The 3-equation model (IS-PC-MR) form Carlin, W. and Soskice, D., 2006. Macroeconomics: imperfections, institutions, and policies.

Q: 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:

1. Suppose the economy exits from a trade and economic union. As a result, the economy suffers from a permanent loss in productivity. Carefully draw a 3-equation diagram and provide a period by period explanation of the adjustment process of the economy to its new medium-run equilibrium.

2. Now, suppose at the same time that the productivity falls, households cut their spending in anticipation of lower income. Use the 3-equation diagram and explain how the economy adjusts to its new medium-run equilibrium.

3. Draw the impulse response function of real interest rate for the above two scenarios. How does the movement in household spending matter for monetary policy making?