Suppose country A has a central bank with full credibility, and country B has a central bank with no credibility. How does the credibility of each country's central bank affect the speed of adjustment of the aggregate supply curve to policy announcements? How does this result affect output stability? Use an aggregate supply and demand diagram to demonstrate.

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The Economics of Money, Banking, and Financial Markets

Chapter 25

The Role of Expectations in Monetary Policy

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Video Transcript

looking at Country A. Which has a central bank with full credibility and Country B. Whose central bank has no credibility. We'd like to show how accurate supply adjusts to policy announcements. So let's go ahead. And for this one let's assume a negative supply shock. Is this policy announcement? Well this is what's going to be happening to our aggregate supply curve. So with a negative supply shock, let's first look at country whose central bank has full credibility. Well in this case We're going to definitely see this shift of aggregate supply to the left, but it's not going to shift by a whole lot. So aggregate supply shifts from AS1-S2. Which gives us a new equilibrium point in which case for Country A. We see output fall from Y. One to Y. Two and we see the price level rise. So in this case Country A. Is going to be experiencing a decrease in output and an increase in inflation. But then if we look at country be whose central government or central bank has no credibility, well in this case their aggregate supply curve is still going to shift to the left but it's going to shift to the left by a lot more than country AIDS did. And this is because they're going to be responding to this negative supply shock much more dramatically we could say are much more significantly because this country doesn't necessarily have faith that the central bank is going to be able to keep inflation levels low. So their expectations of inflation increase which shifts accurate supply even further to the left. So for country Be it shifted from A. S. One all the way to A. S. Three in which case That their new equilibrium has an even lower level of output at Y three and an even higher level of inflation. So for both of these countries were seeing that decrease in output and an increase in inflation. The main difference here, though is that country A experienced a lesser decrease in output and a smaller increase in inflation. So country is decreasing output was less than that of Country B. And their increase in inflation was also less than that of Country B. So what we also see in terms of the speed at which this aggregate supply curve adjust is that country A. Is going to be much quicker to respond and that has to do with that higher level of credibility.

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