Question 1: [55 marks]

When we derived money demand function in class, we assumed that money demand

depends on income and interest rate. Consider an economy that its money demand does not

depend on income and is only a function of interest rate.

Md=L(i)

Suppose that the economy is an open economy that is on a flexible exchange rate system.

1. Draw the money demand and supply curves with money demand and supply on x-axis

and interest rate on y-axis. [3 marks]

2. Show what happens to money demand and supply curves if income changes. [2 marks]

3. Derive the LM curve. [5 marks]

4. Derive the AD curve. [5 marks]

5. In response to the COVID-19 crisis, suppose that the government of the ABOVE ECONOMY increases transfer payments to help people struggling during the COVID-19 pandemic.

(a) Show the short run effects of this policy using the Five-Figures Diagram we drew in class; goods market, money market, the IS-LM curves, the interest parity condition curve, and the AS-AD curves. Explain your answer. [8 marks]

(b) How about the effects of this policy in the medium run? Assume that before and after the changes, the economy is still in a recession (i.e. its output is below its natural level). To answer this question, draw the Two-Figures Diagram; the IS-LM curves and the AS-AD curves. Explain your answer. [5 marks]

(c) Do you think this policy is su cient to compensate for damage done to the economy"s production and consumption of goods and services during the epidemic? Explain your answer. [2 marks]

6. In response to the COVID-19 crisis, suppose that the foreign government increases investment in new hospitals. Sho

7.) Suppose that the central bank of the ABOVE ECONOMY lowers its target for the overnight rate and buys government bonds to provide support to the economy during the COVID-19 pandemic.

(a) Show the short run effects of this policy using the Five-Figures Diagram we drew in class; goods market, money market, the IS-LM curves, the interest parity condition curve, and the AS-AD curves. Explain your answer. [8 marks]

(b) How about the effects of this policy in the medium run? Assume that before the changes, the economy was at the natural level of output. To answer this question, draw the Two-Figures Diagram; the IS-LM curves and the AS-AD curves. Explain your answer. [5 marks]

(c) The more the central bank buys, the lower the interest rates that the government has to pay on new borrowing, and the more the government can borrow. Does this mean the government can spend as much as it wants and protect the economy from damage done by the virus? Explain your answer