WEEK 11 DISCUSSION

This question is based on chapter 8. I strongly recommend you study the simplified discussion of
the Phillips curve that I have uploaded under Lecture 11-12- Rough Notes.

In the modern version of the Phillips curve, inflation is partly fueled by gap variables, or
variables that measure how much economic activity differs from its maximum potential, and
partly by expected inflation.
(a) Put this statement in a single mathematical relationship.
However, recent studies demonstrate that inflation expectations have become more firmly
anchored to in recent decades, as shown by the reduced sensitivity of expected inflation
(insensitivity of expected inflation to incoming data is achieved by watchful monetary policy that
keeps inflation close to its target.)
(b) Incorporate “anchored” expectations, abovementioned, in your equation in part
(a) and explain what the reduced sensitivity of expectations means.

Answer:

a) The expectations-augmented Phillips Curve

π=πe−a( U−Un) a>0,

b) π=π −a(U −Un)

Anchoring is explained by reduce sensitivity of

Ɵ is introduced to measure sensitivity of previous years of inflation to this year’s inflation.

For reduced sensitivity,

Ɵ was close to zero and expectations were roughly given by
U = Un, then π =πe
Anchored expectations are when the inflation rate is stable and constant resulting into a lesser
effect on inflation by any changes in the fiscal policy or economic activities. To keep inflation,
low and stable the Central Bank sets the inflation rate at 2%. This leads to people having a firm
stand on the forecast of future inflation to remain close to 2%. This will maintain even if they
observe inflation rates that are higher or lower than 2%.