Question

2. This exercise requires you to compute inflationary expectations based on a simple formula, and it will help you to understand why backward-looking expectations adjust slowly to changes in economic events. Suppose that the actual inflation rate in yeart is denoted II. Expected inflation for yeart + 1 is denoted 1-1. Now, suppose that workers and firms form their expectations according to 1+1 = ent + (1 - 0), (with 0 <e<1) where IT is the central bank's announced inflation target. This simple equation says that people's expectation for inflation at t + 1 are a weighted average of last year's actual inflation rate and the central bank's currently announced target. We will use this equation to see how the size of determines the extent to which expectations are backward-looking. Consider the table below, which shows the data for a reduction in actual inflation from 10 percent to 2 percent. (10 marks) Year (t) O = 0.1 = 0.9 ma 10 2 2 2 a. Assume that is equal to 0.1. Compute expected inflation for each year and fill in the table. b. On a scale diagram, plot the time path of actual inflation, expected inflation, and the inflation target. c. Now assume that equals 0.9. repeat parts (a) and (b). d. Which value of corresponds to more backward-looking expectations? Explain. e. Given the different speed of adjustment of inflation expectations, predict which disinflation is more costly in terms of lost output - the one with @ = 0.1 or with 8 = 0.9. Explain.

Answer 1

Solution 2 The table hous been completed for both values of o Year Tanget inflation at Coment intalion T&01) (8:09) 9.2 2.8 2.4 -o in lortu b The plot is provided below:

infiationary expectations Current inflation Inflation > Expected inflation (02011 Targenflation inglese - a 1 2 3 5 6 7 8 4 year Table in part a) haus values of expected inflation for 0 -0.9 The goaph is plotted below. 27 Inflationary expectations inflation Corrent inflation. Expected inflation (020.9) a ty Target mflation T 1 2 3 4 5 6 7 8 year

& Expectatiềns are bouckwand looking and to be following inflation when 0 - 0.1 graph plot confirms this 1 @ When o=009 inflationary expectations are wide apart from current inflation and so there is a greater dangen that disinflation is more Costly. This is perhaps because when current inflation follows expected inflation, economic argents can be predictable about the economy with wide difference between the two, business pessimism might set in.