The firms and workers in Bayernland form expectations adaptively. The firms and

Question

The firms and workers in Bayernland form expectations adaptively. The firms and workers in Realland form expectations rationally. Their otherwise identical economies are initially in equilibrium at the natural level of output with 8 percent inflation. The central banks of both Bayernland and Realland make credible commitments to reduce the growth rate of money until they achieve 3 percent inflation. Compare and contrast the adjustment process to the new equilibrium at the lower rate of inflation in both countries. Which country will have the higher sacrifice ratio? Using Okun's Law and the assumption that the sacrifice ratio in Bayernland is four, what is the "cost" of bringing down inflation in Bayernland in terms of GDP and unemployment? Provide two answers, one for the case where the drop in inflation is achieved over one year, and the other where the process is allowed to take five years. Which case strikes you as more realistic?

Explanation / Answer

In Bayerland reduction in AD causes recession. The short run AS will not chnage much because in the past inflation increased to 8% that is the expectation as of now. The reductaion in the AD will cause actual price level to fall to lower output. Only as expectation inflation adjust gradually to short run AS to downward allowing economy to operate in full employment and natural rate. In contrast workers and firms of Bayerland are able to adjust expectations immediately due to the crediable policy announcement and AS adjust shortly. there will be no difference between expected and real price level and econmy will move to the lower rate of inflation without experiencing recession.

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