1. Suppose the real money demand function is: Md/P ? 1500 ? 0.2 Y – 10,000 (r ? (e). Assume M ? 4000, P ? 2.0, (e ? 0.01, and Y ? 5000. Note: we are holding P and Y constant in this problem until we get to case #2, see below. a) What is the market clearing real interest rate? Show your results on a real money supply, real money demand diagram and label this initial equilibrium point as point A. Be sure to label your graph completely! Be sure to put relevant shift variables in parentheses next to the appropriate function. Case #1 b) Suppose Bernanke and the Fed were successful in their campaign to raise inflationary expectations to 4% (.04). Why would they want to do this? Use the Fisher equation to support your argument. c) Solve for the real interest rate that clears the money market given the change in inflationary expectations. Please show work and Label this new point as point B on your diagram. d)) Explain how this strategy of raising inflationary expectations is supposed to stimulate output. Recall that output is equal to C + I + G! Be very specific as this question is worth 10 points. Hint: The price of current consumption in terms of future consumption and the user cost of capital most definitely needs to be in your response. Case #2 e) Let us return to our original conditions. Please redraw the original graph locating point A (this is with (e ? 0.01, we are holding expected inflation constant in case #2). We now experience some economic growth so that Y = 6000. This is the only change. Resolve for the market clearing real rate of interest and label on your diagram as point B. Please show all work. Be sure to put relevant shift variables in parentheses next to the appropriate function. f) Now explain exactly why the real rate of interest had to change the way it did to clear the money market. Please be clear with the intuition being sure to refer to the bond market in your answer. You should begin your response with “At…
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