University Macroeconomics Assignment: IS-LM, Exchange Rates, and Trade

This macroeconomics assignment delves into key economic models and concepts. It begins by defining the LM curve, explaining its positive slope, and identifying factors influencing its steepness. The assignment then uses the IS-LM graph to analyze the effects of an increased money supply on income and interest rates, discussing their inverse relationship. It explores how international trade, under both fixed and flexible exchange rates, alters the LM curve and examines the impact of increased foreign exchange reserves. Furthermore, the assignment defines the Marshall-Lerner condition and its implications for a small country engaging in international trade, and it explains the J-curve phenomenon, considering its effects on an economy with a fixed exchange rate. The assignment includes analysis of the uncovered interest rate parity, real exchange rates, and concludes with an illustrative economic model.

Running head: Macroeconomics
Macroeconomics
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Table of Contents
Assignment 1...................................................................................................................................2
Assignment 2.................................................................................................................................11

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Assignment 1
Question 1: Meaning of the LM curve and the describing the factors that is impacting on
the positive slope of the LM curve
The term LM curve is standing as the liquidity money. The main responsibility of the LM
curve is to bring the equilibrium in the money market. Through the incorporation of the LM
curve, the economy will be able to bring in the equilibrium in the rate of interests and the
demand of money by the consumers. In other words, the demand for the money in every
customer depends entirely on the income of the customer, as income will determine the amount
of the money the consumer is willing to spend (Büntgen et al.2016). On the other hand, the
slope and the curvature of the LM curve also depends on the rate of interests as the LM curve
also highlights the opportunity costs that the customer is losing instead of investing the money.
The LM curve is always positively sloped in nature as the demand of the money is
directly proportional with the income of the customers. The equation of the LM curve is L=kY-
hI. In the above equation, the L = demand for real money. Both the k and h are the sensitive
components and both of these variables are >zero. K is the sensitive component of income and h
is the sensitive component of interest rate. Y is the rate of income and I is the interest rate that is
prevailing in the economy.
Some of the factors can be identified as the mitigating factor for the development of
steepness of the LM curve. One of the major factors for the development of steepness or flatness
of the LM curve is the elasticity or inelasticity of demand of money. If the demand for money is
highly interest inelastic in nature then the LM curve will be steep and if the demand is interest
elastic in nature, then the LM curve will be flatter.

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Question 2: Using the IS-LM curve, determine the effects on the equilibrium level of
income (output) and the interest rate of an increase in the money supply
Figure 1: Effects on the equilibrium level on the IS-LM curve
(Source: Created by Author)
In the above diagram, the increase in the money supply within the economy will
automatically shift the Lm curve towards right. The immediate effect of this increased amount of
the money supply in the economy of Canada will bring the interest rate down. The immediate
effect that the low interest rate will be bringing in the economy is that it will definitely increase
the demand of the loans that the business units will be taking so that they can invest (Blauvelt et
al. 2017). The immediate effect of the low interests’ rate is that the consumers will not stock the
money rather they will spend the money on the investments. Through the increased amount of
the level of the investment, the economy of Canada will grow by heavy margin.

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Income and interest rates are going in the opposite directions. This is important in the
sense that if the income is increasing then the consumers will be willing to invest the money in
any kind of business. This is because with the increase in the income of the customers, the
demand of the money will increase and that is going to increase the spending of the customers.
On the other hand, if the interest rate is increasing then the loan making ability of liquid money
will be erased. This will have deep impact on the growth of the economy of Canada, as the
investment in the economy will fall by huge margin. The horizontal axis is measuring income
and vertical axis is measuring interest rate. Now with the increase in the money supply will
definitely allow the LM curve to shift towards right. Due to this the interest rate is falling that
will lead to more and more level of investment within the economy. The income will shift from
Y1 to Y2 and the interest rate is falling from I1 to I2.
Question 3: How is the LM curve altered by introducing international trade? How is it
altered under fixed exchange rates? How is it altered under flexible exchange rates? What
is the effect on the LM curve of an increase in foreign exchange reserves?
Any alteration in the international trade will obviously bring in changes in the exchange
rate that is going to make an impact on the LM curve. Previously before the formation the
BRICS country (Brazil, Russia, India, China and South Africa) and before the launch of these
countries the exchange rate was showing huge debacles.

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Figure 2: Exchange rate of the US to India currency
(Source: Corporate Finance Institute, 2019)
The above diagram, is showing the monthly exchange rate of the US and India. Before the
development of the Brics the Indian exchange rate was about Rs 48 per dollar and with the
formation of the BRICS the exchange rate was about Rs 45 per dollar. This will definitely make
an impact on the shift of the LM curve. This is important in the sense that through the impact on
the shift of the interest rate, the exchange rate will be looking for the development in the above
LM curve.
Considering the flexible exchange rate, the effect on the LM curve is clearly getting
reflected in the movement of the curves. Under flexible or volatile exchange rate if the domestic
rate of interest lies above the world interest rate then the foreigners will be willing to invest in
the domestic country. Due to increased inflow of capital to the home country will force the home
country to depreciate the rate of interest back to the previous position. On the other hand, the
outflow of the money will bring the equilibrium back to the normal position. The Mundel-
flaming model in case of the open economy is like Y = C(Y – T) + I(r*) + G + NX(e). In the
given equation the level of the investment is depending on the interest rate that is prevailing in

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the economy. The alteration of LM curve will be depending on the development of the exchange
rate and the economy is actually responding to the situation.
However, the situation is quite different in case of the fixed exchange rate. Under these
circumstances, the development of trade will not be a factor. This is because, the shift in the LM
curve will not be a factor in the sense that it will not have any impact on the shift in the LM
curve.
Question 4: Define the Marshall-Lerner condition. What are the likely effects of
devaluation on a small country that purchases imports in a large world market and sells its
exports in such a market?
The Marshall-Learner condition is such a condition that defines that through the
devaluation of the currency, the improvement in the balance of trade if the sum of demand
elasticity of both imports and exports is greater than one. This condition highlights the impact of
the development of the international trade that will definitely increase the level of the
innovations. It is important for international trade to deal with demand elasticity of both imports
and exports that will easily indulge the development of trading.
The scenario is quite explanatory and through the devaluation of the currency the effects
on the trade is quite possible. In the given case study, a small country is making trade with a big
country and is indulging in both imports and exports. Now the small country will be looking to
increase the trading with the big country by making their products cheaper in the international
market. Through the devaluation of the currency of the small country will make their currency
against the big country currency cheaper and that will easily boost up the trade balance. This is
important for the small country to improve the development of trading and commerce that will

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definitely allow them to increase the revenue as well as the foreign reserve of the country.
Through the devaluation of the currency in the small country, the price of the products will be
cheap in the international markets. This will allow the small country to deal with better resource
allocations that will allow better development in the trading with the big country.
Question 5: Explain the J-curve phenomenon. Consider an economy with a fixed exchange
rate with a fixed price level. What is the effect of depreciation on equilibrium income and
trade balance after the first six months of depreciation?
The J curve is one of the curves that are showing the fact that in the initial phase the
points plotted in the graph will fall and points that have been plotted in the graph will increase as
more points are being plotted.
Figure 2: J curve phenomenon
(Source: Corporate Finance Institute, 2019)
The above figure is showing the fact that net cash portfolio is gaining an upward trend over the
years as the cash outflow and cash inflow variable has been put over many years. The given

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curve will be taking shape of the J curve that will allow the increase in the allotted points in an
increased manner after a certain point of time.
Africa is one of the countries that is having fixed exchange rate. This is because of the
fact that due to the lack of the development within the economy, government is not allowing the
increase or decrease of the international and business organizations are not at all investing in the
African economies. In the modern business world, the impact or the consequence of depreciation
is having strong impact on the development of the business. In order to identify the effect of the
depreciation it is important to identify the effect of depreciation on the country having fixed
exchange rate.
After having six months of depreciation, the equilibrium income will definitely going to
fall for the country like Africa that is having fixed exchange rate. On the other hand, through the
fixed rate of exchange rate the country will be facing problem in doing the required amount of
trade. The decreasing amount of trade balance will be affecting the country like Africa
significantly and this will make investment in long run slow in nature. The decreased number of
trade balance will have an impact on the current account and capital account balance. Through
the improvement in the industry, and investment the capital account balance will bring better
level of growth in GDP. In order to highlight the importance in the financial market, the
development of fixed exchange rates will be beneficial for the better resources capitalization.

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Question 6:
The uncovered interest rate parity or UIP is the theory that claims that difference of the
interest rates among two countries will be equal to the relative changes in the foreign exchange
rate of currency in the same period. Forward exchange rate is determined by a steady relationship
among the spot exchange rate and nominal exchange rate.
Question 7: Define the real exchange rate. Suppose that the cost of the market basket in
Canada is PCA = $190
Real Exchange rate or REE is the relative price of trade that happens because of UK and
USA. The real interest rate is going to highlight the peg of interest rate that will develop the
international trades and commerce. Through the development of the real exchange, rate the trade
and commerce that will develop the incorporation of the trade and commerce that will allow the
development. Cost of market basket in the Canada is Pc =$190

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Question 8:
Z = C + I + G + (X – Q)
C = 120 + 0.80(Y – T)
I = 210
G = 500
X = 300
T = 50 + 0.25Y
Q = 30 + 0.1Y
where Y is the domestic income
a) The above equation can be solved in the following way. Putting the value will be
focusing in the above equation will give the following solutions
Z= 120+0.80(Y-T) +120+500+ (300-30-0.1Y)
Z= 120+ 0.80(Y-50-0.25Y)+120+500+(300-30-0.1Y)
Z= 120+ 0.80(0.75Y-50)+ 120+ 500+ (270-0.1Y)
Z= 120+ 0.6Y-40+ 120+500+270-0.1Y
Z= 970+0.6Y-0.1Y
Z= 970+0.5Y

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Figure 3: Keynesian Cross diagram
(Source: Created by Author)
b) The equilibrium level of the income is 1940
c) The amount of taxes will be 535 and the government is in surplus by 35
d) The level of the net exports is 76.