11 Real versus Nominal Interest Rates

ineffective. Only erratic, unpredictable policies can have any effect, and even then only in the short run.
This remarkable conclusion has sparked what is known as the policy ineffectiveness debate. Opponents of such a view make two arguments:
a. Policy credibility. If a policy change is not thought to be credible for example, if people do not believe that the Fed will maintain a change in the rate of growth of the money supply then short-run reactions can be quite different from long-run reactions.
b. Wage and price inflexibility. Even if expectations are formed rationally, the conclusions about policy ineffectiveness do not follow because prices and wages are not perfectly flexible (existing wage contracts may prevent wages from adjusting immediately, for example).
4. Reducing inflation quickly. Although the policy ineffectiveness conclusion does not hold exactly, it does suggest that movement up the long-run Phillips curve may occur much more rapidly than the exposition of figure 12.2 suggested. If people form their expectations in a sophisticated fashion, and if their past experience has led them to believe that increases in the inflation rate can occur quickly, inflation expectations adjust quickly in the upward direction when the money-supply growth rate rises. In figure 12.2 this process is reflected by a relatively steep short-run Phillips curve. The short-run reduction in unemployment due to an increase in the inflation rate is small and of short duration.
Inflation can thus rise quickly. If so, shouldn't this process operate in reverse equally quickly? If expectations are formed rationally, a decrease in the rate of growth of money supply from 5 percent to 3 percent should cause the economy to move down quickly from point D to point A in figure 12.2, so that the cost of lowering inflation is only a modest increase in unemployment for a short period of time. Unfortunately, this assumption is not so. An effort to decrease the rate of inflation by decreasing money-supply growth involves a prolonged period of high unemployment.
12.3
Fighting Inflation With Recession
The reasons why lowering inflation requires a major recession highlight the two arguments of those who oppose the policy ineffectiveness conclusion:
1. Is the policy credible? When the Fed announces that it is decreasing the rate of growth of the money supply, people have reason not to believe that the central bank will stick to this policy; they accordingly do not revise inflation expectations downward. In the past, there have been too many instances in which such a policy was announced and then abandoned later when the resulting unemployment became politically too uncomfortable. This credibility effect inhibits the success of the policy.

 



Macroeconomic Essentials. Understanding Economics in the News 2000
Macroeconomic Essentials - 2nd Edition: Understanding Economics in the News
ISBN: 0262611503
EAN: 2147483647
Year: 2004
Pages: 152

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