The Cost of Reducing Inflation

Imagine two countries, Country A and Country B, both experiencing an undesirable inflation rate of 8%. The central bank of Country A has a long-standing, credible reputation for maintaining price stability, and the public generally believes it will achieve its long-term inflation target of 2%. The central bank of Country B, however, has a history of inconsistent policy, and the public is skeptical of its commitment to lowering inflation. If both central banks implement identical policies to reduce inflation to 2%, what is the most likely difference in the economic outcomes for the two countries during the disinflationary period?

The Mechanism of Disinflation with Credible Policy

If a country's central bank lacks credibility and public inflation expectations are not firmly anchored, the economic contraction required to lower the inflation rate by a specific amount will be less severe than in a country with a highly credible central bank.