This problem asks you to work out in more detail the example of reverse causation described in the text. Suppose that firms that expect to increase production in the future have to increase their current transactions (for example, they may need to purchase more raw materials). For this reason, current real money demand rises when expected future output rises.
a. Under the assumption that real money demand depends on expected future output, use the classical IS-LM model to find the effects of an increase in expected future output on the current price level. For simplicity, assume that any effects of the increase in expected future output on the labor market or on desired saving and investment are small and can be ignored.
b. Suppose that the Fed wants to stabilize the current price level. How will the Fed respond to the increase in expected future output? Explain why the Fed's response is an example of reverse causation.