Reduced Cost of Disinflation with Anchored Expectations Despite Policy Delays

Comparing Disinflationary Policies

Two countries, Credibilia and Volatilia, both have central banks targeting 2% inflation. Credibilia's central bank has a strong, long-term track record of meeting its target, and the public firmly believes it will continue to do so. Volatilia's central bank has a history of inconsistent policy, and the public is skeptical about its commitment to the 2% target. If both countries are hit by an identical, temporary external shock that pushes inflation to 5%, which outcome is most likely?

The Role of Expectations in Disinflation

The Economic Cost of Disinflation

An economy with well-anchored inflation expectations experiences a temporary adverse supply shock that pushes inflation up. Arrange the following events in the most likely chronological order as the central bank works to bring inflation back to its target.

If a central bank has successfully anchored inflation expectations at its 2% target, a temporary supply shock that pushes inflation to 5% will cause a permanent upward shift in the relationship between inflation and unemployment, forcing the central bank to induce a severe recession to restore price stability.

Match each economic scenario describing inflation expectations with the most likely outcome regarding the economic cost (in terms of lost output or higher unemployment) of reducing inflation.

Central Bank Policy Dilemma After a Supply Shock

An economy has a long-established and credible central bank that targets 2% inflation. A temporary global supply disruption causes inflation to spike to 5%. The central bank reaffirms its commitment to the 2% target. Why is the economic downturn required to bring inflation back to 2% likely to be less severe in this economy compared to one with a less credible central bank?

When a central bank has established strong credibility, an unexpected rise in inflation may not lead wage and price setters to demand large increases, because they trust the inflation spike is temporary. This phenomenon, known as having well-______ expectations, prevents a persistent upward shift in the inflation-unemployment trade-off, thereby reducing the amount of lost output needed to return to the inflation target.