Figure 12.23 on p. 377 shows the effects of an adverse supply shock in the AE/PC model. The figure assumes adaptive inflation expectations: n = n(-1) and shows how the economy evolves if the central bank accommodates the supply shock and if it doesn’t. Now suppose the central bank adopts an explicit inflation target, nT. Inflation expectations become anchored at the target: n = nT.
a. For these expectations, show how the economy responds to a supply shock
under accommodative and non accommodative policy.
b. Does the anchoring of expectations make it more or less desirable to accommodate the shock? Explain.