Suppose that the monetary authority wants to keep the nominal interest rate, i, constant. Assume that the real interest rate, r, is fixed. However, the real demand for money, M^(d)/P shifts around a great deal.
a) How should the monetary authority vary the nominal quantity of money, M, if the real demand for money, M^d increases temporarily? What if the real demand increases permanently?
b) How does the price level, P, behave in your answers to question a? What should the monetary authority do if it wants to dampen fluctuations of P, as well as maintain a constant nominal interest rate, i?