The firms and workers in Bayernland form expectations rationally. The firms and workers in Realland form expectations adaptively. Their otherwise identical economies are initially in equilibrium at the natural level of output with 6 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.
a) Compare and contrast the adjustment process to the new equilibrium at the lower rate of inflation in both countries.
b) Which country will have the higher sacrifice ratio?
c) Using Okun's Law and the assumption that the sacrifice ratio in Realland is four, what is the "cost" of bringing down inflation in Realland 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?