Consider an economy at its medium-run equilibrium with output at ye and inflation at the target level of t. Assume that policy affects the economy with a one-period lag and households form their expectations adaptively. Answer the following questions:

a. Suppose the economy exits from a trade and economic union. As a result, the economy suffers from a permanent loss in productivity.

b. Now, suppose at the same time that the productivity falls, households cut their spending in anticipation of lower income.

1. Draw the impulse response function of real interest rate for the above two scenarios.

2.How does the movement in household spending matter for monetary policy making?