Questions: Inflation Expectations and Expectation Formation

Question 1

Workers in a wage negotiation expect 5% inflation next year and successfully demand 5% wage increases to protect their real purchasing power. Firms, facing higher labor costs, raise their prices by 5% to protect margins. Demand conditions are moderate and there are no supply shocks. What happens to actual inflation?

• A. Inflation remains low because there is no demand-pull or cost-push pressure from real economic conditions
• B. Inflation rises toward 5% because the wage increases raised costs and firms passed them through — a self-fulfilling cycle
• C. Inflation falls because higher wages reduce corporate profits, forcing firms to cut prices
• D. Inflation depends only on the money supply; wage expectations have no independent effect

Answer: (B)

This is the self-fulfilling mechanism at the core of inflation dynamics. Workers expecting 5% inflation demand wages that are 5% higher. Higher wages raise production costs. Firms raise prices to protect margins. The expectation of 5% inflation generates 5% inflation even without any independent demand or supply shock. This is why expected inflation appears directly as a term in the New Keynesian Phillips Curve — it is not merely a forecast error correction, it is a causal force.

Question 2

The U.S. Federal Reserve raised interest rates very aggressively in 2022–2023, even as supply-chain pressures began easing. Which concern best explains the urgency of these hikes?

• A. The Fed was worried GDP growth was too fast and needed to be slowed independently of inflation
• B. The Fed was preventing long-run inflation expectations from becoming unanchored, which would trigger a self-reinforcing wage-price spiral
• C. The Fed was following adaptive expectations, mechanically updating policy based on past inflation realizations
• D. The Taylor rule mechanically required these increases regardless of whether expectations were at risk

Answer: (B)

The primary concern was expectations anchoring. If workers and firms began to expect chronic high inflation — updating their long-run expectations upward — the self-fulfilling mechanism would kick in at scale: wages would rise, costs would rise, prices would rise, validating the expectations. This is the 1970s lesson. Acting aggressively early maintains central bank credibility and keeps long-run expectations fixed at the target, preventing the much harder task of breaking entrenched inflation expectations later.

Question 3

Under rational expectations, a credible central bank announcement of a lower inflation target can reduce actual inflation before any interest rate changes take effect.

• T. True
• F. False

Answer: True

Under rational expectations, agents use all available information to form forecasts. If a central bank credibly commits to a lower inflation target, workers and firms immediately incorporate this into their wage and price decisions — because they believe the bank will follow through with policy to achieve it. Expected inflation falls, and since expected inflation feeds directly into actual inflation through the wage-price mechanism, actual inflation declines without waiting for the full policy path to play out. Credibility is the mechanism that makes announcements themselves disinflationary.

Question 4

Rational expectations means that economic agents correctly predict the future in most period, leaving no room for forecast errors.

• T. True
• F. False

Answer: False

Rational expectations means forecasts are unbiased on average — agents use all available information efficiently and do not make systematic, predictable errors. But it does not mean perfect foresight. Inherently uncertain future events cannot be predicted exactly; random shocks always produce forecast errors. The key distinction is between random (unforeseeable) errors, which rational expectations allows, and systematic errors (e.g., always underestimating inflation), which rational expectations rules out. Adaptive expectations, by contrast, can produce systematic errors during trend changes.

Question 5

Explain why inflation expectations are self-fulfilling. What does this imply for the importance of monetary policy credibility?

Model answer: When workers expect inflation, they demand higher wages to maintain real purchasing power. When firms expect higher wages and input costs, they raise prices pre-emptively. Both actions cause the inflation that was expected — the expectation produces the outcome it anticipated. This self-fulfilling property means a central bank whose inflation target is credible has a powerful advantage: anchored expectations keep actual inflation near the target even during temporary shocks, because wages and prices are not reset upward pre-emptively. A bank that loses credibility faces the reverse: unanchored expectations generate inflation that validates and reinforces those expectations, requiring much more contractionary policy — and much more economic pain — to bring inflation back down.

The self-fulfilling mechanism is why the concept of anchoring is central to modern monetary policy. It also explains why fighting inflation after expectations become unmoored is so costly (as the Volcker disinflation demonstrated) versus maintaining credibility continuously.