ECON2004: Macroeconomic Theory and Policy Term 1, Problem set 4 Deadline: 2pm, Thursday 21 November 1. Disinflation and credibility (25 marks) Assume output is initially at its equilibrium level and inflation is 12%. Show this on a PC-MR diagram and explain why monetary policy might generate such a high level of inflation. There is then a policy change and the central bank announces it will target equilibrium output and an inflation rate of 2% (a) If the policy change is perfectly credible, what will its impact be if (i) Agents have rational expectations (ii) The Phillips curve has a lagged term in inflation (b) Why might the policy not be credible? How will your answers to (a) change in this case? (c) Read Carlin and Soskice Ch3 Section 2.6 and discuss the different ways policymakers can achieve disinflation, and their merits. (d) What are the implications for the design of monetary policy frameworks? 2. Monetary policy in practice (25 marks) Download from Moodle the overview of the Bank of England’s Inflation Report from August 2012. (a) What domestic factors does the Report identify as likely to affect the UK economy? Divide these into those relating to demand and those relating to supply, and use the IS-MR-PC model to explain the likely impact of each type. (b) Identify the sources of uncertainty that the Report mentions.