Question

Suppose the statistical office of a country does a poor job in measuring inflation and reports an annualized inflation rate of $4\%$for a few months, while the true inflation rate has been $2.5\%$. What will happen to the central bank's credibility if it is engaged in inflation targeting and its target is around $2\%$$?$

Short answer

The credibility is decreased.

Step-by-step solution

Introduction

Inflation refers to the sustained increase in the general price level. It causes reduction in the purchasing power of money and value of money balances.

Explanation

(a)

If the statistical office does a poor job tracking inflation, there may be a minor gain in confidence in the near term because the economy appears to be better than it is.

To avoid stagflation or hyperinflation, contractionary policies would be required if the genuine inflation rate was lower (i.e.) than the inflation rate of .

As the country's economy grappled with new contractionary measures, there would be a loss of credibility.

(b)

The central bank would have to commit to disinflation alongside the economy.

Which would result in a significant loss of credibility as wages stagnate and aggregate demand falls.