Quote: "Another significant factor influencing medium-term trends in inflation is the public’s expectations of inflation. These...

Quote: "Another significant factor influencing medium-term trends in inflation is the public’s expectations of inflation. These expectations have an important bearing on whether transitory influences on prices, such as changes in energy costs, become embedded in wage and price decisions and so leave a lasting imprint on the rate of inflation."

A. What did Bernanke mean when he said that the public’s expectations of inflation could become “embedded in wage and price decisions”? Please verbally and graphically explain using AD/AS analysis.

B. What would be the effect on the short-run Phillips curve of the public coming to expect a higher rate of inflation? Please verbally and graphically explain using the Phillips curve

Expert Solution

Answer:-

(A). Ben Bernanke means when he said that the public's expectations of inflation could become embedded" in wage and price decisions, that when the public expects the inflation rate to be high then it will take the inflation rate into account when making decisions.

For example, workers while negotiating their wage contract would expect their nominal wages to increase by the same percentage as the increase in expected inflation rate so that their real wages remain constant. While firms also adjust their purchase decisions on the basis of expected inflation rate so that their costs remain under control. Higher expected inflation rate had an impact throughout the economy. For example, when banks make loans, they are interested in the real interest rate on the loan. The real interest rate is the nominal interest rate minus the expected inflation rate. If a bank needs to receive a real interest rate of 3 percent on home mortgage loans and expect the inflation rate to be 1.5 percent, they will charge a nominal interest rate of 4.5 percent. If banks revise their expectations of the inflation rate to 4.5 percent, they will increase the nominal interest rate they charge on mortgage loans to 7.5 percent.

(B). If the public comes to expect a higher inflation rate then short-run Phillips curve would shift up, presenting the economy with a more unfavorable short-run trade-off between

Rahul Sunny answered 2 years ago

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