Question

In chapter 12 the dynamic inconsistency problem was discussed with reference to the Philips curve. Discuss the same issue using the aggregate demand-aggregate (MPRF) aggregate-supply (AS) model

Answer 1

The idea of dynamic inconsistency arises when lower than expected inflation rates damage the economy in the form of high unemployment.Monetary policy makers suffer from dynamic inconsistency with inflation expectations, as politicians are best off promising lower inflation in the future. But once tomorrow comes lowering inflation may have negative effects, such as increasing unemployment, so they do not make much effort to lower it. Thus the net result is that inflation remains high as the trade of between inflation and unemployment cannot be managed. So in case of the AD curve a lower than expected inflation rate will mean that the AD curve will shift leftwards and the aggregate supply curve will also shift rightwards to lower the price level. As the inflation rate is lower the level of unemployment will rise which will demage the economy and so inflation remains at the older level or slightly lower than that. This will mean that as the AD curve shifts leftwards the output and price level are lower than expected as the establishment fails to raise it. This is in effect the Philips curve trade off which policy makers face.