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What is the price level

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Reference no: EM132600633

Question 1: Using the quantity theory of money, suppose that this year's money supply is $100 billion, nominal GDP is $1 trillion, and real GDP is $250 billion. (show all your work)

a. What is the price level? What is the velocity of money?

Suppose that velocity is constant and the economy's output of goods and services rises by 5 percent each year. What will happen to nominal GDP and the price level next year if the Bank of Canada keeps the money supply constant?

What money supply should the Bank of Canada set next year if it wants to keep the price level stable and real GDP has increased by 5 percent?

d. If real GDP has increased by 5% , what money supply should the Bank of Canada set next year if it wants inflation of 5 percent?

Question 2: Suppose that firms become very pessimistic about future business conditions and cut heavily on investment in capital equipment. [Label A, B, C for the initial, new short run and new long run equilibrium respectively]

a. Use an aggregate-demand/aggregate-supply model to show the short-run effect of this pessimism on the economy. Label the new levels of prices and real output. Explain in words why the aggregate quantity of output supplied changes. (Use the sticky wage theory in your explanation)

b. Now use the diagram from part (a) to show the new long-run equilibrium of the economy. Explain what happens to P and Y at the new long run equilibrium. Explain in words why the aggregate quantity of output demanded changes between the short run and the long run. [No policy involvement]

c. Redraw the diagram in part a) to show the pessimism of firms Point A and Point B. Now assume that Bank of Canada uses monetary policy to put the economy back to the initial long run equilibrium. What should it do to restore the equilibrium? Show on the diagram the effect of the policy and the new long run equilibrium. How the long equilibrium in this case compares to the long run equilibrium in b) above?

Question 3:

a. Draw a diagram of each of the three markets for Canada (a small open economy): 1- Money Market; 2 - Output Market; 3- Foreign Exchange Market. [in the output market, you may draw only the demand curve]. The other two markets are in equilibrium with the supply and demand intersection.

b. Now suppose that U.S income rises. As a result, Canada's exports to US increase. What happens to the position of AD curve in the output market in Canada [Show this on the diagram you drew in part a) above] if Bank of Canada allows the exchange rate to be flexible. [Clearly explain what happens in all the markets and all the variables including real interest rate and real exchange rate and show the effects on the diagrams as well].

c. How will your answer to part b) change if the Bank of Canada maintains fixed exchange rate policy? If necessary, draw the diagrams again and explain clearly what will happen to AD demand curve and the variables in other markets including real interest rate, and real exchange rate.

Reference no: EM132600633

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