Monetary Policy - Inflation - Causes

Theory 5 - Price expectations and inflation - what do you expect?

Expectations can be an important determinant of inflation, and this has increasingly been recognised by economists and policy-makers in recent years. As a result, a lot of research has been done in this area. The trouble with economics is that the more work that is done, the more muddled the picture can become. This is certainly true with expectations and there is considerable disagreement between economists on what determines people's expectations.

Some years ago, research was done to see how many times the word 'recession' appeared in newspapers and the press to see if there was any relationship between the expectation of a slowdown and it actually happening. The results suggested that there did indeed appear to be some relationship between the two. The idea was that as people began to expect a slowdown they would adjust their behaviour to accommodate this and thus help to bring about the very problem they had feared! Further information on this idea can be gained by looking at The Economist who maintain an 'R-word index'.

One of the main reasons expectations are important is because people take account of them in their wage claims. If inflation is expected then people will include that in their claim to ensure that they get a real wage increase. This increases firms' costs and so can in itself cause inflation.

If people believe that increases in the money supply will simply cause inflation, then any increase will simply lead to inflation and no real increase in output or employment. This is because they will simply anticipate the effects. This is essentially the monetarist position on expectations. The most extreme version of this is rational expectations. The rational expectations school assume that people will look simply at the present situation and take no account of the past. This means that they will instantly anticipate the impact of any changes. The government therefore have no chance at all of getting away with subtle changes to try to boost demand, as people will simply anticipate the inflationary impact, and the changes will be useless.

The Keynesian position is that if people expect any expansion in demand to lead to an increase in output and employment, then it will. This happens because firms will take on more people in anticipation of an increased level of demand for their product.