3.

(i) What is a balance sheet recession? What factors make these recessions more difficult to recover from than normal recession? Illustrate a balance sheet recession in the 3- equation model.

(ii) Explain the difference between the real exchange rate channel and the real interest rate channel. Which of these channels must dominate for the economy to revert to equilibrium after a shock without any active policy response? Use the three-equation model to illustrate your answer.