1. Your country faces the following
In the product market: IS = 6,752 - 37Y
In the money market: LM = 1.75
In the BOP market: BP = -684 + 62Y
a. Graph the above conditions. Is this an example of the classical case? If yes, explain. If no, show how it would look if it were the classical case.
b. What is the equilibrium level of GDP and the interest rate? Is there a BOP equilibrium or a BOP deficit/surplus. If the money supply is increased by 23% what is the new equilibrium GDP and interest rate? What happens to the BOP? Explain.
c. The country devalues its currency. given the above conditions, will this eliminate any BOP deficit? Explain.
a. To graph the above conditions, we will use the IS-LM-BP model.
IS curve: IS = 6,752 - 37Y
This equation reflects the relationship between the real output (Y) and the interest rate (IS).
LM curve: LM = 1.75
This equation represents the relationship between the interest rate (LM) and the money supply.
BP curve: BP = -684 + 62Y
This equation shows the relationship between the balance of payments (BP) and the real output (Y).
To graph these conditions, we will plot Y on the horizontal axis and the interest rate on the vertical axis. The IS curve will be downward sloping, the LM curve will be a horizontal line at 1.75, and the BP curve will be upward sloping.
If the conditions above are an example of the classical case, we would see a vertical LM curve at a fixed money supply. In this case, an increase in output (Y) would not affect the interest rate (r) since the money supply is fixed. However, since the LM curve provided is a horizontal line, it suggests the opposite of the classical case, where the LM curve would be vertical.
b. To find the equilibrium level of GDP and the interest rate, we need to find the intersection point of the IS and LM curves. At this point, the quantity of goods and services demanded (Y) in the product market equals the quantity of goods and services supplied (Y) in the money market.
Given the IS curve:
IS = 6,752 - 37Y
And the LM curve:
LM = 1.75
To find the equilibrium GDP, we set IS equal to LM:
6,752 - 37Y = 1.75
Rearranging the equation, we get:
37Y = 6,750 - 1.75
37Y = 5,000
Y = 5,000 / 37
To find the equilibrium interest rate, we substitute the GDP value into the IS equation:
IS = 6,752 - 37(5,000 / 37)
IS = 6,752 - 5,000
IS = 1,752
So, the equilibrium level of GDP is approximately 135.14, and the equilibrium interest rate is 1.75.
To determine the BOP equilibrium or BOP deficit/surplus, we need to evaluate the BP curve:
BP = -684 + 62Y
Substituting the equilibrium GDP value into the BP equation:
BP = -684 + 62(135.14)
BP = -684 + 8,386.68
BP = 7,702.68
Since the BOP is positive, indicating a surplus, there is a BOP surplus in this situation.
If the money supply is increased by 23%, we need to adjust the LM curve accordingly. The new equation for the LM curve would be:
LM = 1.75 * (1 + 0.23)
LM = 1.75 * 1.23
LM = 2.1525
To find the new equilibrium GDP and interest rate, we repeat the process of finding the intersection point of the IS and LM curves with the new LM curve:
IS = 6,752 - 37Y
LM = 2.1525
Solving for equilibrium GDP and interest rate using the new LM curve:
6,752 - 37Y = 2.1525
37Y = 6,752 - 2.1525
37Y = 6,749.8475
Y = 6,749.8475 / 37
So, the new equilibrium level of GDP is approximately 182.43, and the new equilibrium interest rate is approximately 2.1525.
As for the BOP, the change in money supply does not directly affect it, so the BOP surplus of 7,702.68 remains unchanged.
c. The country devalues its currency. Given the above conditions, devaluing the currency will lead to changes in the BP curve. A devaluation of the currency makes the country's exports cheaper and imports more expensive.
The new BP equation would be:
BP = -684 + 62Y - d
Where "d" represents the devaluation of the currency.
Devaluing the currency increases the value of "d" in the equation, making the BOP deficit decrease or the BOP surplus increase. Therefore, devaluing the currency can help eliminate a BOP deficit by making exports more competitive and reducing imports.