Lent - Lecture 9 - Inflation Expectations

Question 1

What is ε in the equation: π = π(e) + v(Y - Y̅) + ε? What does is mean?

Answer 1

• a cost-push shock
• ε > 0 ⇒ π > π(e) even if Y = Y̅

Question 2

Explain why it is difficult to reason/say that π(e) is an exogenous constant?

Answer 2

• if π(e) = c always holds, you can have Y* > Y̅ permanently
• doesn’t make sense for inflation to always exceed expectations
• if true, LRAS curve would be meaningless: never has any influence on equilibrium

Question 3

What is meant by adaptive expectations in relation to expected inflation?

Answer 3

refers to π(e) being influenced by past inflation realisations

Question 4

What are the three approaches to modelling inflation expectations?

Answer 4

• complete exogeneity
• adaptive expectations
• rational expectations

Question 5

Give one example of adaptive expectations in relation to expected inflation

Answer 5

• π(e) = π(-1)
• expected inflation equals last time period’s inflation

Question 6

With adaptive expectations, what happens if the monetary policymaker tries to keep Y > Y̅ permanently?

Answer 6

• this could be modelled by assuming the CB always fixes r to obtain Y > Y̅
• this could be seen as a horizontal MP curve, which has no feedback on Y or π
• hence, this means a vertical AD curve at Y* > Y̅
• however, this causes ever-rising inflation (easy to see when drawn out)
• there is no longer a permanent trade-off between Y and π, instead it is between Y and Δπ, can rewrite AS as:
• Δπ = v(Y - Y̅) + ε

Question 7

Explain what is meant by rational expectations in relation to inflation expectations

Answer 7

cannot be any predictable difference between what people expect, and what they observe

Question 8

Give one way rational expectations are good news for policymakers, and one way they are bad news

Answer 8

• bad news for policymakers: CB unable to set r such that Y > Y̅ permanently
• good news for policymakers: credible disinflation is easy

Question 9

With rational expectations, what will happen when there is a credible reduction in the target rate of inflation, π(T)? With adaptive expectations, what will happen when there is a credible reduction in the target rate of inflation, π(T)?

Answer 9

• rational: a credible reduction in π(T) will shift SRAS immediately
• adaptive: there will be shifts in SRAS gradually to allow Y → Y̅ along the AD curve

Question 10

What type of expectations will be focussed on primarily in this course?

Answer 10

adaptive expectations