The Phillips curve model with expectations developed into a short and a long run version. In the short run the trade-off between unemployment and inflation exists, but in the long it doesn't. According to this model although both monetary and fiscal policy commits to low inflation once private agents enter with expectations the authorities get incentives to deviate with unexpected inflation, causing inflationary bias, that referred to time inconsistency. In the question of output maximization we have to know how unemployment and inflation is connected to output.
Unemployment is tightly related to output: one can say that high employment means automatically high output, and low employment means low output. Output and inflation seems to be positively correlated, but the reasoning is much more complicated. Because of the short run trade off, unexpectedly lower inflation means higher unemployment, so lower output. In the long run this direct proportionality does not work if vertical Phillips curve assumed, economy is in potential output (inflation does not affect output).
In the middle term, hysteresis theory should be taken into account. According to this the so called NAIRU, the non-accelerating inflation rate of unemployment (the unemployment rate that belongs to potential output), is changing by the time depending on its previous values. So the potential output depends on previous values of actual output, which means that even short run monetary-fiscal policy coordination affects potential output (altogether low inflation causes lower potential output). Lower inflation means high unemployment in the short run, so some capacities become useless, that is why capatity is reduced, so potential output decreases.
So altogether low inflation means low output. Why is low inflation still desirable? Because in 'rather long term' low inflation suggests that there is a good, secure economic environment, investment increases because of this trust, so growth rates are higher at lower inflation rates. It is important to mention that according to econometric analyses 2% inflation is regarded optimal, a lower level decreases growth as the cost of holding money dramatically decreases, so people will hold money instead of saving it, and this decreases investments, which makes growth slower. So there exists an optimal level of inflation, this 2%.
These complicated relationships make it hard to decide obviously what should be done to maximize output. Besides, output is maximized not only by government but also by other public institutions, which can result opposition of interest. Even if public institutions (like central bank) have long term horizon, government obviously has incentives to follow its short term objectives (regular elections). Besides according to short term Phillips curve, it has the power to do so causing inflationary bias.
The roots of interest opposition of central bank and government can be found in macroeconomic analysis, but seems to be not properly discussed. Political philosophy helps to really understand this complex question.
Unemployment is tightly related to output: one can say that high employment means automatically high output, and low employment means low output. Output and inflation seems to be positively correlated, but the reasoning is much more complicated. Because of the short run trade off, unexpectedly lower inflation means higher unemployment, so lower output. In the long run this direct proportionality does not work if vertical Phillips curve assumed, economy is in potential output (inflation does not affect output).
In the middle term, hysteresis theory should be taken into account. According to this the so called NAIRU, the non-accelerating inflation rate of unemployment (the unemployment rate that belongs to potential output), is changing by the time depending on its previous values. So the potential output depends on previous values of actual output, which means that even short run monetary-fiscal policy coordination affects potential output (altogether low inflation causes lower potential output). Lower inflation means high unemployment in the short run, so some capacities become useless, that is why capatity is reduced, so potential output decreases.
So altogether low inflation means low output. Why is low inflation still desirable? Because in 'rather long term' low inflation suggests that there is a good, secure economic environment, investment increases because of this trust, so growth rates are higher at lower inflation rates. It is important to mention that according to econometric analyses 2% inflation is regarded optimal, a lower level decreases growth as the cost of holding money dramatically decreases, so people will hold money instead of saving it, and this decreases investments, which makes growth slower. So there exists an optimal level of inflation, this 2%.
These complicated relationships make it hard to decide obviously what should be done to maximize output. Besides, output is maximized not only by government but also by other public institutions, which can result opposition of interest. Even if public institutions (like central bank) have long term horizon, government obviously has incentives to follow its short term objectives (regular elections). Besides according to short term Phillips curve, it has the power to do so causing inflationary bias.
The roots of interest opposition of central bank and government can be found in macroeconomic analysis, but seems to be not properly discussed. Political philosophy helps to really understand this complex question.
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