Question: a. Central bankers must manage expectations. Suppose that inflation is running at 10% and the central banker would like to lower inflation to 2% without reducing real growth. What should the central banker tell the public? And at what level should the central banker set money growth? Assume that velocity shocks are zero and that the potential growth rate is 3%. Draw the new SRAS and AD curves.
b. Suppose that the public does believe the central banker. What temptation might the central banker face? Imagine that it is an election year and the central banker would like to see the current administration reelected.
c. If the central banker is not believed, what will happen? Use your answers to parts a and b to discuss the importance of independent central banks.