The Role of Inflation Expectations in Interest Rate Determination Flashcards
What does the Fisher Equation express?
The relationship between nominal interest rates, real interest rates, and inflation expectations.
What is the formula for the Fisher Equation?
r = i − πe
In the Fisher Equation, what does ‘r’ represent?
The real interest rate.
In the Fisher Equation, what does ‘i’ represent?
The nominal interest rate.
In the Fisher Equation, what does ‘πe’ represent?
The expected inflation rate.
How do inflation expectations influence real interest rates?
They affect borrowing, investment, and consumption.
True or False: The Fisher Equation shows that real interest rates are independent of inflation expectations.
False
Fill in the blank: The Fisher Equation is fundamental to understanding the relationship between ________, real interest rates, and inflation expectations.
nominal interest rates
What is the impact of real interest rates on economic activities?
They affect borrowing, investment, and consumption.
What happens to the real interest rate when inflation expectations rise?
The real interest rate declines for a given nominal rate, making borrowing cheaper.
How does rising inflation expectations affect consumption and investment?
It stimulates consumption and investment, reinforcing inflationary pressures through higher aggregate demand.
What was a significant economic event in the 1970s related to inflation expectations?
The 1970s Stagflation, characterized by high inflation partly driven by persistent inflation expectations.
What role did the oil shocks play in the 1970s inflation?
They exacerbated the high inflation during the 1970s.
How did households and firms react to rising inflation expectations in the 1970s?
They adjusted their behavior, leading to a self-reinforcing inflationary spiral.
What was the Federal Reserve’s monetary policy under Arthur Burns during the 1970s?
The Federal Reserve kept nominal interest rates relatively low.
What was the effect of low nominal interest rates during the 1970s?
It led to negative real interest rates, further fueling inflation.
What were the main factors causing inflation expectations to surge post-COVID-19?
Supply chain disruptions, fiscal stimulus, and labor market distortions.
What was the state of real interest rates after the pandemic-induced recession?
Real rates remained negative for a prolonged period.
What action did the Federal Reserve take in 2022 regarding nominal interest rates?
They increased nominal interest rates.
What was the result of the Federal Reserve’s actions in 2022 on inflation levels?
High inflation levels sustained until more aggressive monetary tightening was implemented.
Fill in the blank: The period of high inflation in the 1970s was partly driven by _______.
persistent inflation expectations.
True or False: Rising inflation expectations typically lead to lower aggregate demand.
False
What happens to real interest rates when deflation is anticipated?
Real interest rates increase, discouraging borrowing and investment.
How can higher real interest rates affect the economy during deflation?
They can exacerbate economic downturns by reducing aggregate demand.
What historical event is associated with deflation from 1929 to 1939?
The Great Depression.
What was a key consequence of deflation during the Great Depression?
Higher real interest rates despite nominal rates approaching the zero lower bound.
What role did the Federal Reserve play during the Great Depression?
Its failure to counteract deflationary pressures worsened the crisis.
What period is referred to as Japan’s Lost Decades?
1990s to Present.
What triggered Japan’s prolonged period of low inflation and deflation?
The asset price bubble burst in the early 1990s.
What phenomenon occurs when expectations of falling prices keep real interest rates elevated?
Liquidity trap.
What effect does a liquidity trap have on monetary policy?
It causes monetary policy to lose effectiveness.
Fill in the blank: Deflationary expectations can lead to _______ real interest rates.
higher
True or False: Higher real interest rates encourage borrowing and investment.
False
What is a key effect of declining industrial output during deflation?
Mass unemployment.
What is the primary purpose of inflation targeting by central banks?
To anchor expectations and maintain economic stability
Inflation targeting helps manage public expectations regarding future inflation rates.
Why is the credibility of monetary authorities important in inflation targeting?
It ensures that inflation expectations remain aligned with policy objectives
Credibility affects how effectively a central bank can guide inflation expectations.
When did the UK adopt an explicit inflation target and what was the target percentage?
In 1997, with a target of 2%
This adoption was aimed at enhancing the credibility of monetary policy in the UK.
What external events did the UK’s inflation targeting help stabilize inflation against?
The 2008 financial crisis and Brexit uncertainty
Anchored expectations played a crucial role in stabilizing inflation during these turbulent times.
What significant monetary policy action did Paul Volcker take during the Volcker Disinflation?
Pursued aggressive interest rate hikes, pushing nominal rates above 15%
This strategy was aimed at breaking entrenched inflation expectations.
What was one consequence of the aggressive interest rate hikes implemented by Volcker?
It temporarily caused a sharp recession
The recession was a trade-off to restore credibility and control inflation.
What was the result of the Volcker Disinflation in terms of inflation?
Successfully restored credibility and tamed inflation
The policies implemented during this period were effective in reducing inflation rates.
What is forward guidance?
A tool used by central banks to influence expectations by signaling future policy directions.
How does forward guidance affect market behavior?
It shapes market behavior even before adjusting interest rates.
What period is associated with the Federal Reserve’s use of forward guidance?
2012-Present
Why did the Federal Reserve use forward guidance after the Great Recession?
To reassure markets and facilitate economic recovery.
What conditions did the Fed signal would lead to a change in interest rates?
When inflation and employment met targets.
True or False: Forward guidance is only effective after interest rates are adjusted.
False
Fill in the blank: Forward guidance helps to influence _______ by signaling future policy directions.
expectations
What was a key goal of the Federal Reserve’s forward guidance?
To facilitate economic recovery.
What is the ‘Expectations Conundrum’ in economics?
The Expectations Conundrum refers to the phenomenon where expectations can be self-fulfilling, leading to anticipated inflation materializing due to behavioral responses.
What are self-correcting mechanisms in the context of economic expectations?
Self-correcting mechanisms occur when central banks react swiftly to counteract inflation expectations, preventing them from materializing.
What is the challenge in managing inflation expectations?
The challenge lies in distinguishing transitory inflation from persistent trends.
What happens when nominal rates approach zero?
Central banks lose traditional policy effectiveness.
What are unconventional policy measures used by central banks?
Unconventional measures include quantitative easing (QE) to influence expectations.
What policy has the European Central Bank (ECB) adopted since 2014?
The ECB has adopted negative interest rates to counter deflation risks.
What is the goal of the ECB’s negative interest rates?
The goal is to lower real rates and boost demand.
Fill in the blank: When nominal rates approach zero, central banks utilize _______ to influence expectations.
[unconventional measures]
True or False: Self-fulfilling expectations always lead to positive economic outcomes.
False
