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The LM curve - Essay Example

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Summary
where M is the nominal money stock, Y is the domestic income, r is the domestic interest rate, r* is the foreign interest rate, I is the autonomous domestic investment spending, G is the government spending, Y* is the foreign income and RE is the exchange rate.
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The LM curve
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Download file to see previous pages IS curve or IS schedule explains the investments and savings aspect of market or economy. This explains the activity of goods and services performance in the economy. The LM curve, on the other hand, explains the money market or money aspects of the market and economy. As a whole, they both describe the overall activities of the economy which lead national income. The FE schedule describes the labor market and the labor aspects of the economy.

The IS-LM-FE model addresses the three major areas of any economy. Labor, money and goods and services are all addressed by this model.
We have the IS curve equation. Using the given data, we can calculate for the income Y.
r = 0.1(I+G+0.2Y*-0.2Y+50RE)
as r = r* = 5, we can substitute the value of r* for r in the IS equation.
5 = 0.1 (100 + 100 + 0.2*500 - 0.2Y + 50*1)
Yielding Y = 1500
This gives us the income, Y, as 1500. Y, the income, is local income only as the foreign income Y* has also been considered. This is the equilibrium level of income in the economy.
To calculate for the resulting equilibrium level of money supply, we use the LM curve. The LM curve explains the supply and demand aspects of money in the market and economy.
Using the equation for the LM curve, we can calculate for the equilibrium money supply level in the market.
M=0.25Y-5r
We calculated Y to be 1500 and r is given to be r* which is 5. Solving for M, money supply, we get
M = 350
The money supply has equilibrium value of 350 for the given values of income, exchange rate and other variables.
b)to what extent does r* have to move in order to obtain an income level of 1600explain
For the income to be 1600, we can calculate for the value of r* which is also r is our case. Solving the same equation of IS schedule for r we get,
r = 0.1(I+G+0.2Y*-0.2Y+50RE)
Putting values of I, G, Y*, Y and RE, we get,
r = 0.1 (100 + 100 + 0.2*500 - 0.2*1600 + 50*1)
r = 18
r has to be 18 in order to make the income equal to 1600. This means that the value of r has to increase to 360% of its original value. By reaching this level, the income in the market will be ...Download file to see next pagesRead More
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