A credible disinflation

The chain in words

1. Step 1

   Years of high inflation

   The horizontal axis is the unemployment rate and the vertical axis is the inflation rate. Inflation has been high for years and everyone expects it to stay high. The economy is at A₀ on the LRPC, at the natural rate but with high inflation.

2. Step 2

   The short-run Phillips curve shifts left

   The new chief announces a low target and backs it with rate rises. Because the promise is believed, firms and workers lower their expected inflation. At every unemployment rate, inflation falls, so the short-run Phillips curve shifts left.

3. Step 3

   Low inflation, same unemployment

   The economy moves to A₁, still at the natural rate but with low inflation. Because expectations moved first, the disinflation cost little unemployment. Without credibility, the central bank would have had to force unemployment up along the old curve to grind inflation down.

Takeaway. Credible policy lowers expected inflation, shifts the short-run Phillips curve left, and reduces inflation without a lasting rise in unemployment.

Draw it yourself

More on the phillips curve graph