This question uses the Macroeconomic Simulator available from the Carlin and Soskice website http://www.oup.com/uk/orc/carlin.soskice to show how central bank credibility affects the adjustment of the economy following an inflation shock. Start by opening the simulator and choosing the closed economy version. Then reset all shocks by clicking the appropriate button on the left hand side of the main page. Use the simulator and the content of this chapter to work through the following:

(a) Apply a \(2 \%\) positive inflation shock. Save your data.

(b) Adjust the degree of inflation inertia/credibility of the central bank to zero (i.e. full credibility, which is equivalent to setting \(\chi=1\) in Equation 4.5). Save your data.

(c) Use the impulse response function and Section 4.4 .3 to compare the adjustment path of the economy following the shock in each case. Use the 3 -equation model to explain any differences in the adjustment paths.

(d) Set the degree of inflation inertia/credibility of the central bank to 0.5 (i.e. partial credibility). Save your data.

(e) What do our answers to parts

a. to

d. tell us about the benefit to a central bank of increasing their credibility?

(f) How might a central bank go about increasing their credibility?