Question

(a) Assume that at period 0 the central bank of Fairyland decided that its inflation target of 1% is too low and announced that it would increase it to 2% starting from period 1. Assuming backward–looking inflation expectations analyse how the economy would adjust to a new long–run equilibrium. Specifically, indicate what would happen to output and inflation in period 1, period 2 and afterwards. Use the AS/AD framework in your analysis (including well-labelled graphs).

(b) Would your answer to (b) change if economic agents set their inflation expectations rationally (i.e. ?? = ?̅)? Explain.

(c) What causes a movement along the AS curve and what causes the AS curve to shift?

Answer 1

C movement along the AS curve happen mainly when there is an increase or decrease in price whereas shift in supply curve happen when there is change in any other factor like preferences of the customers and technology etc. Movement in curve happen when other factors remains constant but shift in curve happen when price remain constant.

B if company set their expectation rationally, then their policies would have been better and as per the requirement of the economy and their output will increase as now they would have all measures to cope with the current level of inflation.