Suppose that the Fed's inflation target is 2%, potential output growth is 3.5%, and velocity is a function of how much the interest rate differs from 5%: % triangle v=0.5 x (i-5)

Question

Suppose that a model of the economy suggests that the real interest rate is determined by the equation:
r =8.5-% triangle Y
where Y is the level of output, so %triangle Y is the growth rate of output. Suppose that people expect the Fed to hit its inflation target.

A: Calculate the optimal money growth rate needed for the Fed to hit its inflation target in the long run.

B: In the short run, if output growth is just 2% for two years and the equation determining the real interest rate changes to r = 4.5- %triangle Y, what money growth rate should the Fed aim for to hit its inflation target in that period?
C: If the Fed instead maintained the money growth rate from part A, what is likely to happen to inflation?
D: Which policy do you think is better in the short run? Which is better in the long run?