1 . (20 points) Liquidity Preference and Monetary Policy Examine monetary policy in the context of the IS-LM prices with fixed prices so that P = 0. Suppose demand and in the economy is given by IS) Y, =a+G-2.1, where Y, is the output gap, a: is animal spirits and G, equals exogenous fiscal policy. Assume that government fiscal spending is fixed at steady state levels, G, = 0. Money demand is given by. MD ) MP = Y -4-L. Equilibrium in the money market occur when money supply equals money demand EQ MP = M Assume that the central bank adjusts money supply in response to economic conditions. a. Suppose that the central bank always adjust money supply to keep the interest rate fixed i, =0. Solve for the effects of animal spirits on the output gap and money supply. Y, = F - a,; and M. = F, -a. Solve for F1, and Fr. On the graph, demonstrate how the equilibrium changes if animal spirits increase. F1 F