David K.H. Begg, Gianluigi Vernasca-Economics-McGraw Hill Higher Education (2011)

22.4 Inflation, unemployment and output
Q)
..
0
""'
c
0
4:
0 7t2
;:
c
: B
Beginning at E, the target inflation rate is cut
from 7t1 to n2• Having expected inflation n1,
nominal wage growth has been too high.
Firms cut back output and employment and
the economy moves to A. If the new policy is
credible, the next wage settlement reflects
lower inflation expectations, the short-run
Phillips curve shifts to PC2 and the economy
moves from A to B. Thereafter, it slowly
adjusts along PC2 to F.
Figure 22.6
U* U1
Unemployment rate
Expedations and credibility
However, if people doubt that the new tough
policy will be sustained, nominal wages may
keep growing at 7t1• The short-run Phillips
curve remains PC1• Unemployment stays high,
and inflation refuses to fall.
Expectations and credibility
Figure 22.6 puts this apparatus to work to discuss what happens when a new government is elected with a
commitment to reduce inflation. Think of this as describing the problem faced by Mrs Thatcher. The
economy begins in long-run equilibrium at E, facing the short-run Phillips curve PC1• Nominal money,
prices and money wages are all rising at the rate n 1 .
The government wants to reduce inflation to 1t2 to reach point F. The day the government is elected it
announces a cut in the inflation target from 1t1 to 1t2•
Overnight, firms inherit nominal wage increases that had anticipated the old inflation rate 1t1• They have
little scope to reduce inflation. If inflation does fall, real wages are now too high. Firms reduce output and
employment. Inflation falls a little and unemployment rises. The economy moves along the short-run
Phillips curve PC1 to A.
What happens next? In the good scenario, workers believe the tighter monetary policy will last. The
next wage bargain is based on inflation expectations 1t2. The short-run Phillips curve shifts down to PC2
and the economy moves from A to B. Inflation falls quickly. The economy then moves slowly along PC2
from B to F.
Now for the bad scenario. When the economy first reaches A, workers do not believe that the tough new
monetary policy will last. They think n 1 will remain the inflation rate in the long run. Thinking inflation
will remain high, workers do not reduce nominal wage growth. They believe PC1 not PC2 will be relevant.
Suppose workers are wrong. Although nominal wages grow at 1tp the tough policy
lasts and actual inflation is below 1t1• Real wages rise and unemployment gets worse
without much fall in inflation. The worse the slump becomes, the more likely is the
government to give in, easing monetary policy to boost aggregate demand again.
A belief that the government's nerve will crack can become a self-fulfilling
prophecy.
A self-fulfilling prophecy is
an expectation that creates the
incentive to make it come true.
The economy stays on PC1 and the attempt to reduce inflation fails. Gradually the economy moves back
along PC1 to equilibrium at E.
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