Question 9 [19 points]

The monetary policy rule states that a central bank can monitor inflation and GDP by following the equation given by i = i₀+ ( - ^*) + (Y - Y_p). In reality, the Bank of Canada does seem to follow this rule, and set a targeted inflation rate ^*. For this question, suppose ^*= 1%. Suppose the current inflation = ^*, and yet Y = Y_p. Let i₀= 9%.

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.

i =

0

%

b)Now suppose a drop in investment confidence leads to Y - Y_p= -3%. Let us put aside inflation rates for now. According to the monetary policy rule, what interest rate should the Bank of Canada now set?

Interest rate =

0

%

c)How would you expect to change when i drops? Explain what happens to AE and AD.

As the interest rate drops, firms will spend

(Select here)

on investment, so AD and AE will

(Select here)

, therefore

creating

(Select here)

pressure on inflation.

d)Suppose = ^*- i. Find the new .

=

0

%

e)Suppose the Bank knew that the new 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 find the new i that the Bank should set knowing that = ^*- i.

Interest rate =

0

%

f)Find the corresponding inflation rate.

Inflation rate =

0

%

g)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 that a huge

(Select here)

in

interest rates would

(Select here)

AD and subsequently

(Select here)

inflation. 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 inflation

under control.