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Monetary Policy - Inflation - CausesFurther work - ExpectationsThe importance of anchored price expectationsIf we are to maintain low and stable inflation, then we also need to have low and stable price expectations ('anchored price expectations'). If the economy lacks a credible commitment to low inflation, then people's inflation expectations will rise as a result. If policy allows the economy to expand to this, then we will be left with higher inflation as a result. Getting people's expectations back down again will be more painful and require a harsher deflationary policy than would have been the case to keep the inflation down in the first place! If we can get low price expectations, then any increase in demand and inflation will be seen as just temporary. This will keep expectations lower as people will expect it to fall again. The disinflation required will then have a relatively low cost to the economy. So, low and stable inflation expectations are a key part of a regime of price stability. They have to be anchored to a low value and not be allowed to drift higher if price stability is to be maintained. This may even help to increase the potential level of output over time as uncertainty about investment and macro-economic performance is reduced. What do economists expect?Economists do not agree at all about the behaviour of people's expectations. The 'new classical' school of economists believe that people's expectations will adjust virtually instantaneously to new situations. The impact of any policy change will be anticipated totally. Therefore if there is any expansionary policy, expectations of inflation will adapt immediately. This will mean only inflationary effects and no short-term reduction in unemployment at all. This school of economics is also sometimes called the 'rational expectations' school. Most monetarist and classical economists do not believe that the adjustment is quite so quick. They would argue that there might be a temporary reduction in unemployment from the expansionary policy, but that people's expectations of inflation will soon increase. This will mean that any increase in aggregate demand will soon be eroded away in real terms. Unemployment then rises again to its 'natural rate'. Friedman showed this with the expectations-augmented Phillips curve. Keynesians believe that the economy can settle at any level and therefore unemployment may last over the long-term. They would then argue that the government should actively intervene to try to get the economy back to full employment. |
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