Question 1)

A) Is Keynes' treatment of expectations consistent with the rational expectation hypothesis?

B) What is meant by gents making "systematic errors" under adaptive expectations?

C) Assume that inflation expectation are formed rationally. Use the 3-equation model to show the adjustment of the economy to

1) a permanent demand and

2) a permanent supply shock

Provide a period by period explanation of the adjustment process. Make sure to mention the axes of the diagram and direction of the shift of the curves.

D) In part(c) how does the central bank reaction differ from the cases where we assumed adaptive inflation expectations.