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The monetary policy rule states that a central bank can monitor inflation and GDP by following the equation given by i = i 0 +

The monetary policy rule states that a central bank can monitor inflation and GDP by following the equation given by i = i0+ ( - *) + (Y - Yp). 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 = Yp. 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 =

____%

b)Now suppose a drop in investment confidence leads to Y - Yp= -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 =

_____%

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 .

=_____%

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.

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