Why are the benefits of reducing inflation permanent and the costs temporary? Why are the costs of increasing inflation permanent and the benefits temporary?

Why are the benefits of reducing inflation permanent and the costs temporary? Why are the costs of increasing inflation permanent and the benefits temporary?

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July 23, 2021
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Why are the benefits of reducing inflation permanent and the costs temporary? Why are the costs of increasing inflation permanent and the benefits temporary? Use Phillips-curve diagrams in your answer.

Answer and ExplanationSolution by a verified expert

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In the long-run, monetary policy affects only nominal variables (prices and inflation) and has a neutral effect on output and unemployment level.

Explanation
Unemployment rate is shown on the x-axis and the inflation rate is measured along the y-axis.

Diagram-1 illustrates that the benefits of reducing inflation are permanent and the costs are temporary. The economy starts at point A. The Fed pursues a contractionary monetary policy to reduce inflation which moves the economy downward from point A to point B along the same short-run Phillips curve (SRPC) with lower inflation but higher unemployment rate and lower output level. So, in the short-run, there are costs of reducing inflation. However, this disinflationary recession is temporary. Over time, people start realizing that the prices are falling at a slow rate, then eventually, their expectations of future inflation will fall. As a result, the short-run Phillips curve shifts to the left from SRPC to SRPC, and the economy moves from point B to point C. Hence, in the long run, unemployment will return to its natural rate (U), inflation is lower at point C than it was initially at point A, and point C is on the long-run Phillips curve. So, it can be concluded that benefits of reducing inflation are permanent while costs are only temporary.

Diagram-2 illustrates that the benefits of increasing inflation are temporary and costs are permanent. The economy starts at point A. The Fed uses an expansionary monetary policy to raise inflation which moves the economy upwards from point A to point B along the same short-run Phillips curve (SRPC) with higher inflation rate but lower unemployment rate. So, in the short-run, there are benefits of increasing inflation. However, these benefits are only temporary. Over time, people realize that prices will rise but at a slow rate, then eventually, people's expectations of future inflation will rise. As a result, the short-run Phillips curve shifts to the right from SRPC to SRPC1 and the economy moves from point B to point C. Hence, in the long run, unemployment will return to its natural rate (U), inflation is higher at point C than it was initially at point A, and point C is on the long-run Phillips curve. So, it can be concluded that costs of increasing inflation are permanent while benefits are only temporary.

Verified Answer
Diagram-1 illustrates that the benefits of reducing inflation are permanent and the costs are temporary. The economy starts at point A. To reduce inflation, the Fed contracts the money supply which moves the short-run Phillips curve from point A to B. Inflation declines and unemployment rate rises indicating that there are costs of reducing inflation. However, these costs are temporary because in the long run, people's expectations of future inflation adjust. The short-run Phillips curve shifts to the left from SRPC to SRPC1. The economy returns to its natural rate of unemployment with lower inflation rate at point C, and this point is on the long-run Phillips curve implying that benefits of reducing inflation are permanent.

Diagram-2 illustrates that the benefits of increasing inflation are temporary and costs are permanent. The economy starts at point A. To increase inflation, the Fed expands the money supply which causes an upward movement along the short-run Phillips curve from point A to B. A rise in inflation and a fall in unemployment rate indicates that there are benefits of increasing inflation. However, these benefits are temporary because in the long run, the short-run Phillips curve shifts to the right from SRPC to SRPC1. The economy returns to its natural rate of unemployment with a higher inflation rate at point C than it was at point A, and this point is on the long-run Phillips curve implying that costs of increasing inflation are permanent.

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