The Necessity of a Costly Recession to Counter Unanchored Expectations After a Supply Shock
Following a supply shock, if a central bank's delayed response allows inflation expectations to become unanchored, it must induce a recession that is more severe than what is required simply to reach the new, lower supply-side equilibrium. This seemingly 'wasteful' policy of pushing employment below the new equilibrium becomes necessary to break the entrenched higher inflation expectations. This costly measure can be entirely avoided if expectations remain anchored to the inflation target, as in that case, the Phillips curve does not shift and a less severe policy adjustment is sufficient.
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Introduction to Macroeconomics Course
Ch.5 Macroeconomic policy: Inflation and unemployment - The Economy 2.0 Macroeconomics @ CORE Econ
The Economy 2.0 Macroeconomics @ CORE Econ
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Friedman's Argument: How Adaptive Expectations Fuel Accelerating Inflation
Disinflationary Process from a Sustained Recessionary Shock
Symmetrical Inflationary Dynamics in Booms and Recessions
The Accelerating Wage-Price Spiral
Role of Expectations in Determining Inflation Persistence After a Cost-Push Shock
The Necessity of a Costly Recession to Counter Unanchored Expectations After a Supply Shock
Closed Economy Assumption in the Unit 4 Inflation Model
An economy is in a stable equilibrium with an unemployment rate of 5% and an inflation rate of 2%. Workers and firms have consistently expected inflation to be 2%. A central bank policy announcement then causes the public to credibly revise their inflation expectations for the next year to 4%. Assuming the unemployment rate remains at 5%, what is the most likely immediate outcome for the actual inflation rate, and why?
The Impact of Shifting Inflation Expectations
Analyzing an Expectations Shock
Arrange the following events to illustrate the causal chain through which an increase in inflation expectations leads to a higher actual rate of inflation for any given level of unemployment.
Central Bank's Mechanism to Halt Supply-Shock Inflation
Figure 5.13: An Inflationary Supply Shock
The Necessity of a Costly Recession to Counter Unanchored Expectations After a Supply Shock
Central Bank Policy Dilemma After a Supply Shock
An economy experiences a sudden, sharp increase in the price of all imported raw materials, leading to higher production costs for most businesses. In response, the central bank announces it will prioritize maintaining the current level of employment and will avoid any immediate actions that might slow down the economy. Based on this policy choice, what is the most significant risk the central bank is accepting?
Evaluating a Central Bank's Policy Response to a Supply Shock
An economy, initially at a stable rate of inflation and employment, is hit by a severe drought that drastically reduces agricultural output and pushes up food prices. Fearing that this price spike will lead to widespread, persistent inflation, the central bank immediately implements a very aggressive policy of raising interest rates significantly. Which of the following outcomes is the most significant risk associated with the central bank's aggressive action?
The Role of Central Bank Credibility in Anchoring Inflation Expectations
The Challenge of Economic Forecasting for Policymakers
Learn After
Figure 5.14: The Cost of Disinflation with Unanchored vs. Anchored Expectations
Central Bank Policy Dilemma
A country experiences a major, persistent disruption to its supply chains, causing a sharp rise in inflation. The central bank, hoping the disruption is temporary, delays any significant policy response for over a year. During this time, public surveys indicate that most people and businesses now expect inflation to remain high. To restore its original inflation target, which policy action is now necessary, and why?
The Cost of Central Bank Inaction
An economy, initially in equilibrium, is hit by a negative supply event. The central bank's delayed reaction allows inflation expectations to rise. Arrange the following events in the correct chronological and causal order that describes the costly process of restoring the original inflation target.
After a permanent negative shock to an economy's productive capacity, a central bank can guide the economy to its new, lower potential output level and restore the original inflation target without causing unemployment to rise temporarily above its new, higher long-run rate, provided that the public continues to believe the central bank will maintain the original inflation target.
Evaluating Central Bank Strategies After a Supply Shock
Following a negative supply shock that reduces an economy's potential output, match each term with its correct description in the context of central bank policy and inflation expectations.
Following a negative supply shock, the necessity for a central bank to induce a recession that pushes employment below its new, lower long-run equilibrium level is driven by the need to forcibly lower the public's entrenched ____.
An economy is in equilibrium with stable prices and employment (Point A). It then experiences a permanent negative supply shock, which lowers the sustainable level of employment and raises inflation, moving the economy to Point B. The central bank delays its response, causing the public to expect high inflation to persist. This change in expectations shifts the economy to a new position (Point D) with the same low employment as Point B but even higher inflation. To restore the original inflation target, what path must the economy now follow to reach its new long-run equilibrium (Point C), which is characterized by the original inflation target and the new, lower sustainable employment level?
Central Bank Policy Recommendation