This question requires using the 3-equation and New Keynesian models to analyse the adjustment of the economy after a negative demand shock. Assume the economy is initially in equilibrium and the negative output gap lasts for a set amount of time.

(a) Draw the impulse response functions for inflation and the output gap for each model (as per Fig. 16.6).

(b) Explain why the paths of inflation are different in each model.

(c) How would the adjustment path change for the 3 -equation model if a proportion of households exhibit permanent income behaviour and have rational expectations?