Question

QUESTION 13

SECTION 1
Because deflation is so costly, some have argued that setting an inflation target at 2 percent is too low and it should be set higher, to 3 percent, especially in the economic environment of 2007–2010.

1. Consider the impact of such an increase in the inflation target using the AD/AS framework in the short and long run. Begin your analysis in the long-run equilibrium.
2. How would you change your answer if expectations are rational and the FED is credible?

Answer 1

a) As people have adaptive expectations, rising inflation every year will induce them to purchase durable goods this year inspite of purchasing it next year. It will raise aggregate demand in short run from AD to AD1 which will raise price level as well as output level.

In long run, as there is increase in aggregate demand in the economy, producers will raise aggregate supply of goods such that they can supply enough goods and raise their profit level. Rise in aggregate supply will reduce price to its initial level but raise output level further.

b) If people are rational and does not expect inflation from its past behavior. They judge that as inflation rose last year, there would be less inflation this year because Fed would take necessary actions to remove this.

People expect that inflation will fall next year, they will postpone their consumption of durable goods which will reduce aggregate demand in short run which shifts aggregate demand curve from AD to AD1 and reduces price as well as output level. In long run, producers will reduce their production of goods to avoid inventories which will shift aggregate supply curve to its left which will raise price to its initial level but reduce output level further.