Question

3. The two paths to the mediun-run equilibrim explored in this chapter make two different assumptions about the formation of the level of expected inflation. One path assumes the level of expected inflation equals lagged inflation. The level of expected inflation changes over time. The other path assumes the level of expected inflation is anchored to a specific value and never changes. Begin in medim-run equilibrium where actual and expected inflation equals 2% in period t. a. Suppose there is an increase in consumer confidence in pe- riodt1. How does the IS curve shift? Assume that the central bank does not change the real policy rate. How will the short-run equilibrium in period t 1 compare to the equilibrium in period t? b. Consider the period t 2 equilibrium under the assump- tion that π1+2-m-1. If the central bank leaves the real policy rate unchanged, how does actual inflation in period t2 compare to inflation in period t +1 How must the central bank change the nominal policy rate to keep the real policy rate unchanged? Continue to period t+ 3 Making the same assumption about the level of expected inflation and the real policy rate, how does actual inflation in period t 3 compare to inflation in period t 2 c. Consider the period t + 2 equilibrium making the as- sumption that π1+2-π. If the central bank leaves the real policy rate unchanged, how does actual inflation in period 2 compare to inflation in period t 1? How must the central bank change the nominal policy rate to keep the real policy rate unchanged? Continue to period t3. Making the same assumption about the level of expected inflation and the real policy rate, how does

Answer 1

Answer. This is related to the expectations. There are two types of expectations, Adaptive expectations and Rational expectations.

Adaptive expectations: In this, agents assumes that the future value will depend upon the $\Theta$ times the previous year value.

Rational Expectations: In this, agents assumed that the future value not only depends upon the previous year's value but depends on other factors also.

(A) Now, in period t,, inflation is 2%. If there is a rise in consumer confidence, then spending will increase. It will shift IS curve to the right and AD curve will also shift to right. As aggregate demand rises, prices also rises with it. Hence, inflation in period t+1 rises.

(B) If expected inflation in t+2 = inflation in t+!, then it remains same. If the policy changes, only then it will change.

(C) This is the case of adaptive expectations, in which they are expecting the future inflation rate to rise by 'k', were k is constant.