38.A) As an economy moves into a recession, income falls. Illustrate graphically the impact of a decrease in income on the equilibrium interest rate using the theory of liquidity preference and the market for real money balances. Be sure to label: i. the axes; ii. the curves; iii. the initial equilibrium values; iv. the direction the curve shifts; and v. the terminal equilibrium values.B) Explain in words what happens to equilibrium interest rate as a result of the open-market purchase.A)B) The equilibrium interest rate falls. 4

39.Assume that initially everyone expects the price level to stay the same. Now the Federal Reserve announces that it will increase the rate of money growth in one year. People now expect inflation. Use the IS-LMmodel to illustrate graphically the impact of expected inflation on the level of output and on the real and nominal interest rates.

5

40.In early 1994, Mexico was adhering to a fixed-exchange-rate system. Use the Mundell-Fleming model to illustrate graphically the short-run impact on the exchange rate and level of output of increased country risk caused by the Chiapas uprising and the assassination of presidential candidate Colosio. Be sure to label: i. the axes; ii. the curves; iii. the initial equilibrium levels; iv. the direction the curves shift; and v. the new short-run equilibrium.

. 6

41.Assume that an economy is governed by the Phillips curve π= πe— 0.5(u— 0.06), where π= (P— P—1)/P—1, πe= (Pe— P—1)/P—1, and 0.06 is the natural rate of unemployment. Further assume πe= π—1. Suppose that, in period zero, π= 0.03 and πe= 0.03—that is, that the economy is experiencing steady inflation at a 3-percent rate.A) Now assume that the government decides to impose whatever demand is necessary to cut unemployment to 0.04. Suppose the government follows this policy for periods 1 through 5. Create a table of πand πefor these five periods.B) Assume that, for periods 6 through 10, the government decides to hold unemployment at 0.06. Create another table of πand πefor these five periods. Is there any reason to expect the inflation rate to go back to 0.03?C) If the government persisted in its behavior under part a, do you think the public would continue for long forming expectations according to πe= π—1? Why?A)Period πeπ1 0.03 0.042 0.04 0.053 0.05 0.064 0.06 0.075 0.07 0.08B )Period πeπ6 0.08 0.087 0.08 0.088 0.08 0.089 0.08 0.0810 0.08 0.08There is no reason to expect inflation to fall as long as U= UN.C) After a while, one would not expect the public to be fooled by steadily accelerating inflation. 7