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

Seeing that No Trade-Off Exists between Inflation and Unemployment in the Long Run

The Phillips curve relationship (which we describe in Chapter 9) tells economists that in the short run policy makers can reduce unemployment below its natural rate by creating surprise inflation. Therefore, they may be able to reduce it by pursuing expansionary fiscal/monetary policy (Chapters 10 and 11 have lots more).

But any reduction in unemployment is short-lived. In the long run, unemployment is always equal to its natural rate, so inflating the economy in this way leads only to one thing: higher inflation. Thus policy makers should resist the temptation to reduce unemployment below its natural rate.

To help people, policy makers need instead to reduce the natural rate of unemployment by making labour markets more flexible (see ‘Minimising Unemployment (Though Some Is Inevitable)’ earlier in this chapter).

Discovering Why Policy Makers

Should Constrain Themselves

Economists think that people are pretty smart. As a result, they believe that policy makers can fool people now and again, but shouldn’t be able to fool them persistently.

For example, policy makers can create some surprise inflation and reduce unemployment below the natural rate. But after they’ve done that once, people realise what the sneaky policy makers are up to and fooling them a second time is much more difficult – everyone now expects inflation to be high. So, not only is inflation high, but also unemployment isn’t reduced.

Policy makers may be better off constraining themselves by following a fixed set of rules instead of using their discretion (check out Chapter 13 for more). Following rules gives their announcements credibility: they’re bound to do what they say they’re going to do. Therefore, when policy makers announce that inflation is going to be low, people believe that inflation is going to be low, which then leads to inflation being low in reality.