Expected Inflation

Background

Expected inflation refers to the anticipated rate of inflation that individuals or institutions forecast for particular future time periods. It reflects people’s expectations about how prices will change over time. These expectations can vary widely depending on the time horizon considered and the methods used to derive these forecasts.

Historical Context

The concept of expected inflation gained prominence with the introduction of more sophisticated economic models and the increased significance of inflation expectations for monetary policy. Historically, the sensitivity of financial markets and economic decision-making to inflation expectations became evident, making it a critical variable in both academic and policy discussions.

Definitions and Concepts

Expected inflation cannot be directly observed and must be estimated using various methods. The most common methods include surveys, where individuals or entities are asked about their inflation expectations, and market-based approaches, such as inferring expectations from the difference between the prices of inflation-indexed securities and comparable non-indexed ones.

Major Analytical Frameworks

Expected inflation is a key component across various economic theories. Here’s a comparative overview based on major schools of economic thought:

Classical Economics

While classical economics focused primarily on marked-based equilibria without incorporating feasible inflation expectations, some theories considered expected impacts on purchasing power and market adjustments.

Neoclassical Economics

Neoclassical theorists incorporate expected inflation into models of intertemporal choice and general equilibrium, focusing on its influence on money demand and labor supply decisions.

Keynesian Economics

Keynesian economists deem expected inflation crucial in affecting consumption and investment, with changes influencing aggregate demand and, by extension, employment and output levels.

Marxian Economics

While traditional Marxian economics might not delve deeply into expected inflation, modern interpretations regard it as an aspect of the economy’s broader cyclical patterns.

Institutional Economics

Institutional economists may investigate how institutional structures and the shared beliefs within various economies shape inflation expectations and influence policy outcomes.

Behavioral Economics

Behavioral economists explore how heuristics, biases, and limited information might affect how individuals form expectations about inflation, contributing to divergent and sometimes suboptimal economic decisions.

Post-Keynesian Economics

Post-Keynesians emphasize the role of historical context and the path dependency in forming inflation expectations, often considering focus on specific industries or sectors.

Austrian Economics

Austrian economists highlight the subjective nature of expectations, straightforwardly integrating them into their fundamentally dynamic and time-mediated understanding of economic processes.

Development Economics

In development contexts, managing inflation expectations is vital for governments aiming to stabilize economies, control price levels, and maintain credibility.

Monetarism

Monetarists place a significant focus on expected inflation, particularly concerning the relationship between money supply growth rates and their forecasting accords in shaping economic stability and price level predictability.

Comparative Analysis

Expected inflation varies in its implications and management depending on the county, period, and prevailing economic theories at hand. This comparative analysis showcases its encompassing reach across numerous economic contexts and its consequential importance.

Case Studies

Case studies focusing on economies with different inflation targets, using various forecasting methodologies, offer thorough insights:

1. US Economy during the Volcker Disinflation: Examines how interest rate changes adjusted expectations.
2. Hyperinflation in Zimbabwe: Assesses how extreme inflation shapes and distorts future expectations.
3. ECB Inflation Targeting: Reviews the efficacy of inflation targeting in managing European inflation expectations.

Suggested Books for Further Studies

1. “Inflation Expectations” by Peter Sinclair
2. *“Monetary Theory and Policy” * by Carl E. Walsh
3. “Macro Markets: Creating Institutions for Managing Society’s Largest Economic Risks” by Robert J. Shiller

Related Terms with Definitions

• Inflation: The general increase in prices and fall in the purchasing value of money.
• Deflation: The reduction of the general level of prices in an economy.
• Price Index: A measurement showing how the average price of a basket of selected goods and services changes over time.
• Hyperinflation: Extremely rapid or out of control inflation.
• Disinflation: A decrease in the rate of inflation — a slowdown in the rate of increase of the general price level of goods and services.
• Inflation Targeting: A monetary policy where a central bank has an explicit target inflation rate for the medium term and attempts to steer actual inflation towards the target through policy measures.