How Anchored Expectations Reduce the Cost of Disinflation

Imagine two countries, Country A and Country B, both of which have a central bank with an official inflation target of 2%. The central bank of Country A has a long, established history of consistently taking action to keep inflation near 2%. The central bank of Country B, however, has a history of frequently allowing inflation to drift far from its 2% target without a decisive response. If both countries experience an identical, unexpected economic shock that temporarily pushes inflation up to 5%, in which country are long-term wage and price-setting behaviors more likely to remain stable, and why?

Central Bank Credibility and Inflation Expectations

The Mechanism of Anchoring Inflation Expectations

The Consequences of Unanchored Inflation Expectations

A central bank that consistently allows inflation to remain above its stated target without taking decisive action will find that the public's long-term inflation expectations become more firmly anchored to the official target.

Match each description of a central bank's policy history with the most likely state of the public's inflation expectations in that country.

A country's central bank, previously known for inconsistent policies, wants to firmly establish its credibility and anchor the public's long-term inflation expectations at a new, lower target. Arrange the following events in the most logical sequence that would lead to this outcome.

A country's central bank has maintained a credible 2% inflation target for many years, leading to stable public expectations. A new government administration begins to publicly pressure the central bank to tolerate a higher inflation rate (e.g., 4-5%) for the next several years to stimulate short-term economic growth. If the central bank yields to this pressure, what is the most significant long-term risk associated with this policy shift?

Central Bank Policy Choice After a Supply Shock

In an economy where the central bank has a long and credible history of maintaining its 2% inflation target, a sudden, temporary increase in energy costs pushes the current inflation rate to 5%. In this scenario, businesses and workers are less likely to build this 5% rate into long-term wage negotiations and price-setting decisions because they expect the central bank's actions will cause inflation to ultimately ____.