Assume that there is a short-run tradeoff between inflation and unemployment, that the central bank desires both low inflation and low unemployment, and that the central bank follows a fixed rule in conducting monetary policy. Initially, households and firms expect high inflation. Following a credible announcement by the central bank of a low-inflation policy, households and firms will ______ the central bank's announcement and ______ their expectations of inflation.
A) believe; lower
B) not believe; not change
C) believe; not change
D) not believe; lower

Question

Quizplus · Accepted Answer

If the central bank's announcement is credible, then households and firms will believe the central bank's commitment to a low-inflation policy. As a result, they will lower their expectations of inflation. This is because they will anticipate that the central bank will take actions to keep inflation low, which will make inflation expectations fall. Therefore, choice A is the best answer.

Assume That There Is a Short-Run Tradeoff Between Inflation and Unemployment