Central Bank Independence in Transition Economies

1.1. Why Do Policymakers Like Inflation? 

1.1.1. Phillips Curve and the Employment Motive for Monetary 

Expansion 

In theoretical discussion the short-run relationship between inflation and 

deviations of unemployment from the natural rate, known as a Phillips curve, is a 

predominant motive for monetary expansion. The empirical relationship discovered by 

Phillips (1958), originally as a relation between wage inflation and unemployment in 

UK, was given numerous theoretical explanations which yield different implications 

for economic policy. Recently, the widely accepted “expectations augmented” Phillips 

curve is a relation between deviations of unemployment from its equilibrium level and 

unanticipated shocks to inflation. The relation may be derived either from the Lucas 

(1973) “surprise” supply function or the overlapping contracts models developed in 

Fischer (1977), Phelps and Taylor (1977) and Taylor (1979). The “surprise” supply 

function is based on three assumptions: expectations are rational, producers alter the 

amount to produce if they observe a change in prices of their products relative to the 

aggregate price level and producers do not have perfect information on the aggregate 

price level. In this setting the “rational expectations augmented” Phillips curve is 

vertical even in the short run and no systematic monetary policy can affect output 

(Sargent and Wallace 1975). In the overlapping contracts models prices or wages are 

set by multiperiod contracts. In each period only a fraction of all contracts is renewed. 

As a result, an adjustment to nominal shocks is gradual, even if agents expectations are 

rational. A monetary expansion has real effect and the Phillips curve relationship is 

exploitable even in the long-run.