The Self-Fulfilling Nature of Inflation Expectations Flashcards
What is the wage-price spiral?
A feedback loop where higher inflation expectations lead workers to demand wage increases, causing firms to raise prices, which further fuels inflation.
This phenomenon illustrates how inflation can perpetuate itself through the actions of workers and firms.
What historical period is characterized by high inflation and stagnant economic growth?
The 1970s stagflation.
This period particularly affected the United States and the United Kingdom.
What events exacerbated stagflation in the 1970s?
Oil price shocks in 1973 and 1979, and expansionary monetary policies in preceding years.
These factors contributed to the economic conditions during that decade.
What was the peak inflation rate in the UK during the 1970s?
24.2% in 1975.
This peak was driven by strong union bargaining power and government policies.
What government policy in the UK linked wages to inflation?
Wage indexation.
This policy aimed to help workers keep pace with rising prices.
Who was the Federal Reserve chairman during the 1970s who failed to control inflation?
Arthur Burns.
His policies contributed to expectations of persistently high price growth.
What action did Paul Volcker take to reduce inflation expectations in the early 1980s?
Aggressive monetary tightening, raising interest rates to nearly 20%.
This strategy was successful in curbing inflation expectations.
Fill in the blank: The wage-price spiral occurs when workers anticipate higher inflation and demand _______ increases.
[wage]
This demand is crucial to maintaining their real purchasing power.
True or False: The wage-price spiral is a self-reinforcing cycle.
True
The cycle continues as each action by workers and firms leads to further inflation.
What is the primary focus of central banks to prevent inflationary spirals?
Expectation management
Central banks manage public expectations regarding inflation to stabilize the economy.
Which country first adopted inflation targeting?
New Zealand in 1990
New Zealand’s adoption of inflation targeting set a precedent for other countries.
When did the Bank of England adopt inflation targeting?
1997
The Bank of England followed New Zealand’s example in implementing inflation targeting.
What is the purpose of committing to a stable inflation rate, such as 2%?
To influence wage negotiations and price-setting behavior
A stable inflation rate helps manage economic expectations and reduces inflation risks.
What risk is reduced by managing expectations around inflation?
The risk of runaway inflation
Effective expectation management can prevent inflation from spiraling out of control.
What happens when economic agents expect prices to fall?
They alter their behavior in ways that reinforce deflation.
How do consumers respond to deflationary expectations?
They delay purchases in anticipation of lower future prices.
What is the impact of consumers delaying purchases on aggregate demand?
It reduces aggregate demand.
What actions do firms take when they face weaker sales?
They cut prices, wages, or production.
What was the approximate percentage fall in the US price level during the Great Depression?
Approximately 25% between 1929 and 1933.
What behavior did households and firms exhibit during the Great Depression?
They hoarded cash instead of spending or investing.
What was the peak unemployment rate in the US during the Great Depression?
25% in 1933.
What was the Federal Reserve’s response during the Great Depression?
It failed to provide adequate monetary stimulus.
By what percentage did the money supply shrink during the Great Depression?
About 30%.
What does the Great Depression illustrate about deflationary expectations?
The risks of becoming self-fulfilling and deepening economic downturns.
What economic phenomenon is highlighted by the Japanese Lost Decade?
Persistent deflation discouraged spending, leading to economic stagnation.
What was a notable monetary condition in Japan during the Lost Decade?
Near-zero interest rates.
Fill in the blank: During deflationary periods, firms may cut _______.
prices, wages, or production.
True or False: Deflationary expectations can lead to increased aggregate demand.
False.
What institution plays a key role in shaping inflation expectations?
Central banks
Institutions like the Bank of England and the Federal Reserve are examples.
How do central banks communicate to shape market expectations?
Through policy goals and forward guidance
Clear inflation targets also help in this process.
What is the purpose of forward guidance and clear inflation targets?
To reduce uncertainty and prevent inflation or deflation spirals.
What type of policies are implemented during inflationary periods?
Contractionary policies
Examples include higher interest rates and reduced government spending.
What type of policies are utilized during deflationary threats?
Expansionary policies
Examples include quantitative easing and fiscal stimulus.
What was the UK’s response to COVID-19 in terms of fiscal and monetary policy?
Massive fiscal stimulus and monetary expansion by the Bank of England.
What effect did the UK’s response to COVID-19 have on deflation?
Helped prevent deflation despite an initial demand shock.
What role do strong trade unions play in inflation?
They can prolong inflationary spirals through wage bargaining.
How can wage stagnation affect inflation?
It can exacerbate deflationary pressures
An example is Japan’s Lost Decades.
