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. 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. How would you change your answer if expectations are rational and the FED is credible?

QUESTION

SECTION 1Because 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?

SECTION 2

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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. 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. How would you change your answer if expectations are rational and the FED is credible?
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Your uncle is pleased to hear you are taking macroeconomics; the whole financial crisis of 2008-2009 puzzled him. He was not happy about “bailing” out the banks. He is pretty good with graphs, so do not be afraid to use the IS-MP framework to explain the following:

  • How does the rapid decline of the housing market and the subprime implosion affect the macroeconomy?
  • Why the monetary policy was not being effective to stimulate the economy?
  • And why, pray tell, would we bail out the banks? Aren’t there potential long-run problems with doing this?

ANSWER

The Impact of Increasing the Inflation Target: A Long-Term Analysis using the AD/AS Framework

Introduction

Inflation targeting plays a crucial role in guiding monetary policy decisions to ensure price stability and promote economic growth. This essay examines the proposition that increasing the inflation target from 2 percent to 3 percent, particularly during the economic environment of 2007-2010, can yield beneficial outcomes. Using the AD/AS framework, we will analyze the short and long-term effects of such a policy change, considering both non-rational and rational expectations scenarios, while accounting for the credibility of the Federal Reserve (Fed).

Short-Run Analysis

In the short run, an increase in the inflation target would lead to a temporary shift in the aggregate demand (AD) curve. With a higher inflation target, consumers and businesses may expect higher future prices, leading to an increase in current spending (The Future of Inflation Part I: Will Inflation Remain High?, 2022). This would result in a rightward shift of the AD curve, reflecting higher aggregate demand and output levels. The expansionary monetary policy required to achieve the higher inflation target would lead to lower interest rates, encouraging investment and consumption.

However, in the short run, supply-side constraints may limit the ability of the economy to meet the increased demand. As a result, the economy may experience inflationary pressures, as aggregate supply (AS) struggles to keep pace with the higher aggregate demand. This could lead to a temporary increase in prices, eroding the purchasing power of consumers and potentially causing adverse effects on real output.

Long-Run Analysis

In the long run, the economy adjusts to the changes in the inflation target. If expectations are non-rational, it may take time for economic agents to fully adjust their behavior to the new inflation target. This adjustment process could involve higher wage demands, leading to higher production costs and a leftward shift of the AS curve. The result would be a return to the original long-run equilibrium but at a higher price level.

However, if expectations are rational and the Fed is seen as credible in achieving the new inflation target, the adjustment process would be smoother (“Modifying the Fed’s Policy Framework: Does a Higher Inflation Target Beat Negative Interest Rates? | Brookings,” 2022). Economic agents would quickly incorporate the higher inflation target into their expectations, leading to less disruption in wages and production costs. In this case, the long-run equilibrium would be characterized by a higher price level, but with sustained economic growth and stable output.

Impact of Rational Expectations and Credible Fed

When expectations are rational and the Fed is viewed as credible, the impact of increasing the inflation target becomes more favorable (Salle et al., 2018). Rational economic agents, anticipating the higher inflation target, adjust their behavior accordingly. This reduces the likelihood of supply-side constraints and excessive wage demands, allowing the economy to transition more smoothly to the new equilibrium.

Additionally, a credible Fed enhances the effectiveness of monetary policy. With a track record of successfully achieving its inflation targets, the Fed gains credibility and the ability to influence expectations. This credibility enables the Fed to manage inflationary pressures and stabilize the economy more effectively, ensuring a smoother transition to the new inflation target.

Conclusion

Increasing the inflation target from 2 percent to 3 percent can have significant implications for the economy, both in the short and long run. While the short-run effects may include increased aggregate demand and potential inflationary pressures, the long-run impact is highly dependent on the rationality of expectations and the credibility of the Fed. If expectations are rational and the Fed is seen as credible, the adjustment process becomes smoother, leading to sustained economic growth and price stability in the long run. Properly assessing these factors is crucial for policymakers when considering changes to the inflation target, particularly in challenging economic environments.

References

Modifying the Fed’s policy framework: Does a higher inflation target beat negative interest rates? | Brookings. (2022, March 9). Brookings. https://www.brookings.edu/blog/ben-bernanke/2016/09/13/modifying-the-feds-policy-framework-does-a-higher-inflation-target-beat-negative-interest-rates/ 

Salle, I., Senegas, M., & Yildizoglu, M. (2018). How transparent about its inflation target should a central bank be? Journal of Evolutionary Economics, 29(1), 391–427. https://doi.org/10.1007/s00191-018-0558-4 

The Future of Inflation Part I: Will Inflation Remain High? (2022, April 12). IMF. https://www.imf.org/en/Publications/fandd/issues/2022/03/Future-of-inflation-partI-Agarwal-kimball 

 

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