Chapter 34, Problem 3CYU

To determine

The reason for costly disinflation in an economy and ways through which this cost can be reduced.

Explanation of Solution

Disinflation can be costly for the economy because people expect there would be no inflation in the future or there would be the same inflation trend in the future which makes inflation more painful when it happens. Moreover, there would be a decrease in real GDP which makes the disinflation costly as policymakers need to execute a process that uses a contractionary policy to keep the unemployment rate above the natural rate for a long time period so that the inflationary expected rate would decrease. And, when policymakers try to decrease the inflation rate by keeping the aggregate output below the potential output, disinflation will become too costly for the economy.

This cost of disinflation can be reduced in the following ways:

1. With a clear announcement, the disinflation policy can reduce expectations of future inflation, protecting the economy from the costs of disinflation and shifting the short-run Phillips curve downward. This will help policymakers lower the cost of disinflation.
2. Additionally, the Central Bank's unwavering commitment to fighting inflation will help to lower the cost of disinflation as the economy quickly adjusts to the disinflationary policy, reducing the overall production loss.

Economics Concept Introduction

Introduction: Inflation means there is an increase in the price of goods and services in the economy which affects the consumption level of the people in the country. And unemployment is the rate of unemployed people who do not have any work or source to employ in the economy. When there is a temporary reduction in price inflation then this is disinflation in the economy.