Why Does Fighting Inflation Sometimes Make Things Worse?

Research by Hall and Woodford helped shape new economic models now used by central banks and finance ministries worldwide to assess the effects of monetary and fiscal policies.

Ambassador Arjan; Ali Khairabadi - Robert E. Hall, an economist at Stanford University, and Michael Woodford, a professor at Columbia University, won the 2026 Nobel Prize in Economics. These two economists were honored for their research on the "microeconomic foundations of macroeconomic stabilization"; Research that has helped governments and central banks better understand the impact of household and corporate decisions on inflation, consumption, and economic growth.

The importance of the work of these two researchers lies in the answer to a question that has occupied economic policy makers for decades: when the economy faces high inflation, unemployment or stagnation, how should the government and the central bank intervene so that the situation does not worsen?

Hall and Woodford's research helped to form new economic models that are used today in central banks and ministries of economy of different countries to examine the consequences of monetary and financial policies.

Why did the old economic models fail in the 1970s?

To understand the importance of these researches, one must go back to the oil crises of the 1970s; When Western economies faced a difficult situation. Inflation rose, unemployment increased and economic growth slowed. This situation, called "stagflation", was inconsistent with many of the popular economic forecasts of the time.

Conventional Keynesian models largely relied on statistical relationships between macroeconomic variables. For example, the Phillips curve depicted a relationship between inflation and unemployment, according to which lower inflation was usually associated with higher unemployment and higher inflation with lower unemployment.

But the crisis of the 1970s showed that this relationship is not always stable. Governments and central banks could not correctly predict the outcome of their policies simply by relying on past statistical relationships. In some cases, over-stimulation of demand led to further inflation, without permanently addressing the problem of unemployment and recession.

Economists such as Robert Lucas, winner of the Nobel Prize in Economics in 1995, argued that economic models should be based on the actual behavior of individuals and firms, rather than simply extrapolating statistical relationships from the past to the future. This criticism became one of the grounds for the formation of an approach that later found a central role in the new Keynesian macroeconomics.

What did Robert Hall discover about consumer behavior?

One of the major problems of economists was that they could not easily explain how households decide on their consumption.

If a family's income increases, does it immediately spend more? If he expects his income to decrease in the future, will he reduce his expenses today? And if people become optimistic or pessimistic about the future, how does this change in expectations affect the economy as a whole?

Before Hall's research, economists knew that consumption decisions are not only dependent on current income, but that expectations about future income are also important. However, these expectations were difficult to measure; Because it is not possible to directly access people's minds and observe their optimism or pessimism.

In a 1978 paper, Hall proposed a different approach: instead of trying to find indicators that measure household expectations, one could examine consumer behavior itself.

His rationale was that if households make decisions based on available information and their expectations about the future, predictable changes in income and other variables should not alone be able to consistently predict changes in their consumption. In this framework, the change in consumption should occur mainly in response to new information that could not have been predicted before it was received.

This hypothesis gave researchers a measure to measure consumer behavior. If the changes in regular consumption were explained by predictable variables, they should check whether some assumptions of the model were violated; For example, do some households do not have enough savings or are forced to spend almost all of their current income due to restrictions on borrowing?

Hall also used household data in a joint research with Frederick Mishkin in 1982. The results showed that a large part of the surveyed households behave in accordance with this theory, while another group depends more on current income due to financial limitations.

These findings helped economists distinguish between households that adjust their consumption decisions with an eye to the future and households that are closed to such decisions. This difference is important for predicting the effect of changes in interest rates, taxes and income on aggregate demand.

How did Michael Woodford relate these findings to monetary policy?

If Hall's research helped to explain consumer behavior, Woodford's important contribution was to develop a comprehensive framework for analyzing monetary policy.

In his 2003 book Microfoundations of Macroeconomics, Woodford presented a model that linked the decisions of households and firms to variables such as GDP, inflation, and interest rates. This work became one of the main sources for the formation of new Keynesian models.

This model can be considered a kind of laboratory for policy makers. The central bank can use it to check what effect the reduction of the interest rate will have on consumption and production under certain conditions, or to what extent it may be necessary to increase the interest rate to curb inflation.

In this framework, the economy is not just a collection of numbers and statistical relationships. Households make decisions about consumption and savings, companies set the prices of their products, and all these decisions are influenced by expectations about the future.

One of the important points in Woodford's model is that the central bank can affect economic activity by changing the interest rate, without limiting monetary policy to the amount of money in circulation. This approach highlights the role of expectations and economic decisions in the transmission of monetary policy to consumption, production and inflation.

Why don't companies change prices immediately?

Another important component of this model is explaining the behavior of companies in determining the price.

In the real world, firms usually cannot immediately change the price of their products every time the cost of raw materials or the amount of demand changes. Price changes may incur costs or be delayed due to contracts, competition and business considerations. Economists refer to this feature as "price stickiness".

This has an important consequence: if demand falls, but prices do not fall immediately, firms may face lower sales and reduced production. As a result, the change that first occurred in demand can lead to a drop in production and an increase in unemployment.

On the other hand, if firms expect costs to rise in the future, they may charge higher prices today. Therefore, the expectations of companies also play a role in the formation of inflation.

This is where the connection between the behavior of micro-firms and the state of the economy as a whole becomes clear: the pricing decisions of thousands of firms, along with the consumption decisions of millions of households, can shape the path of inflation and output.

Forward-looking guidance; Why are the words of the central bank important?

One of the practical consequences of these researches is highlighting the role of central bank communication; An issue that became more important after the global financial crisis of 2008.

In that crisis, central banks lowered interest rates to near zero. When the interest rate reaches this level, it becomes difficult to reduce it further, and the conventional tools of monetary policy lose some of their power.

In such a situation, the central bank can inform about the possible direction of the interest rate in the future. This policy, called "forward-looking guidance", aims to influence the expectations of households, companies and financial markets.

For example, if the central bank credibly announces that it will keep interest rates low for a period of time if economic weakness persists, households and firms can make consumption, investment, and financing decisions based on this expectation.

For this reason, the credibility and transparency of the central bank becomes important. Merely announcing a policy is not enough; People and markets must believe that the monetary institution will act accordingly in the future.

However, forward-looking guidance is not a perfect tool. When the economy faces unexpected shocks and extreme uncertainty, it becomes more difficult to predict the future path and the effectiveness of such messages may be limited.

What is the production gap and what does it have to do with inflation?

Another important concept in this framework is "production gap"; An index that shows the difference between the actual production of the economy and its potential production level.

Potential production refers to the level of production that the economy can reach with conventional and sustainable use of labor and capital, without facing severe inflationary pressures.

If demand exceeds the production capacity of the economy, the output gap will become positive and pressure on prices may increase. Conversely, if the economy is operating below capacity, the output gap will be negative, and demand pressure on prices will usually decrease.