On Mermaid island ( a closed economy in the SR), The Mermaids are in a pickle. Someone has decided to counterfeit money. Unfortunately, the counterfeiter is excellent at her job and it is impossible to know the difference between the real and fake money.

Their economy can be expressed as:

C = 50+0.95(Y-T)

T = 2000

G =2000

I = 1000-50r

M = 10000

P = 2

L(r,Y) = Y -200r

While the initial impact of the counterfeit money (M=10,000 to 20,000) is that output will jump, some are worried that the inhabitants will stop using it as a medium of exchange, and the economy would be reduced to bartering – creating a depression.

Your job, as a policy maker is to see how you might be able to neutralize the impact of the money and increase demand,

Good Luck! May you return from Mermaid Island! Answer the following questions:

Question 1 (2 points)

1. Calculate the initial situation (M=10,000) and show the resulting aggregate variables in a table format. (similar to case 2) 
2. Calculate the situation with increase money supply (M=20,000) and show the resulting aggregate variables in a table format next to a).

Question 2 (2 point)

The government has tasked you with neutralizing the impact of the additional money in circulation, you can ONLY use fiscal policy (G, T or a combination of both) (the central bank does not want to reduce its own money supply) to bring back the interest rate to where it was.

Find 2 fiscal options to return r to 15 and show the resulting aggregate variables in a table format

Question 3 (1 points)

Could the government, instead of using fiscal policy, change investor behaviours (change the function)? Propose a policy which would bring back the interest rate top where it was. Make sure you also talk of how it impacts the economies agents and aggregate values (C,I,S,… and Y).

Your policy proposal idea is just a best guess, but the function (I) you use does need to be correct.

Question 4 (1 points)

Could the government, instead of using fiscal policy, change Consumer behaviours  (change the function)? Propose a policy which would bring back the interest rate top where it was. Make sure you also talk of how it impacts the economies agents and aggregate values (C,I,S, … and Y).

Question 5 ( 2 points)

What mermaid Island was scared of taking place; that the fake money would result in inflation has taken place, prices have increased 5 fold as Mermaids are scared they will get fake money. (P=2 to P=10). Find the new equilibrium of the Island  (C,I,S, r ,… and Y).

This questions is independent of question 2,3 and 4.

Question 6 ( 2 points)

What do you propose – as a fiscal policy – to do to being back this economy to where it was (the initial Y) if you can?

In this question, your tasked with dealing with dealing with the collateral damage that inflation has created. A LOT of variables will be impacted when you do something. Are all outcomes bad or are there some that are ok?