In response, firms would reduce the rate at which they were raising prices. Once the desired reduction in inflation had been achieved, the monetary authority could reduce interest rates, allowing economy-wide spending to go up again. Thus, the recent slowing of wages could have been caused by a tightening of monetary policy, and according to this model, would be followed by a reduction in the rate of inflation. We follow his example, which assumes that the monetary authority wishes to reduce unemployment. To do so, it increases the rate of money growth, causing interest rates to fall temporarily.
Spending goes up in response.
If prices have been stable in the past, people will have set wages and prices on the assumption that they will continue to be stable in the future. Consequently, output and employment will expand in response to the higher spending. The fact that firms are quick to adjust their prices in response to the increase in spending while workers are slower in demanding higher wages makes it profitable for firms to raise output. Soon, however, workers catch on to the fact that prices are rising, and they demand increases in wages to compensate for the higher prices. Ultimately, wages adjust fully to the rise in prices.