Suppose that the central bank strictly followed a rule of keeping the real interest rate at 3% per year. That rate happens to be the real interest rate consistent with the economy's initial general equilibrium. Assume a closed economy.
a. Assume that the economy is hit only by money demand shocks. Under the central bank's rule, how will the money supply respond to money demand shocks? Will the rule make aggregate demand more stable or less stable than it would be if the money supply were constant?
b. Assume that the economy is hit only by IS shocks.Under the central bank's interest-rate rule, how will the money supply behave? Will the interest-rate rule make aggregate demand more stable or less stable than it would be if the money supply were constant? Will the central bank be able to follow its rule in the long run?
c. Assume that the economy is hit only by supply shocks (shocks to the FE line). Repeat part (b).
d. Now assume a small open economy with a flexible exchange rate. Repeat part (a) with this assumption.
e. Still assuming a small open economy with a flexible exchange rate, repeat part (b).