Suppose that inflation has increased at an annual rate of 2% for several years. Also assume that the central bank’s target inflation rate is 2%.
(a) If sellers all charge $100 for their products and expectations are adaptive, what price they will charge next year, assuming that the relative demand for their products is unchanged?
(b) Suppose that the central bank now announces that its target inflation rate has increased to 5%, and the actual inflation rate also becomes 5%. What price will the sellers charge if expectations are adaptive? What price will the sellers charge if expectations are rational?
(c) Currently interest rates are very low. Everyone expects that the central bank will raise the interest rates at some point. When the central bank raises the interest rates, will it affect the real GDP or employment? Explain you answer using the rational expectation hypothesis.