Macroeconomics For Dummies®, uk edition Published by: John Wiley & Sons, Ltd

Policy makers choose to aim for point B in order to reduce inflation. Therefore, they increase unemployment.

2. 
   People see that inflation is equal to and revise their expectations down about future inflation to . This shifts the Phillips curve to SRPC₁ – unemployment falls back to its natural rate and the economy is
   

now at point C.

3. 
   Inflation is still high, so policy makers choose to aim for point D. Again, they increase unemployment to lower inflation (and inflation expectations) to .
   

3. 
   People see that inflation is even lower and update their expectations again and the Phillips curve shifts again.
   

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Figure 12-7: Gradual disinflation.

You get the idea. Finally, after repeating this process a number of times, the economy is at point G – inflation is relatively low and unemployment is at its natural rate.

The alternative to the gradual process is trying to disinflate the economy fully in one year – sometimes called shock therapy (see Figure 12-8).

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Figure 12-8: Shock therapy.

Inflation again starts off very high at , but this time policy makers decide to try to get inflation down quickly. The economy starts off at point A and policy makers increase unemployment by a huge amount by choosing point B. They do so to reduce inflation to in one fell swoop – when people see that inflation has indeed fallen, they revise their expectations and this shifts the Phillips curve down to SRPC₁ in one go.

Adjusting expectations for socially costless disinflation

One way of thinking about why disinflation is socially costly is that people’s expectations about inflation take time to adjust. People don’t necessarily believe the initial announcement that inflation will fall. A recession is necessary (and the accompanying lower inflation and higher unemployment) in order to get people to adjust their expectations downward.

These kinds of simple expectation – such as ‘I think inflation this coming year ( ) will be equal to inflation last year ( )’ – are called adaptive expectations:

But what if you could get people to adjust their expectations of inflation downwards without sending the economy into a recession? In theory, it should be possible. If policy makers are absolutely committed to bringing inflation down to, say, as shown earlier in Figure 12-8, and so long as the announcement is credible, people should adjust their expectations of future inflation to immediately. This would cause the Phillips curve to shift downwards and bring inflation down without the need to engineer a recession!

In order for this plan to work, you need two things:


Complete credibility: Policy makers must be able to convince people that they’re serious about achieving low inflation and that no matter what happens – no matter how painful it becomes – they will disinflate the economy.


Rational expectations: Individuals in the economy need a quite sophisticated way of forming expectations. No longer can they have simple adaptive expectations and just look at inflation in the recent past in order to work out future inflation. They need to have rational expectations: that is, they use optimally all available information to make their forecasts, including announcements about future policy.

With adaptive expectations, it doesn’t matter how you spread the pain – the total pain is unchanged. But with rational expectations, disinflating the economy quickly makes sense, because a short, sharp shock of disinflation is much more likely to be credible than committing to disinflate the economy over ten years.

Macroeconomists who strongly advocate rational expectations – such as Lucas (check out the earlier section ‘Taking aim with the Lucas critique’) – also believe that traditional estimates of the sacrifice ratio are far too high. They believe that reducing inflation in an economy without much pain is possible, so long as policy makers are credible when they make their announcement.

Inflation in the UK in 1980 was running at about 20 per cent. The prime minister at the time, Margaret Thatcher, decided to disinflate the economy, that is, reduce inflation. As the Phillips curve would suggest, this increased unemployment substantially – unemployment actually doubled. However, inflation was brought under control to a manageable 5 per cent in 1983.

Now, this was by no means a ‘costless disinflation’ – if it had been, unemployment wouldn’t have increased at all. Nevertheless the costs (higher unemployment) were much less than some at the time had expected (that is, the sacrifice ratio was relatively low). So perhaps the Iron Lady’s credibility forced people to change their inflation expectations and thereby reduced the negative impact of disinflation on employment.

Chapter 13