Questions: Inflation Dynamics and Inflation Persistence

Question 1

A large oil price shock pushes inflation from 2% to 7% and persists for two years. The oil price then falls back to its original level. According to the expectations-augmented Phillips curve, why might inflation not automatically return to 2%?

• A. Oil prices have a permanent multiplier effect on the price level, locking in a new equilibrium permanently
• B. If inflation expectations rose during those two years, the Phillips curve has shifted up, and inflation persists at the new expected level even at normal output
• C. The economy must run above potential output long enough to reverse the original supply shock
• D. Central banks cannot reduce inflation caused by supply shocks — only demand shocks are reversible

Answer: (B)

The key mechanism is the expectations channel. Once firms and workers experience two years of 7% inflation, they revise their expectations upward. In the equation π = π^e + α(Y − Y*), if π^e rises to 7%, then even when Y = Y* (output at potential, no demand pressure), actual inflation settles at 7% — not 2%. The original oil shock is gone, but it has left its mark in shifted expectations. Returning to 2% requires driving Y below Y* (a recession) until price-setters revise their forecasts back down. The supply shock caused the initial rise; expectations cause the persistence.

Question 2

Why did the Volcker disinflation (1979–82) require sustained high unemployment rather than simply announcing a new 2% inflation target?

• A. The Fed lacked legal authority to announce inflation targets, so only unemployment could signal policy intent
• B. Unemployment is the only instrument available to the Federal Reserve under the Federal Reserve Act
• C. Inflation expectations had become anchored at high levels; only a demonstrated period of below-potential output would convince price-setters to revise their forecasts downward
• D. The 2% target was technically unachievable without first achieving zero unemployment

Answer: (C)

By 1979, inflation expectations were entrenched at 6–10% because the Fed had repeatedly tolerated high inflation. A mere announcement of a 2% target was not credible — price-setters had learned to distrust such promises. The only way to re-anchor expectations was to demonstrate commitment through costly action: driving unemployment to nearly 11% and holding it there for years showed that the Fed was willing to bear real economic pain to achieve price stability. Once firms and workers observed sustained low inflation over time, they revised their forecasts downward, re-anchoring expectations. The announcement alone couldn't do this; the prolonged recession could.

Question 3

In the expectations-augmented Phillips curve, if expected inflation rises, inflation can remain elevated even when output returns to its potential level.

• T. True
• F. False

Answer: True

This follows directly from π = π^e + α(Y − Y*). When Y = Y* (output gap = 0), actual inflation equals expected inflation: π = π^e. If expected inflation is 7%, actual inflation is 7% at potential output — there is no automatic return to 2%. The output gap term α(Y − Y*) captures demand pressure, but it is zero when output is at potential. Only a negative output gap (Y < Y*) can push actual inflation below expected inflation and thereby create the conditions for expectations to revise downward.

Question 4

Once the supply shock that caused a surge in inflation has passed, inflation will return to its previous level even if the central bank does hardly anything.

• T. True
• F. False

Answer: False

This is the core misconception that inflation persistence contradicts. If price-setters have updated their inflation expectations upward during the inflationary episode, those expectations persist even after the original shock passes. Removing the shock eliminates one source of upward pressure, but it does not reverse the expectation shift. Actual inflation remains elevated at the new expected level until the central bank actively drives output below potential — accepting a recession — to force expectations back down. Doing nothing after a shock can lock in permanently higher inflation.

Question 5

Why does the expectations-augmented Phillips curve imply that fighting entrenched inflation is more costly than preventing inflation from becoming entrenched in the first place?

Model answer: Once expectations become unanchored — revised upward from the 2% target — every percentage point of expected inflation that must be reversed requires driving output below potential by enough to force actual inflation below expected inflation for long enough to shift forecasts back down. The higher and more entrenched expectations are, the deeper and longer the required recession. Preventing entrenchment (by tightening early, before expectations move) requires only a modest demand restriction to cap the initial inflation rise. The asymmetry is: an ounce of prevention requires a small negative output gap; a pound of cure requires a large sustained recession. Volcker's disinflation — nearly 11% unemployment for years — quantifies the cure; proactive early tightening represents the prevention.

This asymmetry is why central banks with credible inflation targets tend to raise rates preemptively when inflation threatens to exceed target, rather than waiting. The logic is not that early tightening is costless — it is that the cost of late tightening grows exponentially with the degree of expectation drift. A 1% overshoot held for a few months is cheap to reverse; a 5% overshoot held for two years is the Volcker scenario.