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The 3-equation model and expectations Assume that inflation expectations are formed rationally. Use the 3-equation model to show the adjustment of the economy to a

The 3-equation model and expectations

Assume that inflation expectations are formed rationally.

  1. Use the 3-equation model to show the adjustment of the economy to a permanent demand and a permanent supply shock.
  2. Provide a period by period explanation of the adjustment process (as done in chapter 3).
  3. How does the central bank reaction differ from the cases where we assumed adaptive inflation expectations (as shown in chapter 3)?

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