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

Figure 5.14: The Cost of Disinflation with Unanchored vs. Anchored Expectations

Central Bank Policy in Response to an Inflationary Shock

Two countries, Country A and Country B, experience an identical, unexpected surge in global energy prices, causing a temporary spike in inflation. The central bank of Country A has a long-established, proven track record of keeping inflation at its target, whereas the central bank of Country B has a history of prioritizing short-term employment over its inflation target. Based on this information, which of the following outcomes is most likely?

Building Central Bank Credibility

A central bank with a well-established reputation for maintaining price stability will likely need to enact more drastic and sustained increases in interest rates to counteract an unexpected inflationary pressure than a central bank with a weaker reputation.

Impact of Central Bank Credibility on Economic Behavior