Problem
The key elements of a modern "Phillips curve" analysis of inflation are expectations, inertia, demand, and "supply shocks" (such as a commodity price shock or an abrupt exchange rate depreciation that raises the cost of imported intermediate and final goods.)
1) Explain what we mean by "expectations" and "inertia" in the inflation process. Explain why it matters whether inflation is mainly driven by expectations or inertia. You may use the problem of disinflation to illustrate the difference.
2) One objective of "New Keynesian" models of the economy was to provide a more adequate theoretical understanding of the Phillips curve by exploring the process by which firms set their prices when there are small "menu costs" of adjusting prices. What do the basic versions of these models say about the relative importance of expectations versus inertia in the inflation process? Does evidence from the world support this theoretical finding?
3) If expectations are an important driver of inflation, then the credibility of a government's monetary policy may play an important role. How does weak credibility affect the monetary authority's ability to reduce inflation?
The response should include a reference list. Double-space, using Times New Roman 12 pnt font, one-inch margins, and APA style of writing and citations.`