What causes the formation of an expectations trap and how can the Fed prevent one from forming?
What will be an ideal response?
In an expectations trap, people form expectations of higher inflation and the Fed accommodates those expectations so that a recession is avoided. The expectations of higher inflation may arise because people might think the Fed will ease monetary policy before an election, or because policymakers may not realize that potential output growth has slowed, or because the Fed engages in time-inconsistent policymaking. To prevent an expectations trap, the Fed must establish a reputation for not changing monetary policy before elections, have good estimates of potential output, and avoid time inconsistency by following a rule for monetary policy or ensure that policymakers have an incentive to keep inflation low.
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