7. Consider the following Aggregate demand and Money demand model for a closed economy,

= ( ) + () + ( )

(M/P)^d = (, )

with the real interest rate given by = , where denotes the nominal interest rate and represents expected inflation.

Answer the following:

(i) What happens to equilibrium output when government tries to finance its expenditure by raising taxes in this model? [8]

(ii) What happens to output and interest rate in this model, when a fall in the price level is expected in the future? [10]

(iii) Suppose that the economy is in recession and the government tries to bring down the deficit by reducing its expenditures. Using this model, explain what kind of monetary policy the Central Bank should pursue to complement government's fiscal policy to steer the economy out of recession. [7]