The Central Banks of Two Nearly Identical Countries, Fixland and Flexland

Essay

The central banks of two nearly identical countries, Fixland and Flexland, desire low inflation and low unemployment. There is a similar short-run tradeoff between unemployment and unexpected inflation in both countries. Private agents in both Fixland and Flexland form expectations rationally and understand the incentives that central banks may have to renege on low-inflation policies. Initially, the rates of inflation and unemployment are the same in both countries. The central bank of Fixland makes a credible announcement that it will operate according to a low-inflation rule. The central bank of Flexland announces that it plans to follow a low-inflation policy, but retains the right to deviate from this policy
at its discretion.
a. In which country would you expect the rate of inflation to be lower?
b. In which country would you expect the unemployment rate to be lower?