consider an economy in which the demand for money is of the form

Y / (1 + it)

for t = 0, 1, 2, · · · , where output is 150 and it denotes the nominal interest rate in period t. The real interest rate, denoted r, is constant and equal to 4%. In period

0 and 1, the money supply is 100 and people expect that money supply would

be 100 forever. People have rational expectations. In period 2, the central bank

surprises people and sets the money supply will grow at 2 percent forever, that is,

M0 = 100, M1 = 100, M2 = (1.02)M1, M3 = (1.02)M2, and so on.

A. Find the inflation rate, nominal interest rate, real money balance in period 1,

and expected inflation in period 2, given the information available in period

1, π1, i1, M1/P1 and, E1π2.

B. Find the inflation rate, nominal interest rate, real money balance in period 2, and expected inflation in period 3, given the information available in period

2, π2, i2, M2 / P2 and, E2π3.

C. Find the inflation rate, nominal interest rate, and real money balance in period 3, π3, i3, and M3 / P3

.

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