1. Suppose a country has a money demand function (M/P)d = kY, where k is a constant parameter. The money supply grows by 12 percent per year, and real income grows by 4 percent per year. What is the average ination rate ? How would ination be different if real income growth were higher ? Explain . Suppose that instead of a constant money demand function , the velocity of money in this economy was growing steadily because of financial innovation . How would this situation affect the ination rate ? Explain . 2. Suppose that the money demand function takes the form (M/P)'l = L(1', Y) = Y/{5i) 3 . Suppose 1 . 2 . If output grows at rate Q, at what rate will the demand for real balances grow (assuming constant nominal interest rates )'? What is the velocity of money in this economy ? If ination and nominal interest rates are constant , at what rate , if any , will velocity grow ? How will a permanent (once -and -for a]l) increase in the level of interest rates affect the level of velocity ? How will it affect the subsequent growth rate of velocity? the Bank of Canada reduces the money supply by 5 percent . What happens to the aggregate demand curve ? What happens to the level of output and the price level in the short run and in the long run ? According to Okun's law, what happens to unemployment in the short run and in the long run ? (Hint .' Okun's law is the relationship between output and unemployment discussed in Chapter 2.) What happens to the real interest rate in the short run and in the long run ? (Hint: Use the model of the real interest rate in Chapter 3 to see what happens when output changes .) Let's examine how the goals of the Bank of Canada inuence its response to shocks . Suppose central bank A cares only about keeping the price level stable , and central bank B canes only about keeping output and employment at their natural rates . Explain how each central bank would respond to 1. 2. An exogenous increase in the velocity of money. An exogenous decrease in the price of oil