People know that the Fed has the incentive to announce that the inflation rate will be 3 percent next year, so people will build 3 percent inflation into their wage negotiations.But then the Fed has the incentive to increase inflation above 3 percent to make the economy grow faster.This type of phenomenon is known as
A)inflation targeting.
B)time inconsistency.
C)McCallum's rule.
D)an expectations trap.

Question

Quizplus · Accepted Answer

This phenomenon is called time inconsistency, which refers to the situation where a policy may seem optimal at the time it's announced, but in practice, the policy may not be optimal anymore due to people's reactions to it. In this case, the Fed may want to increase inflation to boost economic growth, but if people have already built the expectation of 3 percent inflation into their wage negotiations, the actual inflation rate may end up being higher than what is desirable for the economy.

People Know That the Fed Has the Incentive to Announce