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If inflation expectations are anchored following an inflationary shock, the central bank's policy response is less severe. It only needs to implement a monetary tightening sufficient to guide the economy to the new supply-side equilibrium (e.g., moving from point B to C in Figure 5.14), thereby avoiding the need for a costly recession to bring inflation back to target.

Policy Response to a Shock with Anchored Expectations

Analyze the following economic scenario and predict the most likely policy response from the central bank and the subsequent economic outcome. Justify your reasoning.

Central Bank Response to an Inflationary Shock

Following a temporary event that causes a surge in prices, explain why a central bank that is widely trusted to maintain price stability can bring inflation back to its target with a smaller negative impact on employment and economic output compared to a central bank that lacks such credibility.

Central Bank Credibility and Disinflation Costs

Match each economic event with its most likely direct impact on the distribution of national income between wages (labor's share) and profits (capital's share).

An economy, initially at its long-run equilibrium, experiences a temporary supply shock that pushes inflation above the central bank's 2% target. If the public and financial markets have strong confidence in the central bank's commitment to its inflation target, what is the most likely outcome of the central bank's policy response?

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