Suppose real money demand in trillion dollars is (M/P)d = 0.8Y 100(r + e ), where Y is real output in trillion dollars, r is real interest rate, and e is expected inflation. The Central Bank maintains the nominal money supply at 12 trillion dollars. The real output is 15, the real interest rate is 2% (i.e., r = 0.02).

a. Suppose that the central bank makes a credible announcement that inflation is going to be 3%. What is the current price level?

b. Suppose that the central bank makes a credible announcement that the money supply will be growing at 4% per year for a long time. Assume that real output is constant. What is the value of the expected inflation rate? What is the new price level? What is the actual inflation caused by this announcement?

c. Describe how a change in the expected inflation influences the equilibrium price level (assume everything else is fixed). Provide the intuition.

d. Suppose the economy enters a recession. Draw a sketch of demand for and supply of real money balances and indicate shifts in the demand and supply of the money and changes of the equilibrium.

e. Assume that the price level is fixed. What happens to the equilibrium interest rate if the Central Bank increases the nominal money supply to 12.5?