Questions: Central Bank Credibility and Inflation Expectations

Question 1

Economy A has a highly credible central bank with a 2% inflation target; Economy B has an identical structure but a low-credibility bank with the same 2% target. Both face the same supply shock that could push inflation up. Which outcome best describes the difference?

• A. Economy A will have higher inflation because the credible bank is unwilling to cause recessions
• B. Economy B will require larger interest rate increases and accept more output loss to restore price stability
• C. The outcomes will be identical — credibility affects announcements but not actual inflation dynamics
• D. Economy A's credibility causes the central bank to overreact, creating unnecessary recession risk

Answer: (B)

In Economy A, agents trust the central bank will respond to the supply shock to maintain 2% inflation. Their wage and price-setting behavior reflects that trust, limiting how far inflation rises. The bank may only need modest policy tightening. In Economy B, agents fear the bank will accommodate the shock; they set wages and prices higher preemptively, creating a self-fulfilling inflationary spiral. The bank must then impose much larger rate hikes — and the resulting recession — to credibly demonstrate commitment. The credibility deficit directly translates into higher real economic costs. Option C misses the key insight: credibility changes the inflation expectations that feed into actual price- and wage-setting behavior.

Question 2

Why is a credible central bank's inflation target described as 'self-fulfilling'?

• A. Because the bank legally commits to achieving the target and faces penalties for missing it
• B. Because when firms and workers believe inflation will be 2%, they set wages and prices consistent with 2%, which actually produces 2% inflation
• C. Because the target is set after observing actual inflation, so it always matches the outcome
• D. Because the central bank directly controls all prices in the economy

Answer: (B)

A credible inflation target creates a coordination mechanism among all the wage- and price-setters in the economy. If everyone believes inflation will be 2%, firms set prices with 2% increases, workers accept wages with 2% growth, and the resulting aggregate behavior produces approximately 2% inflation — the expectation becomes reality. The central bank barely needs to act because the private sector does the stabilizing work. This is the power of anchored expectations: the bank gets inflation stability at low cost. Options A and C describe administrative mechanisms unrelated to expectation formation. Option D is factually wrong.

Question 3

Building central bank credibility through consistent policy takes years of demonstrated commitment, but credibility can be lost within months if the bank accommodates inflation or contradicts stated policy.

• T. True
• F. False

Answer: True

This asymmetry is a defining feature of credibility. The Bundesbank spent decades building its anti-inflation reputation after the Weimar hyperinflation. The U.S. Federal Reserve spent most of the 1970s losing the credibility it had accumulated — accommodating oil shocks and political pressure — and Paul Volcker's restoration required a multi-year recession with interest rates above 20%. Credibility is built through repeated, consistent actions over long time horizons; it can be destroyed by a single dramatic break with stated policy or sustained period of accommodation. This asymmetry is why central banks maintain strong independence and resist short-term political pressure.

Question 4

A central bank that announces a 2% inflation target will achieve approximately 2% inflation regardless of whether the public actually believes the announcement.

• T. True
• F. False

Answer: False

This directly contradicts the core insight about credibility. An announcement that is not believed has no effect on private-sector expectations. Workers who doubt the 2% target will demand higher nominal wages to protect against the inflation they actually expect; firms that doubt the target will raise prices preemptively. These behaviors push inflation above 2%, forcing the bank to tighten aggressively. The announcement matters only insofar as it shapes expectations — and expectations are shaped by whether the announcement is credible. A low-credibility bank faces a much harder stabilization task precisely because its announcements fail to coordinate private-sector behavior.

Question 5

How does central bank credibility reduce the real economic cost (in terms of unemployment and output loss) of keeping inflation near target?

Model answer: When a central bank is credible, private agents set wages and prices consistent with the announced target. Inflation expectations are anchored at the target, so actual inflation tends to stay there without requiring the bank to impose tight monetary policy. If inflation does rise, a credible bank can tighten modestly and agents will adjust quickly because they trust the bank will succeed. Without credibility, agents expect higher inflation and embed it in wages and prices, forcing the bank to impose very large interest rate increases and tolerate significant unemployment to signal its commitment — the Volcker disinflation being the historical example. Credibility is effectively insurance: it purchases price stability at low output cost.

The answer should connect credibility → anchored expectations → limited wage-price spiral → smaller policy response needed. The Volcker example illustrates the counterfactual: when credibility was lost in the 1970s, restoration required extreme policy measures and a deep recession. A student who says 'credibility helps because people trust the bank' without connecting this to the expectation-formation mechanism and the resulting difference in required policy severity has not captured the key insight.