COM5030 – MACROECONOMICS MARCH 19, 2021

ACTIVITY 8 – FINANCIAL MARKET & IS-LM

NAMES OF GROUPMATES:
Garces, Bea Trisha D.
Lee, Francesca Garneth G.
Yason, Jazmin Lorraine F.
(2FM4)

Kindly show the solutions:

1. Suppose that a person’s yearly income is P1.6million and the person’s money
demand function is given by Md = $Y(0.40 – i):
a. What is this person’s demand for money when the interest rate is 5%? 10%?
b. What is the person’s demand for money if the interest rate is fixed at 10% but
the yearly income is reduced by 40%? Increased by 40%?
c. Suppose that the interest rate is increased to 15% but the income is reduced
by 25%, what happens to the person’s demand for money?
d. Suppose that the interest rate is decreased to 5% but the income is increased
by 25%, what happens to the person’s demand for money?
e. Summarize the effect of a change in interest rate, yearly income and
simultaneously change in interest rate and yearly income on the person’s
demand for money.

Answers:
a. GIVEN:
Y=1,600,000
Md=$Y(0.40-i)
i=5%

SOLUTION:

Md=Y(0.40-i)

Md=1,600,000(0.40-0.05)

Md=560,000

a. GIVEN:
 Y=1,600,000
Md=$Y(0.40-i)
i=10%

SOLUTION:

Md=Y(0.40-i)

Md=1,600,000(0.40-0.10)

Md=480,000

b. GIVEN:
Y0=1,600,000
Md=$Y(0.40-i)
i=10%
1,600,000 x 40%=640,000
Y1=1,600,000-640,000=960,000

SOLUTION:

Md=Y(0.40-i)

Md=960,000(0.40-0.10)

Md= 288,000

b. GIVEN:
Y0=1,600,000
Md=$Y(0.40-i)
i=10%
1,600,000 x 40%=640,000
Y1= 1,600,000+640,000=2,240,000

SOLUTION:

Md=Y(0.40-i)

Md=2,240,000(0.40-0.10)
 Md=672,000

c. GIVEN:
Y=1,600,000
Md=$Y(0.40-i)
i=15%
1,600,000 x 25%=400,000
Y1=1,600,000-400,000=1,200,000

SOLUTION:

Md=Y(0.40-i)

Md=1,200,000(0.40-0.15)

Md=300,000

EXPLANATION: Money demand decreased to P300,000 as the interest

rate increased to 15% and yearly income decreased by 25%.

D. GIVEN:
Y1,600,000
Md=$Y(0.40-i)
i=5%
1,600,000 x 25%=400,000
Y1=1,600,000+400,000=2,000,000

SOLUTION:

Md=Y(0.40-i)

Md=2,000,000(0.40-0.05)

Md=700,000

EXPLANATION: The income is increased by 25% when the interest rate

is decreased to 5%. The demand for money increases to 700,000
compared to 1.6 million income at 10% interest rate.
 e. As interest increases, the demand for money decreases and vice
versa in the effect of change in interest rate. Money demand is
conversely allied in interest rate. On the other hand, as income
increases, money demand increases and vice versa in the effect of
change in the yearly income. Yearly income is literally linked to money
demand. as interest increases, While income decreases, it can lead to
the person's demand for money to decrease and interest increases in
the change in interest rate and yearly income on the person's demand
for money. Nonetheless, interest decreases in the change in interest
rate and yearly income on the person's demand for money and
income increases can lead to a person's demand for money to
increase.

2. If Md = $Y(0.3 – i) and Y = P500,000 and Ms = P100,000.

a. What is the equilibrium interest rate?
b. If the BSP wants to increase i by 10 percentage points compared to its level in
letter 2a, at what level should it set the supply of money?

Answers:
a.
GIVEN:

Md = $Y(0.3 – i)
Y = P500,000
Ms = P100,000

SOLUTION:

Md = Ms
500,000 (0.3 - i) = 100,000
500,000 (0.3) - 500,000i = 100,000
150,000 - 500,000i = 100,000
-500,000i = -50,000
i = -50,000/-500,000

i = 0.1 or 10%
The equilibrium interest rate is 10%

b.
GIVEN:

Md = $Y(0.3 – i)
Y = P500,000
Ms = P100,000
i = 20%

SOLUTION:

500,000 (0.3 - 0.2) = Ms

500,000 (0.1) = Ms
50,000 = Ms

The supply of money should be set at 50,000

3. Consider a bond that promises to pay $2,500 in one year;

a. What is the interest rate if its price today is P1500? P1750? P2000?
b. If the interest rate is 12%, what is the current price of the T-bill?

Answers:
a.

Present Value = 1,500

2,500 - 1,500 / 1,500

R = 0.66%
Present Value = 1,750

2,500 - 1,750 / 1,750

R = 0.43%

Present Value = 2,000

2,500 - 2,000 / 2,000

R = 0.25%

b.
x = current price

Future Value = x (1 + rate)

2,500 = x (1 + 0.12)

2,500 = 1.12x

x = 2,500/1.12

x = 2,232.14

4. Assuming that the reserve ratio is 25% and the bank has a total deposit of P3.1
million.
a. How much is the reserve requirement of the bank? The excess reserves that
can be lent out or invested.
b. If the reserve ratio is decreased by 10%, What happens to the reserve
requirement and to the excess reserves and its effect on the money supply?

Answers:
a. RESERVE REQUIREMENT
GIVEN:
θ = 25%
D = P3,100,000

SOLUTION:
Rd = θD
 Rd = 25% x 3,100,000
Rd = 775,000

EXCESS RESERVES
θ= 1 - 0.25 = 0.75 or 75%
D = P3,100,000

SOLUTION:
Rd = θD
Rd = 75% x 3,100,000
Rd = 2,325,000

The total reserve requirement of the bank is P775,000, while the excess
reserve is P2,325,000.

b. RESERVE REQUIREMENT
GIVEN:
θ = 15%
D = P3,100,000

SOLUTION:
Rd = θD
Rd = 15% x 3,100,000
Rd = 465,000

EXCESS RESERVES
θ= 1 - 0.15 = 0.85 or 85%
D = P3,100,000

SOLUTION:
Rd = θD
Rd = 85% x 3,100,000
Rd = 2,635,000

If the reserve ratio decreased by 10% the total reserve requirement of the
bank will also decrease to P465,000, while the excess reserve would
increase to P2,635,000.
5. Supposed that the public holds no currency, the reserve ratio to deposits is 0.15,
the demand for money is Md = $Y(0.8 – 4i), the initial monetary base is P10million
and nominal yearly income is P50 billion.
a. What is the value of the money multiplier?
b. Find the equilibrium interest rate by setting the demand for central bank
money is equal to the supply of central bank money.
c. What is the overall supply of money? Is it equal to the overall demand for
money at the equilibrium interest rate in letter b.
d. What is the impact on the interest rate if central bank money is increased to
P30million?
e. If the overall money supply increased to 3billion, what will be the impact on
interest rate?

Answers:
a. GIVEN:
c=0
Reserve ratio = 0.15

SOLUTION:

money multiplier = 1
0

money multiplier = 1
0.15

money multiplier = 6.666666667

b. GIVEN:
Md = $Y (0.8 - 4i)
Initial monetary base = 10,000,000
Y = P50,000,000

SOLUTION:

Md = Ms

Y(0.8-4i) = 10,000,000

50,000,000,000(0.8-4i) = 10,000,000
 40,000,000,000-50,000,000,000(4i) = 10,000,000

40,000,000,000 - 200,000,000,000i = 10,000,000

-200,000,000,000i =10,000,000 - 40,000,000,000

-200,000,000,000i = -39,990,000,000

i = -39,990,000,000
-200,000,000,000

i = 0.19995 or 19.995% or 20%

c. GIVEN:
c=0
reserve ratio = 0.15
Md=$Y(0.8-4i)
initial monetary base = 10,000,000
Y = P50,000,000,000

SOLUTION:

Overall supply of money = Initial Monetary Base x Money Multiplier

Overall supply of money= 10,000,000 x 6.666666667

Overall supply of money= 66,666,666.67

d. Md = Ms
Y (0.8 - 4i) = 30,000,000
50,000,000,000 (0.8 - 4i) = 30,000,000
40,000,000,000 - 200,000,0000,000i = 30,000,000
-200,000,000,000i = 30,000,000 - 40,000,000,000
-200,000,000,000i = -39,970,000,000
= -39,970,000,000 /
-200,000,000,000
 i = 0.19985 or 20%

The interest rate would decrease if the central bank increased to 30

million.

e. Md = Ms
Y (0.8-4i) = 3,000,000,000
50,000,000,000 (0.8 - 4i) = 3,000,000,000
40,000,000,000 - 200,000,000,000i = 3,000,000,000
-200,000,000,000i = 3,000,000,000 - 40,000,000,000
-200,000,000,000i = 37,000,000,000
i = -37,000,000,000 /
-200,000,000,000
i = 0.185 or 19%

The interest will decrease moderately.

6. Consider the following IS-LM model

C = 200 + 0.75Yd; I = 150 + 0.25Y – 1000i; G = 250; Ta = 100
(M/P)d = 2Y – 8000i and (M/P)s = 1,600

a. Derive the IS relation. Equate AS with AD and put Y on the left

of the equation.
b. Derive the LM relation. Equate Md with Ms and put Y on the left of the
equation.
c. Solve for equilibrium real output and equilibrium interest rate by equating IS &
LM.
d. Solve for the values of C & I and S and prove that Y = C + I + G and that I + G
= S + T.
e. Suppose that the money supply increases to P1,840, solve for the new Y, I, C
and describe the effects of an expansionary monetary policy.

f. Suppose that the money supply is reset to its original value of P1,600 but
government spending increased to P400, summarize the effects of an
expansionary fiscal policy on Y, i and C.
Answers:
a. Y = C(Y-T) + I(Y - T) + G
Y = 200 + 0.75 (Y - 100) + 150 + 0.25Y - 1000i + 250
Y = 200 + 0.75Y + 0.75(100) + 150 + 0.25Y - 1000i + 250
Y = 200 + 0.75Y + 75 + 150 + 0.25Y - 1000i + 250
Y = 0.75Y - 0.25Y = 200 - 75 + 150 - 1000i + 250
0Y = 525 - 1000i
0Y + 1000i = 525
0 = 525 - 1000i
1000i = 525
i = 525/1000
i = 0.525 or 52.5%

IS relation is 0Y + 1000i = 525

b. (M/P)d = 2Y - 8000i
(M/P)s = (M/P)d
M/P = 1,600 = 2Y - 8000i
1,600 - 2Y = -8000 (0.525)
1,600 - 2Y = 4,200
4,200 = 2Y - 1,600
2Y = 4,200 + 1,600
2Y = 5,800
Y = 2,900

c. IS: 0Y + 1000i = 525

LM: 1,600 = 2Y = 8000i
0Y = 525 - 1000i
0Y + 1000i = 525
0 = 525 - 1000i
1000i = 525
i = 525 / 1000
i = 525 or 52.5%

M/P = 1,600 - 2Y = 8000i

1,600 - 2Y = -8000 (0.525)
1,600 - 2Y = 4,200
4,200 = 2Y - 1,600
 2Y = 4,200 + 1,600
2Y = 5,800
Y = 2,900

d. C = 200 + 0.75(Y - T)
C = 200 + 0.75 (2,900 - 100)
C = 200 + 0.75 (2,800)
C = 200 + 2,100
C = 2,300

I = 150 + 0.25Y - 1000i

I = 150 + 0.25(2,900) - 1000(0.525)
I = 150 + 725 - 525
I = 350

Y=C+I+G
Y = 2,300 + 350 + 250
2,900 = 2,900
S=Y-C-T
S = 2,900 - 2,300 - 100
S = 600 - 100
S = 500

I+G=S+T
350 + 250 = 500 + 100
600 = 600

e.
(M/P)s = 1,840
(M/P)d = 2Y - 8000i

1,840 = 2Y - 8000i
1,840 = 2Y - 8000(0.525)
1,840 = 2Y - 4,200
4,2000 = 2Y - 1,840
2Y = 4,200 + 1,840
2Y = 4,200 + 1,840
2Y = 6,040
Y = 3,020
The new income is P3,020 and it has increased by P120. When there is an
increase in money supply the income also increases.

C = 200 + 0.75 (Y-T)

C = 200 + 0.75 (3,020 - 100)
C = 200 + 0.75 (2,920)
C = 200 + 2,190
C = 2,390

The new consumption is P2,390 and it has increased by P90. When there
is an increase money supply the consumption also increases.

I = 150 + 0.25Y - 1000i

I = 150 + 0.25 (3,020) - 1000 (0.525)
I = 150 + 755 - 525
I = 380

The new investment is P380 and it has increased by P30. When there is
an increase in money supply the investment also increases.

f.
C = 200 + 0.75Yd
Y = C (Y-T) + I (Y-T) + G
Y = 200 + 0.75(Y-100) + 150+ 0.25Y - 1000i + 400
Y = 200 + 0.75Y - 0.75(100) + 150 + 0.25Y - 1000i + 400
Y = 200 + 0.75Y - 75+ 150 + 0.25Y - 1000i + 400
Y - 0.75Y - 0.25Y = 200 - 75 + 150 - 1000i + 400
0Y = 675 - 1000i
0Y + 1000i = 675
0 = 675 - 1000i
1000i = 675
i = 675/1000
i = 0.675 or 67.5%

IS Relation: 0Y + 1000i = 675

LM Relation: 1,600 = 2Y - 8000i

1,600 = 2Y - 8000i
1,600 = 2Y - 8000(0.675)
1,600 = 2Y - 5,400
2Y = 1,600 + 5,400
2Y = 7,000
Y = 7,000/2
Y = 3500

C = 200 + 0.75Y (Y-T)

C = 200 + 0.75 (3,500 - 100)
C = 200 + 0.75 (3,400)
C = 200 + 2,550
C = 2,750

I = 150 + 0.25Y - 1000i

I = 150 + 0.25 (3,500) - 1,000 (0.675)
I = 150 + 875 - 675
I = 350

Because of the additional increase of P400 from the government

spending there is also an increase in income and consumption. The new
income is P3,500 and the new consumption is P2,750. While the
investment remains the same.