A central bank credibly announces it will reduce money growth to lower inflation from 8% to 2%. Under which expectation mechanism would this announcement alone, without any recession, immediately reduce actual inflation?
AAdaptive expectations — because agents will update their forecasts as they observe the new policy in practice
BRational expectations — because agents use all available information including the announced policy, so expected inflation drops immediately and actual inflation follows without unemployment rising
CSticky information — because a fraction of agents will have updated to the new policy immediately, doing enough work for the whole economy
DAll three mechanisms predict costless disinflation if the announcement is credible
Under rational expectations, agents know the true model of the economy and update instantly on credible new information. If they believe the central bank will follow through, expected inflation drops to 2% immediately. Since wage and price setting responds to expectations, actual inflation follows without needing a recession to force it down. Under adaptive expectations, agents only learn from observed past inflation — the 8% experience anchors their expectations, requiring a real recession to drag observed (and then expected) inflation down. Credibility is worthless under adaptive expectations.
Question 2 Multiple Choice
Sticky information models predict that disinflation is faster and less costly than under adaptive expectations, but slower and costlier than under rational expectations. What drives this intermediate result?
ASome agents are irrational and some are rational; the average behavior falls between the two extremes
BAgents would form rational expectations but update their information infrequently due to information acquisition costs; a fraction adjust immediately while others operate on stale forecasts
CInformation stickiness is a form of menu cost — firms update prices slowly due to adjustment costs, not information gaps
DAgents deliberately delay updating to avoid volatility in their plans
In sticky information models (Mankiw-Reis), updating information sets is costly. In each period, only a fraction λ of agents has the latest information; the rest use information from prior periods. The fraction who updated immediately do incorporate the new policy credibly; the rest are stuck with old forecasts. Inflation persistence arises because the economy is an average over agents with different information vintage. This gives empirically plausible dynamics — not instant adjustment (rational expectations) and not purely backward-looking persistence (adaptive expectations).
Question 3 True / False
Under adaptive expectations, a central bank can permanently reduce inflation without causing any unemployment, as long as it is patient enough and gradually reduces money growth over several years.
TTrue
FFalse
Answer: False
Under adaptive expectations, the Phillips curve is accelerationist: to hold unemployment below the natural rate, you must keep generating surprise inflation, which continuously ratchets up expectations. Conversely, reducing inflation requires holding unemployment above the natural rate until observed inflation falls and drags expectations downward. There is no gradual, costless path — any disinflation requires a period of excess unemployment. The length of that recession determines the 'sacrifice ratio' (how many point-years of unemployment per point of inflation reduced). Patient gradualism changes the pace but not the total cost.
Question 4 True / False
The choice between rational, adaptive, and sticky information expectations is primarily a technical modeling detail that does not affect the main conclusions about monetary policy effectiveness.
TTrue
FFalse
Answer: False
The expectation mechanism is the single most consequential modeling choice for monetary policy analysis. It determines whether announced disinflation is costless or requires a deep recession, whether fiscal stimulus is offset by forward-looking Ricardian consumers, whether central bank communication and credibility matter for real outcomes, and how long inflation remains persistent after a supply shock. Models built on rational vs. adaptive expectations can give diametrically opposite policy prescriptions. This is why debates about expectation formation drove decades of macroeconomic controversy from the 1970s through the New Keynesian synthesis.
Question 5 Short Answer
Why does the choice of expectation formation mechanism determine whether a central bank's verbal announcement of a disinflation target can by itself reduce inflation — and what condition is necessary for even rational expectations to deliver a costless disinflation?
Think about your answer, then reveal below.
Model answer: Under rational expectations, agents form forecasts using all available information including announced policy. If the announcement is credible (agents believe the bank will actually follow through), expected inflation drops immediately to the target, and since price and wage setting is anchored to expected inflation, actual inflation follows without a recession. But credibility is the essential condition: if agents doubt the bank's commitment — perhaps because it has a history of promising disinflation and then backing down — rational agents will discount the announcement and keep expectations high. The key insight is that expectation mechanism and central bank credibility interact: rational expectations makes credibility decisive; adaptive expectations makes credibility irrelevant.
This explains why central banks invested heavily in institutional independence, inflation targets, and transparent communication starting in the 1990s. If you believe agents form rational expectations, then a credible institutional framework (independent central bank, public inflation target) is the primary anti-inflation tool. If agents form adaptive expectations, those institutional features matter much less — you simply have to run a recession and suffer through it.