1

a) Is Keynes' treatment of expectations consistent with the rational expectations hypothesis? (3 points) b) What is meant by gents making 'systematic errors' under adaptive expectations? (2 points) c) Assume that inflation expectations are formed rationally. Use the 3 - equation model to show the adjustment of the economy to i) a permanent demand and ii) a permanent supply shock. Provide a period by period explanation of the adjustment process. (Make sure to mention the axes of the diagram(s), and the direction of the shift of the curve(s)). (3 + 3 = 6 points) d) In part (c), how does the central bank reaction differ from the cases where we assumed adaptive inflation expectations? (2 points)