Unit 5 Macroeconomic policy: Inflation and unemployment

5.10 Monetary policy and anchored inflation expectations

Historical experience shows that bringing inflation down is often costly. By costly, we mean that it is accompanied by a recession. Figure 5.12 provides a vivid demonstration of costly disinflation in the British economy in the 1980s. Figure 5.13 reproduces the situation discussed in Section 5.5 (Figure 5.7) showing the unpleasant trade-off faced by policymakers when the economy encounters a negative supply shock. It shows how an energy price shock shifts the PS curve downwards, causing the Phillips curve to shift upwards.

The top panel shows that such a shock—if it does not reverse itself—implies a higher inflation-stabilizing unemployment rate (at $N^{'}_\text{SSE}$). And because the shock caused inflation to rise at the initial level of output and employment, the economy faces both higher inflation and unemployment. If expected inflation rises, the Phillips curve shifts up and tightening monetary policy to take the economy to the new lower supply-side equilibrium does not take inflation back to the target: the economy is at point E in the middle panel.

If delaying the response to the oil price shock leads to higher inflation expectations, then adjustment back to the inflation target will be more costly.

Starting from point D in Figure 5.14, if the central bank is to restore inflation to target, it must raise the interest rate sufficiently to shift the AD curve downwards until employment falls to point F in Figure 5.14—that is, to a point below the new SSE. At F, inflation is at 2% and the following period, the central bank could relax its monetary policy, raising employment to C: inflation is then at target and employment is at the new SSE. This is a sustainable equilibrium but the adjustment of inflation expectations has made it more costly to get there.

$In the diagram, the horizontal axis displays employment and the vertical axis displays inflation rate, ranging from −1% to 8%. Two upward-sloping, convex lines are labeled “Phillips curve (new SSE, pi^E_t=2%)” and “Phillips curve (original SSE, pi^E_t anchored at 2%)” respectively, with the former positioned above the latter. Point B and C are depicted on the Phillips curve with anchored inflation expectation, with B positioned above C with a horizontal coordinate of N_{SSE} and a vertical coordinate of 4%, and C with a horizontal coordinate of N’{SSE} and a vertical coordinate of 2%. Point D and F are depicted on the Phillips curve with a 4% inflation expectation, with D positioned directly above B with a horizontal coordinate of N{SSE} and a vertical coordinate of 6%, and F positioned to the left of C with a much lower horizontal coordinate and a vertical coordinate of 2%. The arrow pointing from B to C is annotated that anchored expectations equals costly disinflation.$

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https://www.core-econ.org/macroeconomics/05-macroeconomic-policy-10-inflation-expectations.html#figure-5-14

Figure 5.14 The cost of getting inflation back to target; anchored expectations reduce the cost.

This example highlights the potential gains to the policymaker and the lower costs in lost output experienced by the population if inflation expectations do not adjust, but can be anchored to the inflation target. By anchoring, we mean that wage and price setters do not change their inflation expectations when a shock changes the rate of inflation they experience. As Figure 5.14 illustrates, if expectations are anchored, the Phillips curve will not shift upwards even when inflation rises to 4%, because everyone expects the central bank to bring inflation back to target. The central bank then only has to tighten monetary policy to set employment at the new SSE level: the economy will move from B to C and stay there.

Note that if expectations are anchored, disinflation is less costly even if the central bank delays its adjustment of monetary policy.

Remember that in the model, if expected inflation is equal to 2% and the bargaining gap is zero—that is, at the SSE—then inflation will be equal to 2%.

The shifting Phillips curve explains why central banks try to influence inflation expectations as well as inflation. Returning to Figure 5.13, it may seem wasteful for the policymaker to impose a larger recession on the economy than the one entailed by the new lower level of equilibrium employment. But this can only be avoided if expectations are anchored at the inflation target.

Question 5.8 Choose the correct answer(s)

This figure depicts the Phillips curve and the WS and PS curves of an economy. This economy has an independent central bank with an inflation target of 2%.

There are 2 diagrams. In diagram 1, the horizontal diagram shows employment and the vertical axis shows real wage. Coordinates are (employment, real wage). The vertical line at the end of the horizontal axis is labeled labour force. One horizontal lines is depicted and labeled PS curve. An upward-sloping, convex curve labeled WS curve intersects with the PS curve. The point of intersection, labeled as point A, represents the supply-side equilibrium where the bargaining gap is zero. A’s horizontal coordinate is therefore denoted as N_SSE. The difference between A’s horizontal coordinate and the labour force line measures the unemployment rate of 6%. In diagram 2, the horizontal axis displays employment and the vertical axis ranging from −3% to 7% displays inflation rate. Coordinates are (employment, inflation rate). AN upward-sloping, convex curve is depicted and labelled as Phillips curve with a 2% inflation expectation. Point A, replicated from diagram 1, lies on the curve and its horizontal coordinate remains as N_SSE. A’s vertical coordinate represents the inflation rate of 2%.

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Based on this information, read the following statements and choose the correct option(s).

The central bank will try to achieve zero unemployment while keeping inflation at 2%.
Consider an aggregate demand shock that increases unemployment. The central bank would raise the interest rate to put downward pressure on inflation, in order to bring it back to the target rate.
If inflation falls to 1% and expectations are anchored, the Phillips curve will not shift even if the central bank delays its response.
If expectations are not anchored, then a deflationary supply shock will require a larger fall in aggregate demand (tightening of monetary policy) to restore supply-side equilibrium, compared to if expectations are anchored.

The Phillips curve shows that this is not achievable. This reflects the fact that there is always positive unemployment in the supply-side model. The central bank will try to achieve the inflation-stabilizing unemployment rate of 6%, as this is the supply-side equilibrium.
An aggregate demand shock that increases unemployment will reduce inflation along the Phillips curve. Therefore the central bank should lower the interest rate to put upward pressure on inflation, in order to bring it back up to the target rate.
With anchored inflation expectations, people will still expect inflation to be 2% in the next period even if the central bank does not respond immediately.
A deflationary supply shock would result in a negative bargaining gap, so aggregate demand needs to increase rather than decrease.