑑 = 80 − 4𝑃
𝑄𝑠 = −10 + 𝑃 (2.1)
𝑄𝑑 = 𝑄𝑠

Matrix algebra may be utilized to solve for 𝑃 ∗ and 𝑄 ∗ simultaneously by transforming the set
of equations in (2.1) in its 𝐴𝑥 = 𝑑 while taking note of the market-clearing condition:

𝑄 + 4𝑃 = 80
(2.2)
𝑄 − 𝑃 = −10
1 4 𝑄 80
[ ][ ] = [ ]
1 −1 𝑃 −10 (2.3)

1
Lectures notes are in part adopted from Danao (2007).
2
Department of Economics, Ateneo de Manila University, [email protected]

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Cramer’s Rule give us the following solutions for 𝑃∗ and 𝑄 ∗ :

80 4
| | −40
𝑃∗ = −10 −1 = =8 (2.4)
1 4 −5
| |
1 −1
1 80
| | −90
∗
𝑄 = 1 −10 = = 18 (2.5)
1 4 −5
| |
1 −1

In order for the market to clear such that there will be no shortage and no surplus, price should
be set at PHP 8/unit leading to an equilibrium quantity of 18 units.

B. National Income Model with Endogenous Taxes

In this example, we have government spending as a fixed variable in the short run alongside
investment level. Therefore, total income is spent on consumption goods, investment goods
through savings and government expenditures through taxes. Consumption is divided into
autonomous consumption and spending of what is available from disposable income. The
amount of taxes 𝑇 collected by the government increases as national income increases but there
are non-income taxes which government collects as a lump-sum.

Similar to previous discussions where savings must be equal investment spending, the level of
taxation also need not exceed 𝐺0 . If budget surplus arises, this must indicate that consumers
might be earning too much allowing them to pay taxes beyond what is necessary. Hence,
equilibrium income can be expected to go down. On the other hand, if income is too small,
then there might not be enough tax revenues and a budget deficit arises. Hence, national income
must be increased. The model can therefore be expressed as the following system of equations:

𝑌 = 𝐶 + 𝐼0 + 𝐺0
𝐶 = 𝛼 + 𝛽(𝑌 − 𝑇) (2.6)
𝑇 = 𝜙 + 𝜏𝑌

Matrix algebra is again utilized to solve for 𝑌 ∗ , 𝐶 ∗ , and 𝑇 ∗ simultaneously by transforming

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 𝑌 − 𝐶 = 𝐼0 + 𝐺0
−𝛽𝑌 + 𝐶 + 𝛽𝑇 = 𝛼 (2.7)
−𝜏𝑌 + 𝑇 = 𝜙
1 −1 0 𝑌 𝐼0 + 𝐺0
[ −𝛽 ]
1 𝛽 𝐶 [ ] = [ 𝛼 ]
−𝜏 0 1 T 𝜙 (2.8)

Cramer’s Rule give us the following solutions for 𝑌 ∗ , 𝐶 ∗ , and 𝑇 ∗ :

𝐼0 + 𝐺0 −1 0
| 𝛼 1 𝛽|
𝜙 0 1 𝛼 − 𝛽𝜙 + 𝐼0 + 𝐺0
𝑌∗ = = (2.9)
1 −1 0 1 − 𝛽(1 − 𝜏)
|−𝛽 1 𝛽 |
−𝜏 0 1
1 𝐼0 + 𝐺0 0
| −𝛽 𝛼 𝛽|
−𝜏 𝜙 1 𝛼 − 𝛽𝜙 + 𝛽(1 − 𝜏)(𝐼0 + 𝐺0 )
𝐶∗ = = (2.10)
1 −1 0 1 − 𝛽(1 − 𝜏)
|−𝛽 1 𝛽 |
−𝜏 0 1
1 −1 𝐼0 + 𝐺0
| −𝛽 1 𝛼 |
−𝜏 0 𝜙 𝜙(1 − 𝛽) + 𝜏(𝛼 + 𝐼0 + 𝐺0 )
𝑇∗ = = (2.11)
1 −1 0 1 − 𝛽(1 − 𝜏)
|−𝛽 1 𝛽 |
−𝜏 0 1

As it can be seen once, 𝑌 ∗ and 𝐶 ∗ are related given that they are determined by similar factors.
𝛼−𝛽𝜙+𝛽(1−𝜏)(𝐼0 +𝐺0 )
If we add 𝐼0 + 𝐺0 to , what is the answer?
1−𝛽(1−𝜏)

C. IS-LM Model

From the National Income Model, the IS and LM curves can be derived. The IS curve shows
the relationship between income and interest rates when the goods market is in equilibrium.
On the other hand, the LM curve shows the relationship also between income and interest rates
when the money market is in equilibrium. Thus, an equilibrium level of income and interest
rate may be derived by letting the IS curve and LM curve interact.

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 𝑌 = 𝐶 + 𝐼 + 𝐺0
𝐶 = 𝛼 + 𝛽(1 − 𝜏)𝑌
(2.12)
𝐼 = 𝛿 − 𝜀𝑖
𝜌𝑌 − 𝜔𝑖 = 𝑀0

The goods market clears when aggregate supply equals aggregate expenditures. Thus, as far as
the goods market is concerned, i.e. first three equations in (2.12), an equilibrium income can
be derived. Equilibrium in the goods market will therefore give us the following equilibrium
national income that can be expressed as a function of interest rates:

𝑌 − 𝐶 − 𝐼 = 𝐺0
−𝛽(1 − 𝜏)𝑌 + 𝐶 = 𝛼 (2.13)
𝐼 = 𝛿 − 𝜀𝑖
1 −1 −1 𝑌 𝐺0
[−𝛽(1 − 𝜏) 1 0 ] [𝐶 ] = [ 𝛼 ]
0 0 1 𝐼 𝛿 − 𝜀𝑖 (2.14)

𝐺0 −1 −1
| 𝛼 1 0|
𝛿 − 𝜀𝑖 0 1 𝛼 + 𝐺0 + 𝛿 − 𝜀𝑖
𝑌∗ = = (2.15)
1 −1 −1 1 − 𝛽(1 − 𝜏)
|−𝛽(1 − 𝜏) 1 0|
0 0 1

By further rearranging equation (2.15), we can derive the IS curve where interest rate
determines the level of income:

𝛼 + 𝐺0 + 𝛿 𝜀𝑖
𝑌= −
1 − 𝛽(1 − 𝜏) 1 − 𝛽(1 − 𝜏) (2.16)

In the goods market, according to the IS Curve, when interest rates increase, equilibrium
national income decreases due to less spending on investment. In Figure 2.1, an increase in
interest rate 𝑖1 to 𝑖2 led to a lower level of aggregate expenditures from 𝐸1 to 𝐸2 . Hence, the IS
Curve is a downward-sloping curve. It is called an IS Curve because investment expenditures
and savings must be equal in order for the goods market to clear.

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 Figure 2.1. IS Curve

𝑌=𝐸
𝐸
𝐸1

𝐸2

𝑌𝐿∗ 𝑌𝐻∗ 𝑌

𝑖2

𝑖1

IS Curve

𝑌𝐿∗ 𝑌𝐻∗ 𝑌

In the money market, the equilibrium is given by the last equation in (2.12): 𝜌𝑌 − 𝜔𝑖 = 𝑀0 .
This can be further rearranged to expressed income as a function of interest rates:

𝑀0 𝜔𝑖
𝑌= + (2.17)
𝜌 𝜌

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 Figure 2.2. LM Curve

𝑖 𝑀𝑠 𝑖

LM Curve
𝑖2 𝑖2

𝐿2
𝑖1 𝑖1
𝐿1

𝑀 𝑌𝐿 𝑌𝐻 𝑌

In the money market, according to the LM Curve, when there is a higher level of income,
consumers would want to hold a higher amount of liquidity. If the demand for money 𝑀𝑑 (or
sometimes also denoted by 𝐿) increases, then the price of holding money, interest rate,
increases as well. The LM curve therefore shows us that there is a positive relationship between
income and interest rates in the money market. Hence, the LM Curve is an upward-sloping
curve. It is called an LM Curve because demand for money and money supply must be equal
in order for the money market to clear.

Finally, the two curves may be set a system of equations explicitly showing the IS-LM Model.
In this new model, the endogenous variables are national income and interest rate while all
other variables are exogenous. Equation (2.18) put together the IS and LM curves in one system
of equation:

𝛼 + 𝐺0 + 𝛿 𝜀𝑖
𝑌= −
1 − 𝛽(1 − 𝜏) 1 − 𝛽(1 − 𝜏)
𝑀0 𝜔𝑖 (2.18)
𝑌= +
𝜌 𝜌

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Matrix algebra is again utilized to solve for 𝑌 ∗ and 𝐶 ∗ simultaneously by transforming the set
of equations in (2.16) in its 𝐴𝑥 = 𝑑:

𝜀𝑖 𝛼 + 𝐺0 + 𝛿
𝑌+ =
1 − 𝛽(1 − 𝜏) 1 − 𝛽(1 − 𝜏)
𝜔𝑖 𝑀0 (2.19)
𝑌− =
𝜌 𝜌

𝜀 𝛼 + 𝐺0 + 𝛿
1
1 − 𝛽(1 − 𝜏) 𝑌 1 − 𝛽(1 − 𝜏)
[ 𝜔 ][ ] =
𝑖 𝑀0 (2.20)
1 −
𝜌 [ 𝜌 ]

Cramer’s Rule give us the following solutions for 𝑌 ∗ and 𝑖 ∗ :

𝛼 + 𝐺0 + 𝛿 𝜀
1 − 𝛽(1 − 𝜏) 1 − 𝛽(1 − 𝜏)
| |
𝑀0 𝜔 −𝜔(𝛼 + 𝐺0 + 𝛿) − 𝜀𝑀0
−𝜌 𝜌[1 − 𝛽(1 − 𝜏)]
𝜌
𝑌∗ = 𝜀 = (2.21)
1 −𝜔[1 − 𝛽(1 − 𝜏)] − 𝜀𝜌
1 − 𝛽(1 − 𝜏) 𝜌[1 − 𝛽(1 − 𝜏)]
| 𝜔 |
1 −𝜌

𝛼 + 𝐺0 + 𝛿
1
1 − 𝛽(1 − 𝜏)
| |
𝑀0 𝑀0 [1 − 𝛽(1 − 𝜏)] − 𝜌(𝛼 + 𝐺0 + 𝛿)
1 𝜌[1 − 𝛽(1 − 𝜏)]
𝜌
𝑖∗ = 𝜀 = (2.22)
1 −𝜔[1 − 𝛽(1 − 𝜏)] − 𝜀𝜌
1 − 𝛽(1 − 𝜏) 𝜌[1 − 𝛽(1 − 𝜏)]
| 𝜔 |
1 −𝜌

Further simplifying, we have the following equilibrium values 𝑌 ∗ and 𝑖 ∗ :

𝜔(𝛼 + 𝐺0 + 𝛿) + 𝜀𝑀0
𝑌∗ = (2.24)
𝜔[1 − 𝛽(1 − 𝜏)] + 𝜀𝜌
𝜌(𝛼 + 𝐺0 + 𝛿) − 𝑀0 [1 − 𝛽(1 − 𝜏)]
𝑖∗ = (2.25)
𝜔[1 − 𝛽(1 − 𝜏)] + 𝜀𝜌