Explain the role of expectations and credibility in monetary

Explain the role of “expectations” and “credibility” in monetary policy when the policy goal is fighting inflation and keeping it low.

Solution

Expectations play an important role . The effectiveness of a tight money policy can be reduced by expectations . Suppose if the consumers are expecting that in the future prices of goods and services will rise further . Then at present they will cut down on savings and try to buy more and more goods and services . In this case a contractionary monetary policy employed to keep inflation low will not be as much effective . The reduced money supply by this policy will be compensated by reduced household savings . Expectations of producers of reduced prices in future can affect production which might also lead to further deterioration of economic conditions .

Credibility is attained when the central bank\'s actions are consistent with reaching this goal . If the monetary policy is credible then the expected inflation rate can be met . This causes the short run aggregate supply curve to remain constant . The policy is to tighten the money supply so that short run Aggregate Demand curve shifts left causing the inflation to fall back down to the inflation target level .