Credible Central Bank, Cheap Disinflation
A believed inflation target brings inflation down with almost no rise in unemployment, while the same target costs a recession when nobody believes it.
Credible Central Bank, Cheap Disinflation
Phillips CurveA believed inflation target brings inflation down with almost no rise in unemployment, while the same target costs a recession when nobody believes it.
High inflation, high expectations
The economy sits at the natural rate of unemployment on a high short-run Phillips curve. Inflation has run fast for years, so households and firms expect it to keep running fast, and that expectation is written into wage contracts and price lists. Expected inflation is what fixes the height of the short-run curve, so a high curve is really a statement about what people believe.
Now try it yourself: shift the curves in a graded FRQ drill, or open this graph in the free sandbox.
Credible Central Bank, Cheap Disinflation, step by step
- 1
High inflation, high expectations
The economy sits at the natural rate of unemployment on a high short-run Phillips curve. Inflation has run fast for years, so households and firms expect it to keep running fast, and that expectation is written into wage contracts and price lists. Expected inflation is what fixes the height of the short-run curve, so a high curve is really a statement about what people believe.
- 2
The commitment is believed
An independent central bank announces a lower inflation target and backs it with a clear rule and a record of following through. Because the commitment is credible, wage bargainers and price setters revise their forecasts down straight away, rather than waiting to be proven wrong by a recession first.
- 3
SRPC shifts left
Lower expected inflation means firms and unions settle for smaller price and wage increases at any level of hiring, so the short-run Phillips curve shifts down and to the left. Inflation is now lower at every unemployment rate, including at the natural rate where the new curve crosses the unchanged vertical long-run curve.
- 4
Disinflation without a recession
The economy drops onto the new lower curve instead of sliding down along the old one. Because expectations moved together with the policy, inflation falls while unemployment stays close to the natural rate, so very little output has to be given up. The sacrifice ratio, meaning the output lost per percentage point of inflation removed, is small.
- 5
The same policy without credibility
If nobody believes the announcement, expected inflation stays put and the short-run curve does not move at all. The only route to lower inflation is then a movement down along the unchanged curve to a much higher unemployment rate, and that recession has to last until expectations finally break. Same inflation target, far larger bill. This is why independence and transparency are treated as tools of disinflation, not just good governance.
Where it ends up
If a disinflation is credible, expected inflation falls immediately and the short-run Phillips curve shifts down and to the left, so inflation comes down with unemployment staying near the natural rate. Credibility is what makes the sacrifice ratio small.
Now draw it yourself
Same graph, graded on whether you move the right curve and leave the rest alone.
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