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 * = 2%. Suppose the current inflation = *, and yet Y = Yp. Let i0 = 8%. 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.

f) Find the corresponding inflation rate.

g) Discuss intuitively why this interest is higher/lower than 5% . fill in blanks _ The new interest rate drops from __% to __% because knowing that a huge ___ (rise or drop)in interest rates would ___(increase or decrease) AD and subsequently ____(increase or decrease) inflation. Now the bank has to choose a ____(higher or lower) interest rate in order to keep inflation under control.