Suppose that inflation has increased at an annual rate of 2% for several years. Also assume that the central bank’s target inflation rate is 2%.
a. If sellers all charge $100 for their products and expectations are adaptive, what price will they charge next year, assuming that the relative demand for their products is unchanged?
b. Suppose that the central bank now announces that its target inflation rate has increased to 5%, and the actual inflation rate also becomes 5%. What price should sellers charge to keep real prices constant? What price will they actually charge if expectations are adaptive?
c. What will be the consequences for the economy of the error in expectations?