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