Some economists argue suddenly reducing money supply growth is a costly way to reduce inflation and that it may not work. For example, if a government cuts money growth but makes no real fiscal reforms, people will expect the government will eventually

Question

need to expand the money supply to pay for its expenditures. Thus, the promise to fight inflation will not be credible. Explain why credibility is important to a reduction in the inflation rate.

Answer 1

If people believe that the government really will honor its promise to reduce inflation, then inflation expectations fall. This change in expectations shifts the short-run Phillips curve left so that at any actual inflation rate the unemployment rate will be lower. If the government reduces money supply growth and at the same time people reduce their inflation expectations, unemployment will rise by less than if people maintain their inflation expectations.

The same argument can be made using the following equation.

Unemployment rate = natural rate of unemployment - a(actual inflation - expected inflation)

Suppose the government reduces actual inflation. If expected inflation is unchanged, then the unemployment rate rises by more than if people revise their expectations of inflation downward.