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Consider a closed economy with xed prices and wages. Domestic demand for goods is given by: A5 = C (Y:T)+I (i rr")+, while demand for real money balances is equal to D 5; = L (Y, i), where M\" is nominal money demand, P is the price level, Y is real income, and i + _ is the nominal interest rate, It\" is the inflationary expectations. Assume the price level is xed at P = 1. Suppose that the central bank xes the money supply M 5 = M. The liquidity trap. Assume now that the nominal interest rate is so low that the opportunity cost of holding money is negligible. Suppose that as a result people are indifferent concerning the division of their wealth between money and bonds, and that they are therefore willing to change their money holding without any change in the interest rate. Suppose that T and G are exogenous. i. What is the slope of the LM curve? (5 marks] ii. What is the slope of the AD curve? [5 marks) iii. Is aggregate demand irrelevant to determine output if prices and wages are fully exible (so, AS curve is vertical]? [5 marks} The Pigou effect. Suppose, that, in addition, planned expenditure depends on real wealth: AE : AB (1' I T,i rte, G,%). Since the public's holdings of high-powered money are one .1. component of wealth, a fall in the price level increases real wealth. Suppose that T and G are exogenous. i. What is the slope of the AD curve if the economy is still in the liquidity trap? Use graphical analysis to illustrate your answer; (5 marks] ii. Is aggregate demand irrelevant to determine output if prices and wages are fully exible (so, AS curve is vertical]? (5 marks] 1. Milton Friedman: Suppose the demand for real money balances is given by the following liquidity function: Md ? = L(,Y) = 0.5r2Y a) If the nominal interest rate goes up from 10% to 15%. What will be the percentage change in money demand? Hint: You need to nd the elasticity of money demand with respect to the nominal interest rate: L = 6L(Y, z) i 8" 8i L(Y, 2') 2. More Fun with Offer Curves! Consider simple two-person, two-good econ- omy in which agents' utility functions are given by Vi(In1, In) = min{{n, In}, and U2(X12. T22) = min {4x12, 122). (4) and endowments are w; = (30, 0), w = (0, 20). (a) If neither agents can have negative consumption of either good, what is Walrasian equilibrium?4. Human Capital Accumulation Consider our basic, two-period model of Human Capital Accumulation. That is, the individual is born with some level of human capital, Hi, and must decide in each period t = 1, 2 what fraction of time they should invest in human capital accumulation 0 0, 0