Y7

Consider an economy where the impact of monetary policy can be summarized by the relation

=

where Y, M, are output, the money supply, and the monetary policy multiplier, respectively. It is not possible to adjust M to consistently hit a target, say Y, perfectly. This inability to hit the target generates the loss function, L (a function that describes the extent to which a target is missed):

= 1 ( )2 4

Let Y = 5. Based on the above information, compute the choice of money supply M to minimize the above loss function when we are uncertain about the monetary policy multiplier. Specifically can be either 0.8 or 1.2, with a 40% chance of it being 0.8 and 60% chance of it being 1.2