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

CHAPTER 22 Inflation, expectations and credibility
so indebted that further borrowing is impossible. It must resort to printing money or take fiscal action
to cut the deficit.
• The long-run Phillips curve is vertical at equilibrium unemployment. If people foresee inflation and
can completely adjust to it, inflation has no real effects.
• The short-run Phillips curve is a temporary trade-off between unemployment and inflation in response
to demand shocks. Supply shocks shift the Phillips curve. The height of the short-run Phillips curve
also depends on underlying money growth and expected inflation. The Phillips curve shifts down if
people believe inflation will be lower in the future.
• Temporary supply shocks also shift the short-run Phillips curve. Stagflation is high inflation plus high
unemployment.
• Some so-called costs of inflation reflect inflation illusion or a failure to see inflation as the consequence
of a shock that would have reduced real incomes in any case. The true costs of inflation depend on
whether it was anticipated and on the extent to which the economy's institutions allow complete
inflation-adjustment.
• Shoe-leather costs and menu costs are unavoidable costs of inflation and are larger the larger the
inflation rate. Failure fully to inflation-adjust the tax system may also impose costs, even if inflation is
anticipated.
• Unexpected inflation redistributes income and wealth from those who have contracted to receive
nominal payments (lenders and workers) to those who have contracted to pay them (firms and
borrowers).
• Uncertainty about future inflation rates imposes costs on people who dislike risk. Uncertainty may be
greater when inflation is already high.
• Incomes policy may accelerate a fall in inflation expectations, allowing disinflation without a large
recession. But it is unlikely to succeed in the long run. Only low money growth can deliver low inflation
in the long run.
• Operational independence of central banks is designed to remove the temptation faced by politicians
to print too much money.
Review questions connect··
1 Your real annual income is constant, and initially is £ 10 000. You borrow £200 000 for ten years to
buy a house, paying interest annually and repaying the £200 000 in a final payment at the end. (a)
List your annual incomings and outgoings in the first and ninth year if inflation is 0 and the nominal
interest rate is 2 per cent a year. (b) Repeat the exercise if annual inflation is 100 per cent and the
nominal interest rate is 102 per cent. Are the two situations the same in real terms?
2 Does this explain why voters mind about high inflation even when nominal interest rates rise in
line with inflation?
3 (a) Explain the following data taken from The Economist a few years ago (when some countries still
had proper inflation!). (b) Is inflation always a monetary phenomenon?
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