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

The policy maker announces the desired rate of inflation.

2. 
   The individuals in the economy hear the announcement and form expectations about what inflation is likely to be.
   

3. 
   The policy maker chooses the actual rate of inflation.
   

Given that the policy maker dislikes inflation, the sensible approach is for her to announce that the desired rate of inflation in Stage 1 is zero. She hopes that in Stage 2, individuals in the economy believe her announcement and set their inflation expectations equal to zero. So far so good. However, the problem comes in Stage 3: when individuals have formed their inflation expectations, the policy maker notices that she can reduce unemployment by choosing to increase inflation. You can see this in the earlier Figure 13-1: the policy maker prefers situation B to situation A.

As usual, economists assume that people are smart and that they realise in Stage 2 that the announced policy (zero inflation) is just not credible. Given this, it no longer makes sense for them to expect zero inflation. Instead, they form their expectations based on the rate of inflation the policy maker actually chooses in Stage 3. (Remember that higher inflation expectations shift the short-run Phillips curve up.) So here’s what ends up happening under discretion (see Figure 13-2):

1. 
   The policy maker announces zero inflation.
   

2. 
   Individuals ignore the announcement and expect high inflation.
   

3. 
   The policy maker chooses high inflation.
   

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Figure 13-2: Inflation bias.

Actual inflation and expected inflation are equal, so the policy maker has failed to ‘surprise’ the individuals in the economy and the result is situation C in Figure 13-2. Comparing A with C, you notice that in both cases unemployment is equal to the natural rate; however, C is associated with higher inflation.


This difference in inflation between the two is called the inflation bias. It’s caused by the fact that individuals don’t believe the announcement of the policy maker in Stage 1, because they know she has discretion in Stage 3 to choose whatever inflation rate she likes.

But if the policy maker has to follow policy rules, she can convince people that she really is telling the truth and then follow through on her announcement. She can then eliminate the inflation bias and end up at situation A.

Risk premium

You can apply similar reasoning to analyse a government trying to borrow money from financial markets. As you know, governments often spend more than they receive in taxes and typically need to borrow the money needed to make up the difference. Investors may be willing to lend the government the money, but only at a price: that is, they expect some return on the money they’re lending out. The return that they demand depends largely on how likely they think they are to be repaid.

For example, the UK government is able to borrow at very low interest rates because investors think it’s highly unlikely to default. The Greek government, in contrast, has to pay substantially higher interest rates because it’s seen as a riskier bet.

Investors demand a risk premium: a higher expected return to compensate them for the additional risk. The more risky an investment, the higher the premium they demand.

To see how discretion can lead to investors demanding a higher risk premium, consider a timeline with different stages:

1.