The monetary policy rule states that a central bank can monitor inflation and GDP by following the equation given by i = i₀+ ( - ^*) + (Y - Y_p). In reality, the Bank of Canada does seem to follow this rule, and set a targeted inflation rate ^*. For this question, suppose ^*= 1%. Suppose the current inflation = ^*, and yet Y = Y_p. Let i₀= 6%.

Note:Keep as much precision as possible during your calculations. Your final answer should be accurate to at least two decimal places.

a)Find the value of i.

i =

6%

b)Now suppose a drop in investment confidence leads to Y - Y_p= -5%. Let us put aside inflation rates for now. According to the monetary policy rule, what interest rate should the Bank of Canada now set?

Interest rate =

1%

c)How would you expect to change when i drops? Explain what happens to AE and AD.

As the interest rate drops, firms will spend

more on investment, so AD and AE will

rise, thereforecreatingupward pressure on inflation.

d)Suppose = ^*- i. Find the new .

=5%

e)Suppose the Bank knew that the new would be higher. In order to balance between inflation and GDP targets, it has to set a new interest rate weighting both of these effects. Now find the new i that the Bank should set knowing that = ^*- i.

Interest rate =

___%

f)Find the corresponding inflation rate.

Inflation rate =

___%

g)Discuss intuitively why this interest is higher/lower than the one you would have wanted to set in part b).

The new interest rate drops from

____% to____%, because knowing that a huge_________ ininterest rates would_________AD and subsequently_____________ inflation. Knowing this is the result (due to past

experience or economic research), the Bank now has to choose a_________interest rate in order to keep inflationunder control.