Answer to Question #49098 in Macroeconomics for chuabeeyin

Question

Explain how credibility might affect the cost of reducing inflation.

Answer 1

When companies decide to increase the prices of their goods and services they have in mind not only the past development of prices and costs (such as wages, prices, rents), but also their expectations of growth in costs and prices in the future. Thus, inflation expectations are the key determinant of inflation and government should also target inflation expectations and try to positively influence them. Any measure to fight inflation (i.e. more restrictive social policy and remuneration policies) should be announced in advance to influence expectations and thereby directly inflation.