Implications of Persistent Inflation Differentials for the Nominal Exchange Rate

Figure 7.7: Diagram of a Positive Demand Shock in an Economy without an Inflation Target (Spain Example)

In an economy where the central bank does not follow a publicly stated goal for the rate of price increases, a large, unexpected surge in household consumption occurs. According to the principles of wage and price setting, why might the rate of inflation continue to accelerate in subsequent periods, even after the initial consumption surge has ended?

An economy without a formal, credible policy to control the rate of price increases experiences a sudden, large increase in aggregate demand. Arrange the following events in the most likely chronological order to illustrate the resulting economic process.

Analyzing Persistent Inflation in a Hypothetical Economy

The Wage-Price Spiral without a Policy Anchor

Persistence of Inflation after a Temporary Shock

In an economy that lacks a credible, publicly announced policy for controlling the rate of price increases, a temporary positive shock to aggregate demand will cause a temporary rise in inflation that naturally returns to its original level once the shock has dissipated.

In an economy without a formal policy to stabilize the rate of price increases, a sudden, sustained rise in aggregate demand occurs. Match each economic phenomenon to its corresponding description within this specific context.

An economy, which does not have a formal policy to maintain a specific rate of price increases, experiences a large, temporary surge in export demand. This initially causes both production and the rate of price increases to rise. In the subsequent periods, after the export demand has returned to normal, what is the most likely outcome for the rate of price increases if firms and workers base their future wage and price decisions on the most recent inflation trends?

An economy initially has a stable 2% rate of price increases. It then experiences a one-year surge in export sales, which causes the rate of price increases to jump to 5%. In the year after the export surge has ended and sales have returned to their original level, the rate of price increases accelerates further to 6%. Which of the following provides the most direct explanation for the continued acceleration of price increases in the second year, assuming no formal policy to control the rate of price increases is in place?

Evaluating Competing Explanations for Persistent Inflation