Q: Consider an economy at its medium-run equilibrium with output at ye and inflation at 0. The government's budget is balanced and households form their expectations adaptively. Now, suppose the government anticipates a(transitory) negative supply shock in the near future and therefore increases its current spending by borrowing:

1. Use the 3-equation model and diagrams to provide a period by period explanation of how the economy adjusts to its new medium-run equilibrium for the cases of(a) the shock actually does not take place and (b) the shock actually take place.

2. Draw diagrams of debt dynamics after the policy and explain how this policy would impact the debt to GDP ratio, b, of the economy in the long run. Describe a policy that the government can use to avoid an ever-rising/falling b if needed.

3. Is your answer to the question 1 the same if using the RE-PIH model instead of the the3-equation model? Explain.