Question 2 [19 points] The monetary policy rule states that a central bank can monitor inflation and GDP by following the equation given by i = io + (TT - TT ) + (Y - Y p). In reality, the Bank of Canada does seem to follow this rule, and set a targeted inflation rate TT*. For this question, suppose = 2%. Suppose the current inflation IT = , and yet Y = Y _ Let io = Note: Keep as much precision as possible during your calculations. Your final answer should be accurate to at least two decimal places. a) Find the value of i. b) Now suppose a drop in investment confidence leads to Y - Y Interest rate = 6% -3%. Let us put aside inflation rates for now According to the monetary policy rule, what interest rate should the Bank of Canada now set? c) How would you expect TT to change when i drops? Explain what happens to AE and AD As the interest rate drops, firms will spend more on investment, so AD and AE will rise creating upward pressure on inflation. d) SUPPOSeTT - 1.5Ai_ Find the new TL IT = 6,50/0 , therefore e) Suppose the Bank knew that the new TT would be higher In order to balance between inflation and GDP targets, it has to set a new interest rate weighting both of these effects. Now find the new i that the Bank should set knowing that TT Interest rate = 00/0 f) Find the corresponding inflation rate. Inflation rate = 00/0 g) Discuss intuitively why this interest is higher/lower than the one you would have wanted to set in part b). The new interest rate drops from 9 % to 0 0/0, because knowing that a huge (Select here) in interest rates would (Select here) AD and subsequently (Select here) inflation. Knowing this is the result (due to past experience or economic research), the Bank now has to choose a (Select here) interest rate in order to keep inflation -1_5Ai. under control. (Select here higher lower