The Role of Expectations in Inflation Dynamics
Consider an economy that experiences a sustained period of low unemployment, creating a persistent positive bargaining gap. Analyze and contrast the path of inflation over time under two different assumptions about how people form their expectations:
- Scenario A: People expect this year's inflation to be the same as last year's actual inflation rate.
- Scenario B: People have strong confidence in the central bank's target and always expect inflation to be 2%, regardless of the previous year's outcome.
In your answer, explain the mechanism driving inflation in each scenario and evaluate the long-term stability of the economy under each assumption.
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