Suppose that instead of persisting as is assumed in problem 2, the decline in the real exchange rate is only temporary in that after the initial change in the price level that you found in part c od problem 2, aggregate demand returns to its original level.

A. Given that monetary policymakers, firms, and workers all recognize that the decline in the real exchange rate is only temporary and given the three policy responses described in part d of 580 Chapter 17 New Classical Macro Confronts New Keynesian Macro problem 2, again calculate what the long-run equilibrium price level is and what the expected price level is under each response by monetary policymakers. Again calculate by how much monetary policymakers must change the nominal money supply for the expectations of firms and workers to be realized

B. Compare your answers to part d of problem 2 with those of part a of this problem and explain why they are different.

C. Explain what data or other factors that monetary policy makers, firms, and workers might analyze in attempting to determine if the decline in the real exchange rate is temporary or will persist. Finally, suppose that monetary policymakers are better able than firms and workers to determine if a change in the real exchange rate is temporary or will persist and that firms and workers know this. Given your answer to part d of problem 2 and part a of this problem, explain how once monetary policymaker have determined whether the change in the real exchange rate is only temporary or will persist, they could signal their finding to firms and workers.

2. Suppose that the equation for the aggregate demand is Y = $9,000 +Ms/P, where Ms is the nominal money supply and P is the price level. Initially the nominal money supply equals $3,000. In addition, suppose that the expectations of firms and workers are rational in the sense defined on P. 557

a. Calculate points on the aggregate demand curve when the price level equals 0.8, 1.0, 1.2, 1.25, and 1.5, given the initial value of the nominal money supply.
Solution:
We are given that money supply, Ms is $3,000.
If price level equals 0.8, the points on aggregate demand is Y = $9000 + ($3000)/0.8 = 12,750
If price level equals 1.0, the points on aggregate demand is Y = $9000 + ($3000)/1.0 = 12,000
If price level equals 1.2, the points on aggregate demand is Y = $9000 + ($3000)/1.2 = 11,500
If price level equals 1.25, the points on aggregate demand is Y = $9000 + ($3000)/1.25 = 11,400
If price level equals 1.5, the points on aggregate demand is Y = $9000 + ($3000)/1.5 = 11,000
The following points are on the aggregate demand curve: (12,000, 1.0), (11,500, 1.2), (11,400, 1.25), and (11,000, 1.5).

b. Suppose that natural real GDP equals $12,000 and that the short run supply curve is given in the table below, where the price surprise equals P - Pe and Pe is the expected price.

Price surprise -0.2, 0.0, 0.2, 0.25, 0.5
Real GDP 11,900 12,000 12,100 12,125 12,250

c. Suppose that the real exchange rate declines as it did in 2006-2007 and as a result, aggregate demand increases. Also assume that the decline in the real exchange rate will persist over time. As a result of this decline the new equation for the aggregate demand is Y = $9,000+Ms/P. Given no change in the nominal money supply, calculated the points on the new aggregate demand curve when the price level equals 0.8, 1.0, 1.2, 1.25 and 1.5 given the initial value of the nominal money supply. Using the table given in part b, explain what the new equilibrium price level and level of real GDP are in the short run given the price surprise induced by the decline in the real exchange rate.
Solution:

Decrease in real exchange results in increase in aggregate demand so that the new equal for the aggregate demand curve is
Y = $9,600 + M s/P given that initial value of money supply is $3000.
If price level equals 0.8, the points on aggregate demand is Y = $9600 + ($3000)/0.8 = 13,350
If price level equals 1.0, the points on aggregate demand is Y = $9600 + ($3000)/1.0 = 12,600
If price level equals 1.2, the points on aggregate demand is Y = $9000 + ($3000)/1.2 = 12,100
If price level equals 1.25, the points on aggregate demand is Y = $9000 + ($3000)/1.25 = 12,000
If price level equals 1.5, the points on aggregate demand is Y = $9000 + ($3000)/1.5 = 11,600
The following points are on the aggregate demand curve: (12,600, 1.0), (12,100, 1.2), (12,000, 1.25), and (11,600, 1.5).

New equilibrium price equals 1.2 in short run because new level of aggregate demand and short-run aggregate supply are equal to real GDP at 12,100

d. Monetary policymakers respond to the decline in the real exchange rate in one of three ways

(i) they do nothing and leave the nominal money supply as is.

(ii) They change the money supply so as the return the price level as given in part b.

If monetary policymakers change the money supply so as to return the price level to 1.0, which was given in Part b, then the nominal money supply, Ms,

12,000 = $9,600 + Ms/1.0

Ms/1.0 = $12,000 - $9,600

Ms = $2,400

Therefore, monetary policymakers should reduce the nominal money supply to 2,400 for the price level and the expected price level to be 1.0.

(iii) they change the money supply so as to maintain the price level as determined by your answer to part c

Solution:

If monetary policymakers change the money supply so as to return the price level to 1.2, which was given in Part c, then the nominal money supply, Ms,

12,000 = $9,600 + Ms/1.2

Ms/1.2 = $12,000 - $9,600

Ms = $2,400*1.2

Ms = $2880

Therefore, monetary policymakers should reduce the nominal money supply to 2,880 for the price level and the expected price level to be 1.2.

For each of these cases, assume that this is how monetary policymakers have behaved in response to the decline in the real exchange rate. Calculate what the long-run equilibrium price level is and what the expected price level is under each response by monetary policymakers. Calculate by how much monetary policymakers must change the nominal money supply for the expectations of firms and workers to be realized.