1.Suppose an economy is characterized by the following three equations:

u_t- u_t-1= -0.4 (g_yt- 3%)

p_t-p_t-1= - (u_t-5%)

g_yt= g_mt-p_t

Assume, initially, thatp_t=0.07, g_mt=0.1, and u_t= u_t-1=0.075.

If this year money growth is permanently reduced from 10% to 2%, answer the following questions. (hint: first substitute g_ytequation into the Okun's law equation).

a)What will be the unemployment rate and the inflation next year?

b)What will be the unemployment rate and the inflation rate in the medium run?