Reduced Cost of Disinflation with Anchored Expectations Despite Policy Delays
The benefits of anchored expectations in lowering the cost of disinflation persist even if the central bank is slow to adjust its monetary policy. Because expectations remain fixed on the target, a delayed policy response does not lead to the entrenchment of higher inflation, thus avoiding the need for a more severe economic contraction to restore price stability.
0
1
Tags
Economics
Economy
Introduction to Macroeconomics Course
Ch.5 Macroeconomic policy: Inflation and unemployment - The Economy 2.0 Macroeconomics @ CORE Econ
The Economy 2.0 Macroeconomics @ CORE Econ
CORE Econ
Social Science
Empirical Science
Science
Related
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.
Learn After
Consider two economies, Country X and Country Y, both aiming for a 2% inflation target. Both experience an identical, unexpected event that pushes their inflation rates up to 5%. The central bank in both countries waits six months before raising interest rates to combat the inflation. In Country X, the public remains confident in the central bank's commitment, and long-term inflation expectations stay firmly at 2%. In Country Y, the public's confidence wavers, and long-term inflation expectations drift up to 4%. Based on this information, what is the most likely outcome when both central banks eventually tighten policy?
Central Bank Credibility and Policy Delays
The Central Bank of Arcadia's Policy Dilemma
Monetary Policy Lags and Public Confidence
If a central bank delays its response to an inflationary shock, the economic cost of bringing inflation back to target will inevitably be high, because the delay allows inflationary pressures to become embedded in the economy, regardless of the public's long-term inflation expectations.
Match each economic scenario describing a central bank's response to an inflationary pressure with its most likely outcome.
Evaluating a Central Bank's Delayed Policy Response
Central Bank Patience and Public Trust
The Interplay of Policy Lags and Public Confidence
A country with a credible central bank and a 2% inflation target experiences an unexpected event that pushes inflation up to 5%. The central bank, however, does not immediately tighten its monetary policy. Arrange the following events in the most likely chronological order that demonstrates the effect of well-anchored inflation expectations in this situation.