1) The Liquidity Function is given by L(Y,i) = Y^1/2/(1000i)^.25 . The real interest rate is 0.5%, the expected rate of inflation is 1.1%, the price level is 6 and the nominal money supply is 120.

a) What is the equilibrium level of real GDP in the economy.

b) What is the level of velocity in the economy (velocity is the average number of times a unit of currency is used in transactions in the economy. It measures the speed of circulation of a currency. For instance, if nominal GDP is 10,000 and there are 1000 one-dollar bills, then each dollar bill would be used ten times, on average.)

Question 2

Show both versions of the liquidity trap below. On the left side, show how the liquidity-trap can be depicted using the monetary-market model.On the right side, show how the liquidity-trap can be depicted using the AE/PC model (label the target real interest rate with a suffix 'T'. In both cases you can assume the Central Bank is responding to an adverse expenditure shock from the long-run equilibrium and target inflation using countercyclical monetary policy. Label the axes, mark the curves and all points of interest (using methods as outlined in the previous questions). Answer the additional questions below. For simplicity assume no lags.

Money MarketAE/PC

Describe why, with respect to the liquidity-trap, the Central Bank might consider raising the inflation target from 2% to 4%.Don't ramble on. Be clear and complete but especially succinct. Use ONLY the space provided below:

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