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Suppose that the liquidity function is given by: L(Y,i) = 2 x Y X I^(-0.5) **2 times Y times i to the exponent -0.5.** Where Y is real GDP and i is the nominal interest rate. a) Suppose that the money supply is equal to 1,000 dollars, real GDP is equal to 1000 and the nominal interest rate is equal to 3%. What is the price level? Use i=3 in your formula, not i =.03!. b) Suppose that the nominal interest rate increases to 5%. What is the new price level? Explain in words why this represents a failure of the Quantity Theory of Money. c) What is the interest elasticity of money demand? If the nominal interest rate increases from 10 to 12.5 percent, by what percent does the demand for money change? Please note both the direction (positive or negative) and size (%) of this change. d) The Bank of Canada does not choose the money supply directly. Instead they use the nominal interest rate to achieve their policy objective, which is stable inflation at 2%. Suppose that real GDP grows by 2% and the Central Bank targets 2% inflation. If the poli rate decreases by 2%, what must happen to the money supply?

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