Question 1 -

a) Based on your understanding of the money market model, graphically illustrate and critically explain the effect of the following events on equilibrium quantity of money, and nominal interest rate.

i. a sale of government bonds by the Central Bank.

ii. an increase of the reserve ratio by the Central Bank.

b) The demand for money is given by Md = Y (0.2 - i), where Y is the nominal income.

Y = 115 and the supply of money (Ms ) is 21.85.

What is the equilibrium nominal interest rate, i?

If the central bank wants to increase i by 0.5%, at what level should it set the Ms?

Explain what happens to Ms . Show your workings and calculations. (15 marks)

Question 2 -

a) Write down the expectations augmented Phillips curve. Explain what happens to actual inflation, (relative to expected inflation) when the actual unemployment rate, is either above or below the natural rate of unemployment. Give a definition for the natural rate of unemployment. How can an economic crisis affect the natural rate of unemployment?

b) Suppose that the Phillips curve is given by: t = e t + 0.08 2ut where is the inflation rate, e is the expected inflation rate and u is the rate of unemployment.

i. How much is the natural rate of unemployment?

ii. Assume, e t = t1 and suppose that (which is the weight that agents put on previous period inflation) is initially equal to 0. In year t, the government decides to bring the unemployment rate down to 2% and hold it there forever. Determine the rate of inflation in years t, t + 1, t + 2 and t+3.

iii. Do you believe the answer given in (ii)? Why or why not? iv. Now assume that in year t + 4, increases from 0 to 0.5. Suppose that the government is still determined to keep u at 2% forever. Why might increase in this way?

v. How much will the inflation rate be in years t + 4, t + 5 and t+6? Comment on your answer