Dr. Pablo de la Peña S. 1 TECNOLÓGICO DE MONTERREY CAMPUS GUADALAJARA ESCUELA DE NEGOCIOS Y HUMANIDADES MACROECONOMICS EC-1000-30 Dr. Pablo de la Peña Sánchez April, 2012 MONEY MARKET, IS-LM MODEL Exercises I.Warming up questions. 1.Which of the following statements is not correct? a.Investment is negatively related with the interest rate. b.An increase in the Money Supply “Ceteris Paribus” will increase the interest rate ofequilibrium. c.During a recession the Demand for Money (L) will shift to the right. d.None of the above. R: ____2.Which of the following statements is not correct? a.Taxes will reduce consumption and in turn production (Y) will reduce its equilibrium with the Aggregate Demand (A.D.) b.An Open Market Operation in which the Central Bank sells bonds, it will increase the Money Supply (M s ) c.A zero required reserve ratio implies that Banks can lend all of their deposits. d.None of the above. R: _____3.The difference between M1 and M2 is a.M2 is money for everyday transactions. b. M2 includes travelers checks and M1 does not. c.M2 includes savings accounts. d.None of the above R: _____4.Chapala Bank has deposits for 300 million dollars, with a required reserve ratio of 30%, the Central Bank allows Chapala Bank to lend up to a.210 million dollars b.90 million dollars c.3.3. times its amount of deposits. d.None of the above R: _____5.An open market operation in which the Central Bank buys bonds for 500 million dollars, knowing that the required reserve ratio in the economy is 15%, the Central Bank is reducing the Money Supply (M s ): a.3,335 million dollars b.75 million dollars c.425 million dollars d.None of the above R: _____
The IS-LM Model helps us to understand the dynamism in the whole economic system. Both the IS as well
as the LM show the equilibrium between the production in the economy (Y) and the interest rate. We know
that the production in the economy is measure by the GDP, and the importance of analyzing its relationship
with the interest rate is because the Goods and Services Market is strongly related to whatever happen inthe Money Market, and vice versa. The IS curve shows a negative or inverse relationship between
production and interest rate, this means that the higher the interest rate the lower the production. This
relationship between Production (Y) and interest rate (r) in the IS can be better understood by analyzing the
relationship between interest rate and investment. The IS stands for “Investment and Savings”, and we
know that “investors” – which are usually companies – will be willing to borrow money to invest in
increasing their production capacity only if the interest rate is relatively low. The interest rate represents the
cost of borrowing money, or the opportunity cost. Thus, higher interest rates will inhibit investors to
increase their production capacity. This is why during high interest rates period, private investment is low,
and therefore production in the economy may also be low. In order to increase the level of investment so
we can have higher levels of production, we need to have low interest rates. However, low interest rates do
not attract people willing to save their money – to make deposits. Remember that Banks use those deposits
to make loans. So, it may well be the case in which companies are willing to borrow large quantities of
money because interest rates are low, but Bank, on the other hand do not have deposits because people in
the economy are not finding attractive those low interest rates. People will be willing to increase their
deposits if they find the interest rate attractive, a relatively high interest rate that represents a future gain on
their savings. Thus, the Central Bank has the challenge to maintain a relatively low interest rate to motivate
companies to borrow money, so they can invest in more production capacity and then, production in the
economy keeps growing. But, on the other hand, Central Bank has also the challenge to maintain a
relatively high interest rate, to attract people willing to make deposits.
Interest rate (r ) Investment (I ) Production (Y)
Production (Y) = IS Interest rate (r )
Now, the LM stands for Liquidity and Money, and it also shows a relationship between interest rate and
production, but it shows a positive relationship. This is because the LM depicts the relationship between the
Demand for Money (L), the Production level (Y) and the interest rate. Specifically, the LM shows the
changes in the interest rate due to changes in the Demand for Money caused by changes in the production
level or income (Y). Remember that the Demand for Money (L) is a function of the interest rate and
Income (Y), which is coming from the GDP, or the level of production in the economy. Thus, if the GDP isgrowing, there will be more income in the economy; thus, people may be willing to increase their demand
for money (liquidity) this is (L) so they can buy more goods and services. If people increase their demand
for money (L) will see a shift in the Demand for Money curve up to the right, if the central bank decides to
keep its current level of Money Supply (M s) with no change, then we will see an increase in the interest rate
along the Money Supply vertical line, up to a point in which crosses with the new Demand for Money (L)
curve. Then, after this process, we have a higher interest rate, and a higher Demand for Money due to an
As we can see, an increase in the interest rate from 4% to 4.6% will reduce the production
level 9.24%, this is Δ%Y = [ (8,100 / 8,925) – 1 ] * 100
(LM) example. Using the previous example as departing point.
a. As we do not want reductions in the level of production in the economy, the Central Bank
should need to do something in order to avoid this 9.24% reduction in Y. Then, suppose
the Central Bank decides to make an Open Market Operation in order to reduce the
interest rate from 4.6% to 4% once again. This means that the Central Bank should put
more money in the market, to do so, it will buy bonds. But the real question is how much
bonds should the Central Bank buy in order to reduce the interest rate to 4%, considering
there is a multiplier effect. Let’s suppose the reserve required ratio is 25%.
First, we need to calculate the final money supply that will find its equilibrium with a 4%interest rate and with the money demand that cause the increase in the interest rate.
Remember that the demand for money that took the interest rate up to 4.6% was one with
a level of production of 8,925 which was 10% higher than the original (Y).
Ms2 = 200 + 0.30(8,925) – 20,000r because the target interest rate is 4%, we have:
Ms2 = 200 + 0.30(8,925) – 20,000 (0.04)
Ms2 = 200 + 2,677.5 – 800
Ms2 = 2,077.5
This should be the new Money Supply, but the question is how much Bonds should the
Central Bank needs to buy in order to take the Money Supply up to 2,077.5 from 1,950?
ΔMs = Ms2 – Ms
1 ΔMs = 2,077.5 – 1,950
ΔMs = 127.5
Assuming that the reserve required ratio is 25%, then the multiplier is:
Multiplier = (1 / 0.25) = 4
Then, the Central Bank should buy bonds for 31.875 million dollars so that by the
multiplier effect the Money Supply will be increased up to 2,077.5 million.
