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Range of Uncertainty in the Price Level & Inflation

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Suppose that the Fed is required to keep the inflation rate between 1 percent and 2 percent a year but with no requirement to keep trend inflation at the midpoint of this range. The Fed achieves its target.

a. If initially the price level is 100,
i. Calculate the highest price level that might occur after 10 years.
ii. Calculate the lowest price level that might occur after 10 years.
iii. What is the range of uncertainty about the price level after 10 years?

b. Would this type of inflation goal serve the financial markets well and provide an anchor for inflation expectations?

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Solution Summary

Given the initial price level, and the upper and lower limits of future inflation, this solution shows how to calculate the range of future uncertainty about the price level after 10 years.

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a) Let IR = Inflation Rate

i) Let IR = 2%
CPIfinal = CPIinitial(1 + IR)^10
CPIfinal = 100(1.02)^10
CPIfinal = ...

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