Suppose that money demand is given by MD = $Y (0.25-i). If Y = $100 and the supply of money is $20, what is the equilibrium interest rate?

If the marginal propensity to save increases, what happens to the IS curve?

Suppose that money demand is given by MD = $Y (0.25-i). If Y = $100 and the supply of money is $20, what is the equilibrium interest rate?

If the marginal propensity to save increases, what happens to the IS curve?

Answer:

At equilibrium, demand for money should be equal to supply of money.

M^{d} = (0.25-i)*100 = 25-100i M^{s} = 200

25-100i = 200

i = 0.05 This is the equilibrium rate of interest.

The slope of the IS curve depends on the slopes of investment and saving fuctions.

The IS curve will be relatively steeper, the higher the MPS (marginal propensity to save). A given decline in the interest rate leads to a given increase in investment and for product market to be in equilibrium along the IS curve, saving must be higher by the same amount. If the MPS is relatively high, then a smaller increase in income will generate this new saving than if the MPS were low. This means that the IS curve is relatively steeper, other factors as given, the higher the MPS.