Our success in delivering low and stable inflation over the last decade is all the more remarkable when one remembers that, in the early years, the project of a single European currency was received with a degree of scepticism by prominent commentators. These critics have clearly been proven wrong.
In this framework, a macroeconomic shock moves projected inflation off target and the central bank adjusts interest rates in a manner that brings inflation back to target over the next six-to-eight quarters. For ease of exposition, assume a negative shock to foreign demand, prompting the central bank to cut interest rates to keep inflation on target.