Problems with Solutions

Example: Determination of Equilibrium Interest Rate along

with C,I and M
Given:
C=102+0.7 Y , I =150−100i , M s=300, M t =0.25Y , M z =124−200 i .
Find (a) the equilibrium level of income and the
equilibrium rate of interest and (b) the level of C, I and M , t

an M when the economy is in equilibrium.

z

a. Commodity Market Equilibrium (IS) exists where

Y =C + I
¿ 102+0.7 Y +150−100i
Y −0.7 Y =252−100 i
0.3 Y +100i−252=0

Monetary Equilibrium (LM) exists where

M ❑s=M t + M z
300=0.25Y + 124−200i
0.25 Y −200 i−176=0

Simultaneous equilibrium in both markets requires

that

0.3 Y +100i−252=0 (1)

0.25 Y −200 i−176=0 (2)
 Hint: find a term to cancel out, this can be done by
multiplying equation (1) by 2 and then subsequently
adding it to equation (2) to eliminate i.

0.6 Y +200i −504=0

0.25Y −200i−176=0
0.85 Y =680
Y =800

Substitute Y = 800 in equation (1) or (2), here we

choose equation (2)

0.25 Y −200 i−176=0

0.25 ( 800 ) −200i−176=0
−200i=−24
i=0.12

b. At Y = 800 and i = 0.12,

C=102+0.7 ( 800 ) =662

I =150−100 ( 0.12 ) =138

M t =0.25 ( 800 )=200

M z =124−200 ( 0.12 )=100

And
C+ I =Y

662+138=800

M t + M z=M s
200+100=300

Example: Determination of Equilibrium Interest Rate along

with C,I and M
Find (a) the equilibrium income level and interest rate and
(b) the levels of C, I, M and M in equilibrium when: C=89+0.6 Y ,
t z

I =120−150 , M =275, M =0.1Y M =240−250

i s t z i

a. For IS:
Y =89+0.6 Y +120−150 i

Y −0.6 Y =209−150i

0.4 Y +150 i−209=0

For LM:
M s=M t + M z

275=0.1Y +240−250i

0.1 Y −250i −35=0

In equilibrium,
0.4 Y +10 i−209=0 (1)
0.1 Y −250i −35=0 (2)
Multiply equation (2) by 4 and subtract the result from
equation (1) to eliminate Y.
0.4 Y +150 i−209=0
 −( 0.4 Y −1000i−140=0 )
1150 i=69

i=0.06

Substitute i = 0.06 in equation (1) or equation (2), here we

choose equation (1)
0.04 Y +150 ( 0.06 )−209=0

0.4 Y =200

Y =500

b. At Y = 500 and I = 0.06

C=89+0.6 ( 500 )=389

I =120−150 ( 0.06 )=111

M t =0.1 ( 500 )=50

M z =240−250 ( 0.06 )=225

And
C+ I =Y

389+111=500

M t + M z=M s

50+225=275