Suppose that yet no supply side effects took hold but due to the demand side effects of the policy inflation build up to %70. And monetary authorities decided to fight with inflation using contractionary monetary policies. Assume that individuals have rational expectations and Central Bank has credibility. Using Phillips curve, analyze the effects of the contractionary monetary policies. Briefly explain.

1- How would your analysis change if individuals have rational expectations and yet Central Bank does not have credibility? Explain the SR consequences of the contractionary monetary policy (the one that is trying to decrease inflation) on your Philips curve. Explain why even if the long-run consequences regarding the inflation changes will be the same as in part (f) the SR consequences of the policy will differ when CB does not have credibility.

2- Consider two different agents: the lenders and borrowers. Explain which of these agents will loose and which will gain due to the high interest rate that the contractionary policy creates?

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1 When individuals have rational expectations but the Central Bank does not have credibility the shortrun consequences of contractionary monetary poli... View the full answer