Problem 2.9 states that, according to the Cleveland Fed, inflation expectations in 2010 were well anchored. The Making the Connection “The End of Stagflation and the Volcker Recession” discusses how the Fed may have induced a recession to reduce both current and expected inflation.
a. Suppose that inflation expectations lose their anchor; in other words, assume that households and firms now expect that inflation will be considerably higher next period. Use the AD–AS model to show the short-run effect of this change.
b. What will the Fed have to do to reduce inflation? Carefully analyze using AD–AS model.