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Question 2 [19 points] The monetary policy rule states that a central bank can monitor ination and GDP by following the equation given by i = i0 + (Tr - 1T*) + (Y - Yp). In reality, the Bank of Canada does seem to follow this rule, and set a targeted inflation rate 11*. For this question, suppose 11* = 2%. Suppose the current ination 1T = 11 , and yetY = Yp. Let i0 = 8%. Note: Keep as much precision as possible during your calculations. Your final answer should be accurate to at least two decimal places. a) Find the value of i. li=0%| b) Now suppose a drop in investment condence leads to Y - Yp = -5%. Let us put aside ination rates for now. According to the monetary policy rule, what interest rate should the Bank of Canada now set? [Interest rate = 0% I c) How would you expect Tr to change when i drops? Explain what happens to AE and AD. As the interest rate drops, rms will spend (Select here) on investment, so AD and AE will (Select here), therefore creating (Select here) pressure on ination. d) Suppose 1T = 11* - Ai. Find the new 11. I1T=0%| e) Suppose the Bank knew that the new 1T would be higher. In order to balance between inflation and GDP targets, it has to set a new interest rate weighting both of these effects. Now nd the new i that the Bank should set knowing that Tr = 1T* -Ai. [Interest rate = 0% l f) Find the corresponding ination rate. llnation rate = 0% l 9) Discuss intuitively why this interest is higher/lower than the one you would have wanted to set in part b). The new interest rate drops from 0 %to 0 %, because knowing thata huge (Select here) in interest rates would (Select here) AD and subsequently (Select here) ination. Knowing this is the result (due to past experience or economic research), the Bank now has to choose a (Select here) interest rate in order to keep ination under control