b. Based on the GDP deflator, what is the inflation rate from Year 1 to Year 2? (6%)

7. Comment on the following statement and show what would happen in the long run if such advice were followed by the Central Bank: "The increase in the stock market has increased people's wealth. As a result, their consumption has increased, increasing aggregate demand and output. So the Central Bank needs to increase the money supply, since with higher income, people's demand for real money balances will be higher." (12%)

8. Consider the Solow model. Country A has a capital-labor ratio (k) that is initially twice as big as that of country B, but neither is yet in a steady state. Both countries have the same production function, $$f(k) = 6k^{1/2}$$. Country A has a 10% saving rate, 10% population growth rate, and 5% depreciation rate, while country B has a 20% saving rate, 10% population growth rate, and 20% depreciation rate.

a. Calculate the steady-state capital-labor ratio for each country. How does the initial capital-labor ratio affect your results? (6%)

b. Calculate output per worker and consumption per worker for each country. Which country has the highest output per worker? The highest consumption per worker? (6%)

9. Use the Keynesian IS-LM model with flexible exchange rates for this question. Describe the effects of contractionary fiscal policy by the domestic government on output, the real interest rate, and net exports in both the domestic and the foreign country. (14%)

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