Question 1: The determination of equilibrium income and the price level (40 points)

Consider the AD-AS model of the economy where the expressions for AD and AS curves are,

respectively,

P = 600 - 0.5Y

P = P_-1 + 0.5(Y - Y*)

where Y is real income, Y* is full-employment income, and P_-1 is the price level in the previous

period. The economy is originally in long-run equilibrium - i.e, real income is equal to full

employment income in period 0 and P_-1 = 100.

Q1. What is the value of Y* in this economy? What is the initial equilibrium value of P*?

Q2. Suppose that in period 1 there is a permanent increase in aggregate demand, and the

expression for AD becomes P = 800 - 0.5Y . What are the short-run equilibrium values

of Y and P in period 1?

Q3. Explain what happens to the AS curve in period 2. What are the short-run equilibrium

values of Y and P in period 2?

Q4. Explain what happens to the AS curve in subsequent periods. What will be the new

long-run equilibrium values of Y and P?

Question 2: Targeting the rate of interest and changes in bank reserves (40 points)

Suppose that the demand for money function was MD = 4Y - 1000i where MD is the quantity of money demanded, i is the rate of interest (an interest of 5 means 5 percent in this problem), and Y is real national income, which currently is 1500. The supply of money is 1000, currency in circulation outside the banking system is 100, the target reserve ratio is 10 percent, there is no cash drain in the banking system, and the recessionary gap is 250. The price level does not change in this problem.

Q1. What is the equilibrium value for the intest rate? What is the level of cash reserve of the

banking system?

Q2. Suppose that the Bank of Canada estimates that a reduction of the rate of interest to 4

percent would move the economy to full employment. Given this estimate, what would be

the quantity of money demanded at full employment?

Q3. Suppose the Bank of Canada reduces the target for the overnight rate, prompting commercial

banks to reduce the market rate of interest to 4 percent. Are the commercial banks

experiencing a situation of excess cash reserves or of too little cash reserves? What is the

size of this excess/insucient cash reserve when Y = 1500?

Q4. What will the commercial banks do to eliminate excess/insucient cash reserves? By how

much should the level of cash reserves of the banking system change for the economy to

move to full employment?