What would be the likely effects, if any, on output and unemployment? Would your answer be different in the long run and the short run? Can disinflation be costless?
Classical theory provides a framework to represent this situation with the AS / AD model (figure 12.2). Through the quantity theory of money we understand that the change in price level can be expressed as
p = m + v - y
where the above variables represent percentage changes. Given the velocity of money and the forecast change in GNP, inflation can be reduced decreasing the rate of growth of money supply. The effect is to create a negative shock on aggregate demand with the effect of shifting the AD curve inwards in figure 12.2 (we approximate the model indicating on the axis not the real value of prices and output, but their percentage changes - inflation and growth rate).
The conclusions change according to the time horizon under consideration. In the short term, imperfections in the markets lead to a positively sloping AS curve (see Chapter 11, question 6). Equilibrium moves from point A to point B: inflation decreases but not as much as needed. The counter effect is a lower growth rate and therefore a lower total employment.
In the long term, markets work efficiently and the AS is vertical. After the process of adapting to low inflation, the original level of employment is reached consistently with lower inflation (movement from B to C), supposed to be 3% in this case. There are no recessive costs of a restrictive monetary policy in the long period.
However, this is not the only possible explanation. If certain assumptions are met, the system can move directly from A to C avoiding short-term costs. These assumptions are:
i) the low target of inflation must be clearly spelt out by the central bank.
ii) the Central Bank must be credible.
iii) the Central Bank must be independent (it must be able to implement the relevant monetary policy needed to reach the target).
iv) agents in the economy must have rational expectations.
If these conditions are met, economic agents know that the new target of inflation will be eventually reached and therefore they will change their expectations by now (for example trade unions will moderate pay increases and banks will lower nominal interest rates) allowing the system to adjust from A to C directly in the short term.
This orthodox way of looking at the economy, which is dominant in the 1990s and which rules out recessive costs of restrictive monetary policies, is challenged by the new-Keynesian position embodied by the concept of hysteresis (see Chapter 14, p. 367). According to this theory, the process of adjusting to low inflation involves a restructuring in the economy; new sectors grow and traditional sectors lose, leaving part of the workforce without employment. The implication is that the natural rate of unemployment increases overtime (after a deflationary policy) leaving the economy also with a structural cost in the long run. Students should look at real data to debate which