Question

3. Explain what is meant by the following statement: "disinflation can be costless if the central bank is perfectly credible". Draw the impulse response functions for output, inflation and the real interest rate following an inflation shock and interpret your results, when:

   (a) inflation expectations are fully backward looking
   (b) inflation expectations are firmly anchored to the inflation target.

Answer 1

Solution -

If the inflation targets are firmly anticipated, then in the backdrop of the shaking, Philips does not change the curve, as long as inflation does not change. A fully credible central bank receives strongly excited expectations. Therefore, if they are announced new, reducing the target of inflation and if it is completely reliable, the output output will go to new balance without the need. In other words, the reversal is low and the impulse response response does not show any change in the output or unemployment; There will be a completely transit effect on inflation. There is a need for a back-to-back increase in unconstitutional expectations of unconstitutional, unemployment in order to target inflation again.