L9 Inflation Expectations

Question 1

What would a sudden oil price imply for the AS-AD diagram?

Answer 1

There’s no reason for AD to be affected for any given inflation rate since it’s a ‘supply-side’ phenomenon

SO treat it as shock to AS

Pi = Pi^e + v(Y-Ŷ) + ę

ę is our shock term (a cost push shock). Even if output at capacity level we could have the case where inflation exceeds expectations.

Question 2

What’s the feedback process between realised inflation and inflation expectations?

Approach one: complete exogeneity

What does this imply for the inflation-output tradeoff?

What’s the problem with this?

Answer 2

We can have permanently higher output if we accept a permanently higher inflation rate

Pi = Pi(bar) + v(Y-Ŷ) + ę

So essentially LRAS is not source of gravitational pull

How can inflation always exceed expectations? Ppl gotta be pretty dumb

Question 3

Approach 2: Adaptive expectations

What replaces the forward-looking component Pi^e?

What happens?

Answer 3

The backward-looking one, which is Pi_-1. So Pi^e is influenced by past inflation realisations

AS curve becomes

Pi = Pi_-1 + v(Y-Ŷ) + ę

• when inflation expectations meet those of the previous year, the inflation-output trade-off is only temporary because we CONVERGE to the AD-LRAS intersection (shown by (6))

Question 4

What happens if the CB chooses to fix RŶ permanently. Ie what’s the slope of the AD curve and how does it interact with SRAS?

Answer 4

Keeping Y* above Ŷ would place the vertical AD curve on the RHS of the LRAS curve. This would interact with SRAS by shifting it up to each new inflation rate. Here people have the continuous how that their error will be zero, so they’re making predictable mistakes systemic in one direction (always undershooting)

Question 5

What does the theory of adaptive expectations tell us about the trade off between Y and inflation?

Answer 5

Nothin! It tells us about the trade off between Y and the CHANGE in the inflation, which means that permanent output above capacity is only possible at the cost of ever-rising inflation

Change in pi = v(Y - Ŷ) + ę

What does this mean? We’ll have an ever-rising i, via the Fisher eqn

Question 6

Approach 3: Rational expectations

What does it rule out?

What are the cons and pros?

Answer 6

Cannot be any systemic difference between what people expect and what they observe

Rules out possibility of permanently-rising inflation

Cons: CB can’t set R such that Y>Ŷ is held permanently (unlike fixed inflation expectations)

Pros: Credible disinflation is easy! (Unlike adaptive expectations)

Question 7

What happens in if want to undergo disinflation in an adaptive expectations model?

Answer 7

CB has to undergo painful process of showing the public that it wants lower inflation