Evaluating Competing Explanations for Persistent Inflation
An economy experiences a large, one-time government spending increase. In the year of the spending, the rate of price increases rises from 2% to 5%. In the following year, after the spending has returned to its normal level, the rate of price increases rises further to 6%.
Two economists offer explanations for the continued rise in the second year:
- Economist A: "The continued inflation is a delayed effect of the initial spending shock. It simply takes more than a year for the full impact on prices to be felt throughout the supply chain."
- Economist B: "The continued inflation is due to a shift in how businesses and workers form their expectations. The initial price rise led them to anticipate further price increases, influencing their subsequent wage and price decisions."
In a system where there is no formal, publicly-known policy to control the rate of price increases, which economist's argument provides a more robust explanation for the acceleration of inflation from 5% to 6% in the second year? Justify your choice by explaining the underlying economic mechanism.
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Figure 7.7: Diagram of a Positive Demand Shock in an Economy without an Inflation Target (Spain Example)
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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