Question 5)

Consider the government spending G and taxes T as given. Assume no output growth, that is gY = 0. The central bank uses a contractionary monetary policy by decreasing the inflation target from 5% to 4%. Ceteris paribus, what would happen to the following in the medium-run?

(a) The natural level of output, Yn.

(b) Money growth, gM.

(c) Real interest rate. (Hint: The natural real interest rate, rn, is the real interest rate needed to sustain G when the output is at its natural level, Yn.)

(d) (2.5 marks) Nominal interest rate.