Problem 1: Monetary Policy [17 Points] Suppose that an economy begins in Long-Run Equilibrium. This economy has a Short-Run AD and AS given by: AD:Y = 1,200 4p AS:Y =2p 1. What must be Potential Real GDP (Y*) if we are in long-run equilibrium with the above AD and AS? [1 point] Now suppose that the Simple Multiplier for this economy is equal to 3. Also suppose that there is a decline in exports of $80. 2. What is the new Short-Run Equilibrium Real GDP (Y) and price level (p)? [3 points] 3. Is this economy in a Recessionary Gap or Inflationary Gap? How do you know? [2 points] Now suppose that there is Money Demand given by the following, where r is the interest rate (for example, a 10% interest rate has r = 10): Mp = 2,000 100r Note that for simplicity, we have assumed that MD does not change when p and Y change. This economy currently has $200 of cash currency and $400 of Total Bank Deposits, with cash drain of 0% and a reserve rate of 10%. 4. What is the current Money Supply (MS) and market interest rate (r)? [2 points] Now suppose that the Central Bank is considering taking action to close this output gap. 5. Why might the Central Bank be interested in closing this output gap instead of letting it adjust back to long-run equilibrium naturally? [2 points] Finally, suppose that for every 1% decrease in the interest rate, Desired Consumption (C) increases by $20 and Desired Investment (l) increases by $20. 6. How much does Aggregate Demand need to change to return this economy back to long- run equilibrium? [2 points] 7. How much does the interest rate need to change to achieve this required change in Aggregate Demand? [2 points] 8. How much does the Money Supply (MS) need to change to achieve this required drop in the interest rate? If the Central Bank wanted to achieve this MS change by changing the reserve rate, how much would the reserve rate need to change? [3 points]