Suppose that the equation for the aggregate demand is Y = $9,000 + Ms/P, where Ms is the nominal money supply and P is the price level. Initially the nominal money supply equals $3,000. In addition, suppose that the expectations of firms and workers are rational in the sense defined on p. 547.

(a) Calculate points on the aggregate demand curve when the price level equals 0.8, 1.0, 1.2, 1.25, and 1.5, given the initial value of the nominal money supply.

(b) Suppose that natural real GDP equals $12,000 and that the short-run supply curve is given in the table below, where the price surprise equals P - Pe and Pe is the expected price level:

Given that the expected price level is initially 1.0, explain why the economy is in long-run equilibrium when the price level equals 1.0 and real GDP equals $12,000.
(c) Suppose that the real exchange rate declines and as a result, aggregate demand increases. Also assume that the decline in the real exchange rate will persist over time. As a result of this decline, the new equation for the aggregate demand is Y = $9,600 + Ms/P. Given no change in the nominal money supply, calculate the points on the new aggregate demand curve when the price level equals 0.8, 1.0, 1.2, 1.25, and 1.5, given the initial value of the nominal money supply. Using the table given in part b, explain what the new equilibrium price level and level of real GDP are in the short run, given the price surprise induced by the decline in the real exchange rate.
(d) Monetary policymakers respond to the decline in the real exchange rate in one of three ways:
(i) They do nothing and leave the nominal money supply
(ii) They change the money supply so as to return the price level to its level as given in part b;
(iii) They change the money supply so as to maintain the price level as determined by your answer to part c. For each of these cases, assume that this is how monetary policymakers have behaved in the past and this is how firms and workers expect them to behave in response to the decline in the real exchange rate.  Calculate what the long-run equilibrium price level is and what the expected price level is under each response by monetary policymakers. Calculate by how much monetary policymakers must change the nominal money supply for the expectations of firms and workers to be realized.

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0.2 0.0 0.2 0.25 0.5 Price surprise - Real GDP 11,900 12,000 12,100 12,125 12,250